The Mother of All Bubbles: Huge National Debts Could Push Euro Zone into Bankruptcy

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In March, the rating agencies Standard & Poor's and Moody's warned that even the US's perfect triple-A rating could be jeopardized if the country's financial situation didn't change drastically soon. The third main rating agency, Fitch, had already issued a warning in January. So far, none of the three agencies has announced an actual downgrade of the country's credit rating. Economists suspect, however, that the fear of the incalculable consequences for the economy might have prevented them from doing so.

At any rate, experts like Harvard economic historian Niall Ferguson warn that confidence in the United States could be lost at some point, and that this could come as a complete surprise, with a single piece of bad news serving as a spark and potentially triggering a global conflagration.

The "alarm bells should be ringing loudly" in the United States, says Ferguson. He points out that historically, large empires like the Roman Empire and the Chinese Ming dynasty also fell into decline because they had overextended themselves economically.

Warnings like this help explain why US Secretary of State Hillary Clinton defines the crisis as one of historic dimensions. She has argued that the deficit and debt should be viewed "as a matter of national security, not only as a matter of economics."

Safe Haven

Surprisingly enough, the dollar has managed to make its way through all the turbulence seemingly unscathed. On Wall Street, US securities, particularly American treasury bonds, are still considered a safe haven for investors' money.

By studying financial crises over the centuries, US economists Kenneth Rogoff and Carmen Reinhart have calculated an average value at which the debt burden starts to become critical for a country: 90 percent of GDP. Above that level, economies achieve only half as much growth as those that are not as heavily indebted. This key indicator is currently at about 84 percent in the United States, but in two years the Americans are expected to surpass the 100-percent mark. In other words, time is of the essence.

Unless the United States takes drastic steps immediately, the public debt will amount to more than 300 percent of GDP by 2050, according to calculations by the Center on Budget and Policy Priorities, the leading fiscal policy think tank in Washington.

The prospects are not one iota better on the other side of the world in Japan. Its economy is even more indebted, with the debt burden amounting to almost twice the country's annual economic output. However, hardly any of Japan's creditors are abroad. Instead, most are government institutions and Japanese citizens, so that at least their fate lies in their own hands.

Increasing Burdens

Nevertheless, the Japanese debt crisis will likely be just as difficult to resolve. Some 22 percent of all Japanese are older than 65 today, and in two decades, when a large percentage of baby boomers will have entered retirement, that number is expected to climb to 30 percent. The burdens that will be imposed on pension funds and the healthcare system by an aging society will cause debt service to continue to rise dramatically in the future, particularly in Japan, but also in several European countries.

In Britain, new borrowing has already reached Greek dimensions. The national debt has grown by more than half in only two years, and this year, the budget deficit is expected to make up close to 13 percent of GDP. Rescuing institutions like the Royal Bank of Scotland has come with a price. According to recent figures, the government has already spent about 200 billion pounds (€230 billion, $306 billion) to support the financial industry.

And now the country will go to the polls on Thursday. There are many indications that the result will be a hung parliament, so that the new government will lack the strength to make unpopular decisions.

"Many industrialized countries face enormous fiscal policy challenges to rectify their escalating government debt," a current study by Deutsche Bank Research concludes.

Relatively Unscathed

So far, Germany has come through the crisis relatively unscathed, compared with other Western industrialized nations. While Britain and the United States are showing deficits of more than 10 percent of annual economic output for 2009 and 2010, Germany's budget deficit only totaled 3.2 percent in 2009, which is only slightly higher than the euro zone's 3-percent ceiling. This year, the deficit is likely to climb to about 5.5 percent.

Unlike most other countries, Germany entered the deepest recession of the postwar era with a balanced budget. As a result, the federal government had to take on less new debt to support the economy and banks during the crisis, as well as to fund the higher costs of rising unemployment.

But the absolute figures of German indebtedness reveal the true scope of the challenge. State institutions have borrowed some €1.7 trillion, with more than half of the total attributable to the federal government, which exceeded the €1 trillion threshold last year. The country's states owe a total of €526 billion and municipalities are €112 billion in debt.

To date, there has been no question on the financial markets that Germany's federal government, as well as its state and local governments, will live up their obligations. Germany, with a triple-A rating, is considered a borrower with a credit risk of almost zero. German government bonds set the benchmark in Europe. As a result, all three levels of government can borrow money at relatively favorable rates.

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• Part 1: Huge National Debts Could Push Euro Zone into Bankruptcy
• Part 2: Living Beyond Their Means
• Part 3: Calls to Eject Greece from the Euro Zone
• Part 4: 'Panic Is Slowly Taking Hold'
• Part 5: How Empires Fall
• Part 6: A Tough Course of Cold Turkey