Total debt-to-GDP levels in the 18 core countries of the Organisation for 2012 in written in the sandEconomic Co-operation and Development (OECD) rose from 160 percent in 1980 to 321 percent in 2010. Disaggregated and adjusted for inflation, these numbers mean that the debt of nonfinancial corporations increased by 300 percent, the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent. But the costs of the West’s aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher. (See Exhibit 1.)

Add to this sobering picture the fact that the financial system is running at unprecedented leverage levels, and we can draw only one conclusion: the 30-year credit boom has run its course. The debt problem simply has to be addressed. There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring and write-offs, and creating inflation.

Saving and Paying Back. Could the West simply start saving and paying back its debt? If too many debtors pursued this path at the same time, the ensuing reduction in consumption would lead to lower growth, higher unemployment, and correspondingly less income, making it more difficult for other debtors to save and pay back. This phenomenon, described by Irving Fisher in 1933 in The Debt-Deflation Theory of Great Depressions, can result in a deep and long recession, combined with falling prices (deflation). This is amplified when governments simultaneously pursue austerity policiesósuch as we see today in many European countries and will see in the U.S. beginning in 2012. A reduction in government spending by 1 percent of GDP leads to a reduction in consumption (within two years) of 0.75 percent and a reduction in economic growth of 0.62 percent. Saving (or, more correctly, deleveraging) will reduce growth, potentially trigger recession, and drive higher debt-to-GDP ratiosónot lower debt levels. Indeed, during the early years of the Great Depression, President Hooveróconvinced that a balanced federal budget was crucial to restoring business confidenceócut government spending and raised taxes. In the face of a crashing economy, this only served to reduce consumer demand.

For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage. Martin Wolf put it trenchantly in the Financial Times: “The Earth cannot, after all, hope to run current account surpluses with the people of Mars.” The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.

Saving and paying back cannot work for 41 percent of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.

Growing Faster. The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be doneófor example, in the U.K. after the Napoleonic Wars and in Indonesia after the 1997/1998 Asia crisis (although Indonesian debt levels were nowhere near contemporary highs in the West). Attacking today’s debt mountain would require reforming labor markets or investing more in capital stock. Neither is happening.

Politicians are unwilling to interfere in labor markets given today’s elevated levels of unemployment. Moreover, empirical evidence shows that the initial impact of such reforms is negative, as job insecurity breeds lower consumption.

Companies can afford to invest significantly more, as they are highly profitable. The share of U.S. corporate profits in relation to U.S. GDP is at an all-time high of 13 percent (as are cash holdings), yet corporate real net investment (that is, investment less depreciation) in capital stock in the third quarter of 2011 was back to 1975 levels. But companies are reluctant to invest while demand is sluggish, while existing capacities are sufficient, and while the outlook for the world economy remains highly uncertain.

The aging of Western societies will be a further drag on economic growth. By 2020, the workforce in Western Europe will shrink 2.4 percent, with that of Germany shrinking 4.2 percent.

The inability to grow out of the problem is bad news for debtors. Look at Italy, for example: Italian government debt is 120 percent of GDP. The current interest rate for new issues of ten-year bonds is 7 percentóup from 4.7 percent in April 2011. If Italy had to pay 6 percent interest on its outstanding debt, such a high rate would materially increase the primary surplus (that is, the current account surplus before interest expense) that Italy would need to run in order to stabilize its debt level. If we assume that Italy’s economy grows at a nominal rate of 2 percent per year, the government would need to run a primary surplus of 4.8 percent of GDP (calculated as 6 percent interest incurred on its debt minus 2 percent nominal growth multiplied by 120 percent debt to GDP) just to stabilize debt-to-GDP levels; the latest forecasts show only a 0.5 percent surplus for 2011. Any effort to increase the primary surplus through austerity and tax increases runs the risk of creating a downward spiral. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth, and rising interest rates.

Debt in itself makes it more difficult to grow out of debt. Studies by Carmen Reinhardt and Kenneth Rogoff and the Bank for International Settlements show that once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. Exhibit 2 shows the current debt level of key economies by sector. In all countries, the debt level of at least one sector is beyond the critical mark. Somewhat perversely, only in Greece are the two private sectors below the threshold. And only in Germany and Italy (in addition to Greece) do private households have a debt level below 70 percent of GDP.

[Note: For those not familiar, the flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain, in order. ñ JM.]

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