What went wrong?

A look at the world's debt

The US and the euro-zone have found themselves in trouble over their debt. They both barely survived default, but the problem is not going away easily. Where did it come from?

Economists argue that it all started with the dotcom bubble bursting and 9/11. Following the era, there was a period of extremely low interest rates that allowed people to borrow large sums of money and invest it in property, thus creating the housing market boom. With too many people now in massive debt and their houses unsold, the 2008 financial crisis that caused a global recession, followed.

In their petty attempts to save the world, governments worldwide stepped in by borrowing money to pay the banks which were loaded with bad debts. Naturally, this resulted in massive debts on the governments' balance sheets.

The US federal government alone is estimated to have spent about $1.6 trillion on its response to the financial crisis, which put a big dent in the public finances. The crisis also meant that the government received less in taxes from companies and individuals hit by the downturn.

If that was not enough, fighting wars in Iraq and Afghanistan have been another burden for the US public finances for the past 10 years, estimated to have cost about $1.25 trillion. Some also blame President Bush's tax cuts for the level of debt that the US government now finds itself dealing with.

The US

On Friday 5th of August, what some may have deemed impossible to happen, happened. The world's largest economy had its debt downgraded by the ratings agency Standard & Poor's, as it was on the edge of defaulting.

The US makes up for 26% of the global bond market, where participants buy and sell debt securities. However, owning the largest share in such market is not a good thing. Borrowers can reach a point at which they have so much debt that their credit quality worsens. Therefore, given the scale of its borrowing pile, the US no longer looked like an AAA issuer and was consequently downgrade to AA+.

Ultimately, government spending proved to have a limit, as the credit rating agency doubted whether the US is able to repay its debt.

In addition, the total US debt is expected to overtake GDP this year, which means that the US will spending more than the revenue it is generating.

The Euro-zone

The same saga applies to the euro-zone. In early 2010, Greece, Ireland, Spain and Portugal a crisis of confidence has emerged as a result of a sovereign-debt increase due to bank bailouts following the 2008 financial crisis, leading to the widening of bond yield spreads and risk insurance on credit default swaps.

In May 2011, the crisis resurfaced, concerning mostly the refinancing of Greek public debts. However, the crisis situation was brought under control when the Greek government managed to pass a package of new austerity measures to get their balance sheets on track, to be granted the EU bailout package agreed a year earlier.

In 2 May 2010, the euro-zone countries and the IMF agreed to a €110 billion loan for Greece, conditional on the implementation of harsh austerity measures. The Greek bail-out was followed by a €85 billion rescue package for Ireland in November and a €78 billion bail-out for Portugal in May 2011.

Consequently, following such bailouts from the EU, concern about rising government deficits and debt levels across the globe together with a wave of downgrading of European government debt created alarm in financial markets.

In an attempt to gain control over its finances, on 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth €750 Billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF).

Do countries grow with debt?

Debt is known to be a critical component of any economy. If kept under control, economies need a combination of debt and equity, as debt can serve as the fuel of the financial system. For centuries, we have relied on debt to maintain our standards of living, as borrowing money would allow us to buy a bigger home, better car etc.

In addition, economists argue that, to some degree, governments need to borrow more money to repay their current debt. Since more than half of the annual budget is mandatory spending, which would be difficult to cut, debt could be used as a tool to keep paying out money thus maintaining momentum in the economy.

According to a study by economists on economic growth and inflation at different levels of government and external debt, the relationship between government debt and real GDP growth is rather minimal for economies with a threshold of 90 percent of GDP. If the ration surpassed 90 percent, which means that governments are borrowing 90% of the money they are generating, the average growth rate drops considerably.