The Sustainability Of Government Debt Editor: The actions of its new leader, Shinzo Abe, are likely to mean that Japan will be the first major nation to “hit the wall” in terms of its out-of-control spending – something that could begin this year. The sovereign debt crisis will then likely come to Britain in 2014-15, and the US not too long after that. The funding crisis that these (and other nations) will experience will result in a severe devaluation of their currencies. Ultimately the bursting of the bond bubble will prove far more destructive than the global financial crisis of 2008.

Rising U.S. debt levels ultimately will prove to be unsustainable, so the only uncertainty is the timing of when the markets will force a change. The problem may not yet be acute, but it will become so within the next five years.

The sustainability of government debt depends on the size of the primary deficit and the gap between nominal GDP growth and borrowing costs. In the case of the U.S., GDP growth has been above interest costs, but the debt-to-GDP ratio has been rising because the primary deficit has been so large. Italy also has rising debt burdens, but for the opposite reasons: the primary balance is in large surplus but interest costs are far above nominal GDP growth. Japan has the worst of both worlds: a large primary deficit and rates modestly above GDP growth, while Germany has the reverse: a primary surplus and growth above interest costs.

The IMF provides estimates the fiscal adjustments that various countries will need in order to bring debt-to-GDP ratios back to 60% by 2030. The U.S. needs far more adjustment than the peripheral euro area countries that currently are being punished by the markets and only Japan is in a worse position. Indeed, the adjustment needed in the U.S. is more than twice the size of the fiscal cliff that currently is causing so much consternation.

Thus far, the markets have been remarkably tolerant of large U.S. fiscal deficits, and Japan has been able to live for years with massive deficits and a debt-to-GDP ratio above 100%. A world of moderate economic growth, rising private sector savings, risk-averse investors, and zero short-term interest rates has kept the bond vigilantes at bay. These conditions can last for quite a while longer, so a market riot point may be inevitable, but is nonetheless not imminent.

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