Andrew Gawith: Payback time for debt-burdened nations

The global financial crisis may not be over. The souring of sub-prime debt in the US that brought the banking system in America and Europe to its knees over 2008/09 is now largely consigned to history.

At its core the sub-prime crisis was about lending money to people who couldn't pay it back.

The question now is whether governments can pay back the massive amount of money they are borrowing to stimulate their economies. The debt servicing burdens for some are already economically and politically unsustainable, and for others, the outlook is uncomfortable.

Most of us know that managing our own personal debt is a matter of how much of our income goes to paying the interest on that debt each month.

The more of our income we are required to devote to paying interest on our mortgage the less we have to spend meeting our day-to-day needs and on the things it would be nice to have and do.

The story is similar for governments, but many are starting from an even more difficult position - they are spending more than they earn so the amount of debt they are having to service keeps rising.

Although Greece has hugged the headlines over the past month or so, underlying fiscal deficits in the big economies look equally awful: US -7.3 per cent; UK -6.8 per cent and Japan -5.6 per cent, compared to Greece at -6.0 per cent.

Furthermore, the cost of government debt is likely to rise for some countries as lenders (buyers of government bonds) demand higher interest rates as they come to grips with the fact that even sovereign debt carries risk.

The simple fact is that most developed countries are going to face an increase in their debt servicing costs over the remainder of the decade.

British historian Niall Ferguson estimates that US and UK public debt servicing costs will rise to around 10 per cent of GDP by 2020. That suggests that roughly a quarter of US tax revenues could be required to meet interest payments on government debt by the end of this decade.

By comparisons the cost of servicing public debt in New Zealand peaked in the second half of the 1980s at around 8 per cent of GDP.

Large fiscal deficits add to the pile of debt that needs to be serviced. Rising debt servicing costs require ever more stringent fiscal policy - increased taxes or lower government spending, or both.

That almost certainly translates into slower economic growth and that in turn means weaker growth in tax revenues (or possibly a shrinking tax take), and more social spending (unemployment, health).

Deficits become intractable, economic growth withers and a vicious cycle sets in. Some smaller European governments are clearly teetering on the edges of this whirlpool.

The financial crisis is in fact a debt crisis - people and now countries have borrowed money they will have great difficulty paying back (and some won't), and banks in particular have been guilty of investing peoples' savings in financial instruments and government bonds with insufficient concern for the associated risks.

There are two schools of thought about what to do from here. One is for the big economies at least to ignore the public debt and deficit problem until economic growth is more firmly established.

Growth, if it can be secured, is a logical and appealing solution, but that "if" is big.

The other is to cut deficits and public debt now, take the short-term hit to growth but come out the other side with a much healthier economy. But critics of this alternative argue that such an approach risks plunging the world economy back into recession.

Germany's decision to take a knife to its deficit is firmly in line with the second approach. Germany is better placed than most to try to demonstrate to fellow member states in Europe that this austerity will be good for them - its growth is the least anaemic in the eurozone, its fiscal position is one of the least bad and the lower euro will stimulate its important and successful export sector.

If Germany can't make an economic virtue out of fiscal rectitude then heaven help most other developed economies.

Japan has followed the first approach for more than a decade with little obvious success but a truly gargantuan pile of public debt. The US seems inclined to follow Japan's example for now.

The UK may be forced to tow Germany's line and the smaller European economies have no choice but to adopt harsh fiscal medicine knowing that the hit to their growth is likely to be much more severe and prolonged than Germany is likely to suffer.

Deleveraging governments' balance sheets is going to take time, and it will definitely require some painful reductions in government spending. That prospect has already generated social unrest and it's a huge challenge to the political mettle of most governments.

But the worst of the financial crisis is behind us; the current fiscal/public debt problems are likely to be resolved without a return to global recession - most governments will do almost anything to avoid that.

* Andrew Gawith is a director of Gareth Morgan Investments.