End ‘extend and pretend’

The biggest threat to the global economy today can be summed up in one word: debt'. There's Europe of course, where the list of countries on the hit-list gets longer by the day. Never mind Greece or Portugal, the cost of Italian borrowing is now rising inexorably into the danger zone.

But it's not just Europe. In the US, politicians are turning a debate over their artificial debt ceiling into a potential disaster for the US Treasury market. Even China, the superpower-in-waiting, has a wodge of bad loans to sweep under the carpet. As the central bank tries to tackle inflation by raising interest rates, China's commercial banks are sitting on lots of infrastructure loans made during the investment binge of recent years, which are now likely to turn bad.

Why did we build up all this debt in the first place? You need look no further than Britain's example for the answer: to keep the people happy. Low interest rates fuelled a consumer boom that kept house prices rising and home-owners cheerful. Meanwhile, government spending bribed voters who might otherwise have lost out, with a vast expansion of state-funded jobs and welfare benefits. You can say the same for the US, all those eurozone countries, and even China: it's hardly a free society (although modern democracy has plenty of problems), but its investment spending is all based on a need to keep unemployment low and its people from rioting.

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The trouble is, we've spent a lot of money on rubbish (Austrian economists would describe these as malinvestments'). Now the bill is coming due. But no one wants to pay it, or face up to the fact that, in many cases, we can't pay it. In Europe, EU leaders are even threatening to set up their own credit-ratings agency to give them the ratings they want, rather than the harsher verdicts of Moody's.

Yet by trying to avoid any pain, we're just making things worse. No one can invest with any certainty because they don't know where the next blow-up is coming from. This is the Japanese solution to a debt crisis: keep covering up and hope it goes away. It doesn't. Wouldn't a clean break be better? Iceland's banks failed in 2008. The country returned to debt markets last month, borrowing over five years at a rate of just 3%. Iceland's prime minister has warned it was painful. But southeast Asian countries said the same after the 1997/1998 crisis then went on to become some of the world's fastest-growing economies. We need to deal with our bad debts now, or we'll be extending and pretending' and jumping at our own shadows for the next decade.