CALL it the rich-uncle theory. When the private sector struggles, governments often step in to pick up the bill. And when individual countries have trouble meeting their commitments, they turn to their neighbours, or to the International Monetary Fund, for help.

The recent recession, and the financial crisis that precipitated it, have led to a sharp increase in government debt in the developed world, on a scale virtually unprecedented outside world wars. For some states this burden has arisen at a time when their finances were already stretched. And for most countries in the rich world this has happened when they are having to face up to a range of problems associated with ageing populations.

Countries have long had a complicated relationship with their national debt. It was the need to repair its national finances that forced the ancien regime of Louis XVI in France to summon the Estates-General in 1789, an event that triggered the French revolution. In his book, “A Free Nation Deep in Debt”, James Macdonald argues that the national debt was a source of strength for countries such as Britain and the Netherlands, whose governments were financed by merchants and bankers. In wartime such countries could easily outspend those run by aristocrats, which had a history of default. For Britain and the Netherlands there was no incentive to default on the debt owed to the classes that controlled them.

During the first and second world wars governments on both sides of the conflict exploited the patriotism of their citizens, persuading them to buy “victory” bonds and the like. Those same governments then penalised the patriots by inflating away their debt after the war. From 1945 onward government debt became a tool of economic management as Keynesian deficit spending was used to cushion economies during recessions. The booms of the 1980s and 1990s led to a surge in tax revenues and kept the debt problem under control. But the recent financial crisis caused some of the biggest deficits recorded in peacetime. The debt-to-GDP ratio of the G7 group of nations is at its highest level for 60 years (see chart 5).

That has started to raise questions about whether countries can actually meet the bill. Allowing governments to assume debt has some obvious advantages. If companies, and in particular banks, go bust, they cause a lot of knock-on social costs, including lost jobs and consumer uncertainty.

Governments are much less vulnerable to credit runs because they can raise taxes and print money to buy time for the debt shock to be absorbed. Governments also find it easier to fund deficits during recessions, when nervous investors are only too happy to shelter behind the safety of government bonds. But in the long run deficit financing is the equivalent of a private individual getting a new credit card and making the minimum repayment every month. For a while it seems like free money. The tricky point comes when the credit limit is reached.

For governments, that credit limit can vary enormously. One reason why the crisis has hit the euro zone before other regions is that its countries have renounced the money-printing and devaluation options by adopting a common currency. In some ways the problems facing euro-zone members are akin to those facing countries on the gold standard in the 1930s. They had to choose between imposing austerity to maintain the standard or repaying creditors in devalued currency. The countries that went off gold soonest tended to recover fastest. But abolishing the link to gold was far easier than it would be to replace, say, the euro with a new drachma.

With luck, today’s government deficits will be temporary, gradually disappearing as the private sector comes to the fore again. Countries recovered from even bigger government debt burdens after the second world war. But at that time the personal, industrial and financial sectors of the economy were much less indebted.

Economists are still arguing about how quickly to cut government deficits. Earlier this year the different schools sent rival letters to the Times, discussing the suitability of early efforts to cut Britain’s budget deficit (the new coalition government announced cuts of £6 billion in May). The fear is that higher taxes and spending cuts will cause job losses and hit demand at a point when the economy is still fragile.

The doves contend that the first priority should be to stimulate growth, since that will automatically raise tax revenues and cut expenditure on items such as unemployment benefits. The hawks counter that there comes a point when further deficits are self-defeating. Carmen Reinhart and Kenneth Rogoff suggest that the crunch arrives when the debt-to-GDP ratio reaches around 60% in emerging markets and 90% in developed economies. In rich countries median growth rates tend to fall by around one percentage point a year once that limit is reached.

When debt gets too high, a number of problems arise. First, a spiral is set off in which lower credit ratings for a country lead to higher borrowing costs, in turn increasing the deficit. Markets already seem unwilling to fund some countries at sustainable rates: by the time Greece turned to the IMF and its EU partners for help, its short-term bond yields were nearly 20%. Ramin Toloui of PIMCO, a fund-management group, explains the process this way: “When government debt reaches extreme levels, concerns about government creditworthiness become so severe that additional government spending produces increases in long-term interest rates that exacerbate, rather than ameliorate, the economic contraction.”

Second, once a country is stuck in this debt trap, it has to bring in austerity programmes to reduce the deficit; but such austerity holds back economic growth because higher taxes and lower spending reduce demand. Like the Red Queen in Lewis Carroll’s “Through the Looking-Glass”, the country has to run as fast as it can just to stand still. Ireland has been the good boy of the sovereign-debt markets, taking quick action to reduce its deficit through measures such as cutting public-sector pay. But other countries may not be in a rush to emulate it: its nominal GDP has fallen by over 16%.

Third, larger government deficits imply greater government interference in the economy and thus a less efficient use of resources. One study found that each percentage-point increase in the share of GDP devoted to government spending reduced growth by 0.12-0.13% a year.

Last, according to the doctrine of Ricardian equivalence, consumers and businesses see larger deficits as the precursor to higher taxes in future, so they save more of their income, meaning that pump-priming by the government ceases to work.

Even those governments that are tempted to keep stimulating the economy may find that the markets punish them for it. Once a crisis of confidence has occurred, governments find it difficult to raise the money they need at an acceptable interest rate. A report by an economic adviser to the Bank for International Settlements in March noted that “our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.”

Countries that decide to embark on deficit reduction may face another problem. According to Andrew Smithers of Smithers & Co, a consultancy, a debt-cutting policy will make it harder for the government to bail out the private sector in times of need, as well as reducing companies’ cashflow by imposing higher taxes.

An even bigger problem may be the unfunded liabilities that government face from ageing populations. This is a double burden: benefits for growing numbers of pensioners will have to be paid for by a shrinking band of workers. These liabilities are difficult to calculate. Pierre Cailleteau of Moody’s, a rating agency, says that “the state of public-finance accounting is extremely rudimentary relative to private-sector accounting.”

A 2009 report by Jagadeesh Gokhale, of the right-wing Cato Institute in Washington, DC, estimated that the average EU country would need a fund worth 434% of its GDP, earning interest at the government’s borrowing rate, to meet such liabilities; alternatively, it would need to save 8.3% of its GDP each year. Neither seems realistic. The only answer is to cut future benefits. But the elderly form a powerful voting block, with a higher turnout than their children, who will pay the bill.

European extremes

Neither Greece nor Iceland has had any choice about tackling its deficits. They may be a long way apart, both geographically and culturally, but both are casualties of the debt crisis. Iceland was the little country that could. A land with just 300,000 people, best known for its volcanoes and its fish, it privatised its banks and suddenly became an international financial powerhouse. “In the Icelandic system, all the banks were aggressive broker-dealers like Bear Stearns and Lehman,” says Asgeir Jonsson, an economist and author of a book, “Why Iceland?”.

A high exchange rate encouraged its corporate sector to go on an overseas acquisition spree. Its housing market boomed as fishermen took out cheap loans in euros and yen. The country became an egregious example of the excesses of financial liberalisation. Its politicians failed to halt its debt spiral because its citizens (and particularly its elite) seemed to be doing well out of the boom. Houses doubled in price, the strong krona allowed its people to go shopping in London and its billionaires to buy British retailers and football clubs.

Greece, for its part, was not noted for an aggressive banking sector or a housing boom. It was traditionally dismissed by investors as a country of high inflation and repeated devaluations. When it joined the euro zone in 2001 it reaped an immediate dividend in lower interest rates, but it failed to tackle its underlying problems.

Dodgy accounting disguised the size of its government debt. Its businesses remained uncompetitive, causing a large trade deficit. The economy is riddled with inefficiencies and restrictive practices. For example, cruise ships are not allowed to take on new passengers at Greek ports, and the number of lorry licences is still the same as in 1990 even though GDP has doubled. Such restrictive practices are keeping transport costs too high. According to Yannis Stournaras of IOBE, a think-tank, it is cheaper to transport goods to Athens from Italy than from Thebes, just 32 miles away.

Greece is an exemplar of the flaws in the European welfare model. The state gets remorselessly bigger because political parties of the right and left have bought votes by providing supporters with jobs or subsidies. Antonis Kamaris of Levant Partners, an investment group, says the state must “remove benefits that have built up like a ship accumulates barnacles”. Public-sector workers were mollycoddled with pay for 13 or 14 months per year and arcane allowances for things like firewood or carrying files between office floors.

Tax evasion is widespread. A report by the London School of Economics estimates that it reduced Greece’s potential tax yield by 26%. It is normal to do deals under the table. On the birth of his baby daughter one parent was asked to hand over €2,500 in cash to the doctor, in exchange for a receipt for €1,500. The Greeks are attempting to tackle this issue. The austerity packages introduced over the past 12 months require higher earners to provide receipts for expenditure before they can qualify for their tax-free allowance.

Market discipline did not work in either country. Greece benefited from the implied credit upgrade provided by joining the euro zone. Iceland, with its high interest rates, got a boost from the “carry trade”, with investors borrowing money in low-yielding currencies (eg, the yen) and buying high-yielding ones (eg, the krona). “It was a classic case of monetary boom and bust,” says Thordur Palsson, a former chief economist at Kaupthing, a big Icelandic bank. “The money supply increased at 40% a year over a five-year period.”

Both economies face fundamental difficulties. For Greece, being a member of the euro zone is now a hindrance rather than a help. Its costs are too high but it cannot devalue its currency, and trying to inflate its way out of its debt would, in effect, be impossible. Iceland, which is not a member of the European Union, has been able to devalue the krona, but that created a problem for individuals and companies which had borrowed in foreign currencies. Its banks had to be nationalised and domestic depositors were favoured over foreign creditors.

Both countries have had to call in outside help. The Icelanders have borrowed from the IMF, with their negotiations made more complex by a dispute with Britain and the Netherlands over compensation for foreign depositors in one of its big banks. Iceland is trying to reduce its fiscal deficit, which in 2008 reached 13.6% of GDP, via increases in value-added tax, income tax, and petrol and alcohol duties. Rising unemployment has prompted many Icelanders to emigrate, causing the population to fall for the first time since the 19th century.

In Greece spiralling debt costs also forced the government to turn to the IMF as well as to its EU partners. But it remains to be seen whether the population will tolerate the austerity needed to bring the debt burden down to a reasonable level. The most recent package of cuts provoked a wave of strikes and riots in which three bank employees died.

America also faces a huge debt problem. The Congressional Budget Office calculates that the federal government will accumulate a deficit of $10 trillion between 2011 and 2020, and even that depends on some fairly optimistic assumptions about economic growth. Unless policies are changed, total government debt will reach 100% of GDP by 2023. There are unfunded liabilities on top of that. Chris Watling of Longview Economics reckons that the net present value of spending commitments under the Medicare, Medicaid and Social Security programmes is 276% of GDP. The Democrats resist cuts in entitlements and the Republicans resist tax increases, so nothing much gets done. Efforts to establish a bipartisan deficit-cutting commission have failed.

Advantage America

But America has two huge advantages over other countries that have allowed it to face its debt with relative equanimity: possessing both the world’s reserve currency and its most liquid asset market, in Treasury bonds. Even in the midst of the credit crunch, when some of the biggest Wall Street banks were collapsing, the dollar rose and Treasury bond yields fell, making it easier and cheaper for America to finance its deficit. There may come a time when America is hit by a funding crisis, but it does not look imminent.

America would be more at risk if the Asian central banks and sovereign-wealth funds had an obvious alternative. But with Europe in the midst of its own debt crisis, the euro does not look like an appealing option. And there is simply not enough gold in the world to absorb a substantial portion of central-bank reserves. For the moment, the dollar is the one-eyed currency in the land of the blind.

Judging the judges

The travails of the rating agencies

Jun 24th 2010

THE rating agencies did not have a good debt crisis. They were accused of being, at best, naive about the safety of complex structured products such as collateralised debt obligations (CDOs) and, at worst, being less than impartial because of the fees they got from issuing CDOs.

Now companies such as Standard & Poor’s, Moody’s and Fitch are back in the limelight. Every time they change the rating of a sovereign debt they move the markets. For a while the rules of the European Central Bank seemed to give enormous power to just one agency, Moody’s. Had it downgraded Greece, the country’s government bonds would not have been eligible for use as collateral for loans from the ECB. (The ECB eventually amended the rules to accept Greece’s bonds, whatever their rating.)

More recently the agencies have been accused of being too harsh, and even of being part of an Anglo-Saxon conspiracy to hold down the southern European nations. Countries have been outraged by downgrades. There has been talk of setting up a rival European rating agency. The agencies put up a vigorous defence, pointing to the good record of their ratings in predicting sovereign default rates. No country rated AAA, AA or A has gone on to default for 15 years. Nearly 98% of countries ranked AAA were still ranked either that or AA 15 years later.

When Standard & Poor’s downgraded Greece to junk status in April, David Beers, its head of sovereign ratings, put the move into perspective: “We provide an independent view that investors may or may not choose to consider. Ratings are one of many inputs that investors look at, and they are only one of many factors that may affect movements in the market.”

Mr Beers argues that people may be paying too much attention to maintaining the top AAA rating: “People’s perceptions are that a downgrade from AAA means that minutes later you default, but in fact it means only a slight increase in default risk.” But Pierre Cailleteau of Moody’s says that “because of the crisis we have to define the boundary between AAA and AA ratings very clearly.” The agency uses three concepts: economic and institutional strength, government financial strength and susceptibility to event risk.

Mr Cailleteau says the key measure is not the debt-to-GDP ratio but the proportion of government revenues devoted to interest payments. Once that proportion exceeds 10%, keeping the AAA rating becomes more difficult. But the agency will not downgrade the country if the government is committed to decisive action to reduce the deficit.

But what constitutes decisive action? In judging that, the rating agencies are bound to be drawn further into tricky political territory. For example, they will have to weigh the new British coalition’s plans to deal with its deficit, and assess how far EU countries are likely to go in bailing out their indebted fellow members. One thing is certain: the agencies will be shot at from all sides.

In a hole

Stagnation, default or inflation await. The only way out is growth

Jun 24th 2010

THERE is an old joke about a stranger who asks a local for directions and gets the cheerful reply: “If I wanted to go there, I wouldn’t start from here.” That advice sums up the dilemma the developed countries face in dealing with their debt. They have accumulated a mountain of it at every level, from the personal to the corporate and the sovereign. As this special report has shown, this was encouraged by a legal system that sheltered debtors, a corporate and financial sector that used debt to boost its returns and a cultural change that made it more respectable.

Central banks and governments implicitly guaranteed this debt, riding to the rescue whenever a repayment crisis loomed. They intervened in a host of small financial fires, using low interest rates to put out the flames. But this merely allowed the tinder to build up that set off the huge conflagration of 2008. Now the governments’ own balance-sheets have deteriorated. In America the amount of government debt per person has risen from $16,000 in 2001 to $34,000 now, and household debt has gone up from $27,000 to $44,000. In Britain government debt per head has almost trebled, from £5,000 in 2001 to nearly £18,000 today, and household debt has jumped from just under £14,000 to £24,000.

Cutting the debt back to more acceptable levels is both hard and unappealing, since it may involve years of austerity and slow economic growth. It also requires some tough political decisions. If being able to borrow makes people feel richer (however illusory the sensation), having to repay the debt makes them feel poorer. They resent the sacrifices involved, especially if they are imposed by outsiders. This is particularly true in democracies. In a referendum Icelanders voted overwhelmingly against a debt repayment deal with Britain and the Netherlands.

Dani Rodrik, an economist at Harvard, has talked of a “trilemma” in which countries aiming for the three goals of deep economic integration with the rest of the world, national sovereignty and democratic politics can achieve two of them but not all three. Left to themselves, voters will resist the sacrifices needed to remain competitive in a system of deep economic integration, and nation states are constantly erecting barriers to international trade. One way of eliminating those barriers would be to set up some sort of global federal government. Another would be to install a “free-market Stalin”—a figure in the mould of Chile’s Augusto Pinochet—who would force his country’s citizens to accept the constraints of the global market, including debt repayment. Neither option is appealing.

The citizens of Europe may now be realising that debt transfers power from the borrower to the creditor. The first world war destroyed Britain’s credit position and ushered in the era of American financial dominance. Now the debt burden reflects the shift in the balance of economic power from rich countries to developing ones. It is striking that on average developed countries now have a higher debt burden than emerging nations. Investors have certainly noticed, and have poured money into emerging-market bonds funds over the past year. Developing countries also have more chance of outgrowing their debt burdens. According to Tony Crescenzi of PIMCO, investors are asking themselves, “Would I rather lend money to nations whose debt burden is worsening, or to nations where it is improving?”

This pattern of debt is the opposite of what you might expect. At the level of individual consumers, people tend to borrow when they are young because they are hoping for higher incomes in the future. As they reach middle age they start to pay off their debts and save for retirement. By extension, rich countries with their greying populations should be saving whereas younger, fast-growing developing countries should be borrowing heavily. But in fact it is the other way round.

This is not unalloyed joy for the creditor nations. Once the exposure of a creditor to a borrower gets sufficiently large, the two sink or swim together. The relationship between China and America has been described as vendor financing, in which the Chinese lend the Americans the money to buy their cheap manufactured goods; a collapse in American demand would cause substantial unemployment (and social unrest) in China.

The longstanding system of vendor financing may have encouraged the rich world to concentrate on consumption rather than investment and to enjoy the resulting “artificial” growth, like a child on a sugar high. Richard Koo, who wrote a book about the Japanese recession, “The Holy Grail of Macroeconomics”, refers to a debt-financed boom as “cherry-blossom” economics. He recounts the tale of the two brothers who bought a barrel of sake to sell to revellers at Japan’s cherry-blossom festival. But instead of taking money from the thirsty crowd, each brother charged the other for a cup of sake, then used the proceeds to buy a cup for himself, and so on. The brothers ended the day drunk and empty-handed.

Jeremy Grantham of GMO, a fund-management group, is a detached and cynical observer of the financial and economic scene. The way he sees it, “all debt seems to do is bring growth forward a little. If you get people to spend 1% more than their income every year, after 20 years they are going backwards because interest expense is eating up more of their salary.”

Robert Bergqvist, chief economist at SEB Group in Sweden, is equally pessimistic. “The leverage-led growth model is dead,” he says. “Households and corporates can increase borrowing and enhance today’s consumption and investments but that requires that we can assume higher future incomes and expected returns and/or rising asset values. And this is not certain.”

Running out of ammunition

The debt burden may also have had a distorting effect on economic policy. In the 1960s and 1970s governments grappled with a wage-price spiral in which demands for higher wages forced companies to increase their prices, which in turn triggered demands for higher wages. The past two decades have seen a debt-interest rate spiral. It starts off with the private sector borrowing a lot of money. This is followed by a crisis in which the central bank cuts interest rates to help borrowers. That encourages the private sector to borrow more, which makes it all the more imperative for central banks to come to the rescue when the next crisis comes along. With short-term interest rates now at 1% or less in America, Britain, Japan and the euro zone, this process cannot go any further.

If the 1960s and 1970s produced consumer inflation, the debt-interest rate spiral created asset inflation. In 2000 this pushed share prices to unprecedented peaks; indeed many stockmarkets have yet to regain the levels they reached a decade ago. Now the support of asset prices has entered a new stage, with central banks buying assets (in particular, government and mortgage-backed bonds) directly to boost the financial sector.

Indeed, that sector was the biggest beneficiary of this spiral. Before the credit crunch it generated some 35% of all domestic profits in America. A highly sophisticated society would be expected to spend quite a lot on finance, but that figure still looked too high. “We have been transferring aggregate income and wealth to the financial-services industry. All this financial activity is just a deadweight on the system,” says Mr Grantham.

During the debt boom the optimists argued that the huge growth in derivatives did not add to risk in the system because every buyer was matched by a seller. Nobody drew attention to the fact that with each new instrument the finance sector took a cut in the form of a fee, or the spread between buying and selling prices. As derivative was piled on derivative, debt on debt, the cut got ever larger.

Financial profits may have artificially boosted the government’s revenues across a range of items, from corporate profits to capital gains and taxes on bonuses. Some of that revenue may now be lost for good. Mr Koo points out in his book that whereas in 1990 Japanese tax receipts were ¥60 trillion ($416 billion), in 2005 they had come down to only ¥49 trillion, even though Japan’s nominal GDP was 13% higher. When revenues were booming, governments thought they would keep coming and increased their spending accordingly. Now it is hard to see how the gap can be closed.

The vast amount of debt at every level also raises the question whether the pool of savings is large enough to absorb it all. In the early 2000s there was no problem. Central banks and sovereign-wealth funds in the emerging economies seemed only too happy to recycle their current-account surpluses into the government bonds of rich countries. This forced down bond yields and tempted rich-world investors to look for better returns by buying mortgage-backed and high-yield corporate bonds.

All that changed with the credit crunch. Suddenly the business sector found it very difficult to borrow. By contrast, governments found it easy because their debt was seen as safe. But once economies start expanding again, business and governments may start competing for the same pool of savings and the public sector may “crowd out” the private one. As the Greek crisis has shown, countries which want to dip into that pool would do well to keep their finances in order.

If attracting international investors is too hard, governments will be tempted to lean on their domestic savers. Theo Zemek, who heads the fixed-income division at AXA, a giant insurance company, reckons that a combination of regulatory and accounting changes will encourage banks and insurance companies to buy more bonds, and ageing populations in the rich world will also want to hold more assets that produce fixed incomes.

Historical factors such as legal, tax and monetary policy have provided incentives for consumers, companies and (crucially) the finance sector to pile on debt. The level of debt has become untenable, but the options for reducing it are not enticing.

Here’s how not to do it

One example not to follow is Japan, which has suffered a long period of stagnation accompanied by ever-rising government-debt-to-GDP ratios. This has proved sustainable only because of the country’s strong external position; it owes its debt to its own institutions.

For nations that owe money to foreigners, a long period of stagnation is likely to lead to at least partial default. This may be the eventual outcome in Greece, despite the recent rescue package put together by the IMF and the EU. Ms Reinhart and Mr Rogoff argue that the world is due for a wave of sovereign defaults, which are common after serious financial crises.

Another undesirable model is to inflate the debt away, as has often happened in the past. At the extreme, as in Germany in the 1920s, central banks “monetise” the debt, simply printing the money to allow the government to pay its bills. Some regard quantitative easing—in which central banks create money to buy financial assets, mainly government bonds—as monetisation by another name. But many countries may find this difficult, especially if they have a lot of short-term debt. Dhaval Joshi of RAB Capital, a hedge fund, explains that 53% of government debt will have to be rolled over by 2012, for example. If investors think inflation is set to rise, they will demand higher yields, increasing the cost of servicing the debt.

Stagnate, default, inflate—they all seem equally grim. The best solution for rich countries is to work off their debts through economic growth. That may be harder for some than for others, given that many countries’ workforces are set to level out or shrink as their populations age. It will be all the more important for such countries to pursue structural reforms that will increase productivity.

But outgrowing debt is not easy: the McKinsey study found that, out of 32 cases of deleveraging following a financial crisis that it examined, only one was driven by growth. America, which has a younger workforce than Europe or Japan, might still manage it. But for many other countries the hole they have dug for themselves may already be too deep.

Another opinion:

emocracies produced Nazi Germany and Fascist Italy, fulfilling the expectation of Socrates and Machiavelli that democracies end in tyranny. Now democracies are fulfilling the complementary expectation of Nobel laureate economist Milton Friedman that democracies end in bankruptcy. Put a democracy in charge of the Sahara, Mr. Friedman once said, and sand itself will become scarce. Democracies are indeed profligate trustees – or have been for the past 30 or 40 years. Mr. Friedman’s primary fret, though, was the tendency of democracy to centralize political and economic power in the same hands. Most critiques of democracy reflect this elemental distrust. “Democracy is two wolves and a lamb,” Benjamin Franklin reputedly said, “voting on what to have for lunch.”

Democratic self-deprecation isn’t quite as funny as it once was. Mobs have already taken to the venerable, iconic streets of European states, notably among them Greece, birthplace of Athenian democracy. It’s apparently easier to give wealth away than it is to take it back. Democracy assembled the welfare state peaceably enough. Can democracy dismantle it as peaceably? No, it can’t. The mobs are not finished.

In a disturbing analysis titled Democracy, Debt and Disorder, prophetically published early in 2008, two Italian economists assert that Italian governments have accumulated so much debt that it’s essentially impossible to avert the disintegration of the country’s social contract. Giuseppe Eusepi and Luisa Giuriato, of Sapienza University in Rome, do not specify violent insurrection as a consequence. They do specify an end to Italy’s welfare state – and to the “disorder” that will arise when government divides the spoils.

Profs. Eusepi and Giuriato studied Italy’s history of public debt across 150 years – since the country became a unified state in 1861. They found that successive governments commonly resorted to significant debt but that they never came close to the country’s current dependency on debt, year after year, to fund current expenditures.

In 1861, for example, Italy’s public debt stood at 35.8 per cent of GDP. At the end of the Second World War, it stood at 40 per cent. In 1970, it was at 50 per cent. Italy’s debt now stands at 120 per cent of GDP, equivalent to Greece’s debt. The country must soon choose between its welfare commitments and its interest payments. The two professors say it can’t afford both.

At the end of the First World War, Italy’s debt hit 160 per cent of GDP – an extraordinary indebtedness. Ironically, it was the Fascists, who seized power in 1922, who dealt with it. Profs. Eusepi and Giuriato credit the country’s first Fascist finance minister for cutting government expenditures in half in six years and for reducing public debt to 50 per cent of GDP. “The idea of [extreme] deficit and debt accumulation,” they say, “was simply culturally unacceptable at the time.”

This is an intriguing observation, suggesting that the accumulation of debt in affluent democracies reflects a cultural adaptation – in which public debt funds la dolce vita – as much as it reflects political ideology or novel economic theory. Beginning in the late 1960s and early 1970s, governments abandoned the old virtues. Profs. Eusepi and Giuriato describe the fiscal excesses that followed as “a public indebtedness saturnalia.”

Nevertheless, the professors blame Keynesian theory, too: “The adoption of Keynesian analysis provided politicians with a rationale for borrowing money to buy votes.” In 1961, public spending took 27.6 per cent of GDP. In 1971, it took 34.8 per cent and, in 1994, 121.1 per cent. The irony, the economists say, is that Italians could have afforded all of the largesse that flowed to them from the state – if only they had paid for them.

In fact, though, much of Italy’s debt purchased benefits that weren’t necessary. It paid for early retirement of public-sector workers, for example, and provided these pensioners with incomes much higher than private-sector workers. Now, with revenues falling and costs rising, Italy can avert insolvency only by adopting a constitutional prohibition of deficits, the economists say. This stringent assignment is Mission: Impossible.

Incidentally, Capital Economics – the international consultancy company – said in a research note last week that Italy will find it hard to avert bankruptcy. “Italy’s public finances are a time bomb waiting to explode,” the company said. “We believe that it might take a decade or more of falling wages for Italy to restore its full competitiveness.”

Democracies have made people more dependent on the state than any humanitarian necessity required. For Italy, and for other democracies, the worst is surely yet to come. Already, hundreds of thousands of middle-class people have thronged the streets of Paris and Rome, of Milan and Sarajevo, of Reykjavik and Bucharest (where demonstrators stormed the presidential palace, an insurgent act that evokes the spectre of revolution). The World Socialists’ website proclaims an age of rage ahead – and chillingly quotes British historian Simon Schama: “You can smell the sulphur in the air.”