Quotes of the Day

Countries aren't supposed to go bankrupt. Governments, after all, are funded by the tax revenues of entire economies, and, since they manage nations, they're not likely to evaporate, Enron-style, in a sudden financial flame out, or close up shop and flee their creditors. That's why lending money to states is considered the surest bet around. Reputation aside, however, politicians abuse their ability to borrow just like any spendthrift with too many credit cards, and often pile up more bills than they can handle. Argentina, Russia, Mexico and others have stiffed their bankers over the past 30 years. In fact, the sovereign-debt crisis goes back as far as the concept of the sovereign state. The first recorded government default took place in the 4th century B.C., when Greek municipalities failed to pay back loans granted by a temple.

Perhaps, then, it's only fitting that Greek government debt is the biggest threat to global financial stability today. Warning that Greece was in "critical condition," Prime Minister George Papandreou recently said that his country "faces the risk of sinking under its debt." Jitters over a potential Greek default have punished the value of Europe's common currency, the euro, and driven down stock markets around the world. Policymakers worry that Greece's woes will spread to other weaker members of the euro zone, such as Portugal, Ireland, Italy and Spain — a collection of countries traders have nicknamed the PIIGS. Government leaders nowhere near Europe are concerned as well. "Such events far away can hurt Singapore," warned Lee Hsien Loong, the city-state's Prime Minister, in his Chinese New Year address. "Singaporeans should be psychologically prepared ... and not let down our guard too soon."

Lee's right to be worried. The debacle in Greece could be a harbinger of a new stage of the financial crisis, one in which irresponsible politicians, not bankers, are the main source of economic turmoil. Across the developed world, sovereign states have amassed potentially unsustainable mountains of debt. The Organization for Economic Cooperation and Development (OECD) forecasts that by 2011 the ratio of government debt to gross domestic product — the main measure of a state's financial health — will reach 100% in the U.S., up from 62% in 2007. That's almost as large as Greece's burden today. Ireland's debt burden is expected to triple over that same period to 93%, while the U.K.'s could double to 94%. Japan is the worst of the bunch, with its ratio likely to top 200%. Just as risky private-sector indebtedness caused the Great Recession, government debt, if not addressed, threatens to stall economic growth and spark renewed waves of confidence crises in global financial markets. "Attention has shifted to the second part of the story, to the impact [of the financial crisis] on government balance sheets," says David Beers, global head of sovereign ratings at Standard & Poor's in London. That has "intensified the pressure that was already there to start a process of repair."

To a certain extent, mounting sovereign debt is a natural outcome of the recent recession. As in any downturn, tax revenues shrank but government spending increased to stimulate sagging economies. The result: budget deficits and more borrowing. Expensive banking-sector bailouts made the burden even heavier. That's not automatically dangerous. There is no particular level of debt that acts as a trip wire and tosses an economy into crisis. Different economies can bear different levels of government debt, depending on their ability — real or perceived — to finance it. While Greece's small and uncompetitive economy is struggling to stay afloat, Japan, with ample domestic sources of funds, hasn't had trouble financing its deficits, and investors still consider U.S. Treasury bills a safe haven. In a January report, Barclays Capital argued that the cost of the crisis on the U.S., the U.K. and Japan would be spread over many years and is therefore less scary than it may appear. "We do not believe that the global crisis is a watershed for the long-term fiscal sustainability" of those countries, the report said.

That doesn't mean there's no downside. Supersized sovereign debt is likely to depress economic growth. Hefty debt payments lead to heftier taxes, which bite into consumer spending and corporate investment. Economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University found in a recent study that once a country's government-debt-to-GDP ratio passes 90%, growth declines by at least one percentage point a year. For industrialized economies that rarely expand more than 2% or 3% a year, that's a huge chunk. "We're coming at a point in which growth prospects are really taking a hit," Reinhart says. Growth could also be restrained by the budget cuts necessary to narrow deficits and reduce borrowing. The effect could be felt for a protracted period. Jean-Luc Schneider, a deputy director of the economics department at the OECD in Paris, says some countries will take as many as 10 years to reduce their fiscal deficits to more sustainable levels. And since the deficits of so many nations will have to shrink simultaneously, the impact on developed economies is likely to be amplified. "Doing it all at the same time will be more painful," Schneider says.

But also inevitable. Pressure is building on political leaders to prove they're serious about getting their countries' finances in order. In late January, S&P warned that it could downgrade Japan's sovereign rating if the new administration of Prime Minister Yukio Hatoyama doesn't rein in the deficit. In his January State of the Union address, President Barack Obama pledged to freeze discretionary fiscal spending for three years starting in 2011. "Like any cash-strapped family, we will work within a budget to invest in what we need and sacrifice what we don't," Obama said.

Nowhere is the urgency to deal with debt greater than in Europe, where it has become the most serious test of the 11-year-old euro-based monetary system. While euro-zone nations use the same currency, there is no mechanism in place to financially aid wayward members. That's how a crisis in Greece, which represents a mere 2.8% of the zone's GDP, can have such an outsized impact. The ultimate fear is that Greece will default, dragging down the euro with it. "A lot of the euro's problems today are rooted in those members having failed to integrate enough," says Bob Hancké, a professor of European political economy at the London School of Economics. "I'm one of those people who can imagine there being no euro — or at least not one similar to what we know today — within three years." That may be an extreme view, but the severity of the problems is forcing a significant change in the way the euro zone works. In a dramatic step in mid-February, Europe's leaders pledged a coordinated rescue for Greece, if necessary, to preserve stability in Europe overall (though how that would be done was left uncertain).

That help has a price. European ministers are insisting that Greece implement a severe austerity plan to quickly reduce its fiscal deficit. Papandreou has already promised pay cuts for public employees and tax hikes, but his European counterparts are demanding an even stricter program. That presents a huge test to his regime. Government workers have already staged strikes to protest Papandreou's plans. So far, he's held firm. A recent poll showed that two-thirds of Greeks believe the Prime Minister's measures are necessary; only 41% think they go far enough. "The government has seen the problem and is trying to do something," says Helen Tourkogeorgou, a 32-year-old stay-at-home mother in Athens. "The crisis has opened its eyes."

The same realization will have to come to governments across the developed world. But S&P's Beers warns that process has only just begun. "There is hope that somehow the square can be circled," he says. But "it is going to be increasingly hard to say there aren't difficult choices to be made." Hopefully our political leaders won't just skip town.

—with reporting by Bruce Crumley / Paris and Nicole Itano / Athens

• Michael Schuman
• From Greece to Japan, rich countries have racked up massive state debts. Paying them off will take time — and pain