Debt’s Double-Edged Sword

Debt is a double-edged sword. Sometimes it provides opportunity to invest for the future and sometimes it robs the future of prosperity.

Debt also contains one immutable law – it must always be repaid, either by lender or borrower. The lender assumes a loss in the event that the borrower defaults. This law applies to all types of debt: personal, business and government.

The business pages of this morning’s newspaper contained a story about the Nine television network. It’s a business with an estimated profit of $250 million dollars. However, those earnings are smashed by the crippling debt load estimated at a massive $4 billion. The result could see the network placed into receivership and the current owners lose their investment.

There is also a growing list of individuals who have been so mired in debt that they see no way of getting out of the financial hole they have dug for themselves. When debt repayments exceed 10 or 20 or 30 per cent of income, individuals and families are effectively financially crippled. There is often little option other than to declare bankruptcy and try to rebuild with a clean slate.

However, concern about debt levels shouldn’t be confined to business and individuals. Globally, the sovereign debt of governments is very worrying. The level of debt is escalating at an almost exponential pace, which history suggests cannot be sustained.

In the Western world, national governments have obligations they simply cannot hope to meet. These financial commitments apply to both their citizens and to their creditors.

They are borrowing money; not to invest in future output or productivity, but simply to sustain the size of government and their welfare programs.

In the UK, government borrowing is up 22 per cent compared with the year before. In France, even with massive hikes in tax rates, the government will be running a deficit of 3 per cent of GDP. The USA has clocked up another $1 trillion of debt in less than ten months and Japan is looking to borrow to fund up to 40 per cent of their annual budget.

In effect, these countries (and others) are borrowing to simply pay the interest on their existing debt; a sure-fire recipe for a fiscal death-spiral that could cause severe complications for the world economy.

History is littered with examples of the eventual result. Whether it be the Soviet Union, Argentina or Spain, many nations have been through a sovereign debt crisis before.

In France during the 1780s, the monarchy spent 30 per cent of revenue on interest payments. Just eight years later, that proportion rose to 62 per cent. That’s when the Revolution began and led to 26 years of civil war, dictatorship and hyperinflation.

A similar effect befell the Ottoman Empire during the 19th Century. In only 11 years debt servicing rose from 17 per cent to a massive 52 per cent before they defaulted on their debt.

These are just two examples that demonstrate just how quickly financial problems can overwhelm spendthrift nations.
But is that really a scenario that could befall modern Western nations today?

Consider, for example, the United States. Ten years ago debt servicing accounted for nine per cent of revenue. It stayed that way until around the end of the decade. However, in the last three years the interest to revenue ratio has jumped exponentially to over 15 per cent. This is occurring at a time of record low interest rates and massive debasement of the domestic currency.

As the world’s largest economy, this trend is alarming enough – but the news gets worse. The US is not alone in facing the fiscal cliff.

Rarely, if ever, have we faced a potential co-ordinated financial crisis like that which could emerge globally in the years ahead. Should it eventuate, one can only hope that we have our own house in order – personally and politically.

With Australia’s national credit card limit already pushing $300 billion, thanks to just four years of financial ineptitude by the Labor Government, the task of withstanding a potential economic storm will be made much harder than it otherwise would be.