Greece could set off bigger debt bomb

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Let's play a little game called Disaster. Imagine an event that could trigger a genuine, knock 'em down, worldwide catastrophe. Think of Pearl Harbor, multiplied by 10, or even 100.

We'll limit the options to man-made events, but eliminate traditional candidates like nuclear war or co-ordinated terrorist attacks. Climate change scientists might put their money on a massive greenhouse gas-induced drought that triggers uncontrollable emigration-entire countries emptying out, their citizens swelling the populations of Europe and North America. Doomsday economists, on the other hand, could raise the spectre of a global debt bomb: When industrial and emerging economies all exceed debt thresholds, a sovereign default by one country spreads like a firestorm, and triggers a global depression.

There's no telling when, or if, the climate-change scenario could take place. Unfortunately, that's not true of the second one. Debt bomblets have already exploded. And the big one-the Daisy Cutter-is being primed for action.

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Greece is ground zero. Look at the damage the country inflicted on European debt, equity and currency markets this spring. How could a nation that accounts for less than 3% of the European Union's gross domestic product (GDP) be so destructive?

There are two possible explanations. The first is that Greece's fiscal problems belied its size. When Argentina, a country much wealthier than Greece, defaulted on its debt in 2001, the country's annual budget deficit was the equivalent of 3% of its annual GDP. Its total accumulated public debt was 50% and its yearly international current-account deficit was 2%. And Greece? Its budget deficit last year was a whopping 13.6% of GDP, its public debt was 115% and its current-account deficit was 10%.

The second is that Greece is not a special case. Some of the world's largest developed countries have budget deficits almost as large, relative to the size of their economies. The United Kingdom's deficit weighs in at 11.4% of GDP, Spain at 11.2% and the United States at 9.9%. As deficits climb, so do national debts. Federal debt in the United States has climbed by half since 2006, to $12.3 trillion (U.S.) at the end of last year, swelling the debt-to-GDP ratio to 84%. Japan and Italy have debt ratios well beyond 100%. Almost every other country in the 30-nation Organization for Economic Co-operation and Development is watching its debt ratio climb relentlessly toward triple digits. Enormous debt loads used to be a problem for emerging economies. Today those burdens are also a problem for the allegedly wealthy countries.

National debt loads in the West will continue to climb as economies struggle to recover. The debts are only affordable now because central bankers have kept interest rates near zero. Watch what happens when interest rates rise. Economic growth isn't rapid enough to stabilize debt-to-GDP ratios. Tax revenues have yet to recover, and no politician dares to take an axe to stimulus spending if it means plunging the economy back into recession. With governments, businesses and consumers still carrying such heavy debt loads, another major banking disaster could trigger another round of costly bailouts or nationalizations. Oh yes, aging populations will also inevitably create a pension crisis.

Economists Kenneth Rogoff and Carmen Reinhart, authors of the 2009 book This Time Is Different: Eight Centuries Of Financial Folly, calculated that, on average, countries add 86% to their debt loads within three years of a credit crisis. Governments of mature economies will issue an estimated $4.5 trillion (U.S.) worth of bonds this year.

The upshot is that some major countries face debt restructurings, debt defaults or both. High debt-to-GDP ratios alone can kill growth, as governments soak up private savings to pay interest charges and borrow more. Since 1980, Mexico, Russia and Argentina have all defaulted on their debt. The same thing could happen in bigger Western countries-the Daisy Cutter event.

Sovereign defaults can wreck economies. Banks can go bust as the prices of government bonds they hold plunge to cents on the dollar of face value. They can't lend any more, which paralyzes businesses big and small. Currency devaluations destroy consumers' buying power. Yes, eventually a mess can sort itself out, but that could take years, even decades. The Mexican peso crisis of 1994 walloped the rest of Latin America, and as late as 2002, some Brazilian bonds traded as low as 40 cents on the dollar.

Here's a guess: Governments will take the cowardly option and try to inflate their debts away. They won't stop spending, and the currency printing presses will run flat out. But that strategy often backfires, and the threat of default grows ever larger. Gold and productive real estate, like wheat farms, may be the defensive investor's only remaining assets of choice. Have a nice day.