By Chang Se-moon

On April 13, 2011, Senators Carl Levin and Tom Coburn of the U.S. Senate Permanent Subcommittee on Investigations released their 635-page final report on their inquiry into key causes of the financial crisis.

According to the report, mortgage companies knew at least five years before the crisis became public that lending standards were lowered and the bubble was building up, but they continued to securitize “hundreds of billions of dollars in high risk, poor quality” mortgages.

Investment banks “assembled and sold billions of dollars in mortgage-related investments that flooded financial markets with high-risk assets. Some of these securities were referred to by traders as “crap” and “pigs,” and rushed to sell it “before the market falls off a cliff.” We all know that the bubble burst into the financial crisis.

The financial crisis led to credit crunch, which in turn led to the 2007-09 recession in the U.S. and beyond. The recession lowered tax revenues while making it necessary for the government to increase its spending. This combination led to a dramatic increase in annual budget deficits and the cumulative debt of the public sector in many OECD countries.

Standing alone, public sector debt is not a problem. Too much debt is the problem. What constitutes too much debt? A debt of $5,000 can be an excessive burden to a family making $10,000 per year, but a debt of $100,000 would not be a problem for families making a million dollars per year. It all depends on the ability of the borrowing government to make payment on a timely basis. Economists use the ratio of government debt to nominal GDP as a measure of the ability of the government to pay.

How high should the debt to GDP ratios be for these ratios to reach a crisis level? Policymakers usually try to keep these ratios below 100 percent. When the ratios are deemed excessive, countries begin to experience difficulties in borrowing since investors such as buyers of the government securities, have less confidence in the government’s ability to pay back the loans.

This anxiety felt by investors leads them to demand higher yields. In other words, interest rates start rising. The debt to GDP ratios for Greece, Ireland, Portugal, and Italy are well above 100 percent and substantially higher than the average of the entire euro area which is rapidly approaching 100 percent. Greece, Ireland, and Portugal have already asked for assistance from the European Union and the IMF, and Italy has been widely reported as experiencing a serious debt problem. The four countries have also experienced a slower growth rate of GDP in recent years than the average of the euro countries.

Policymakers in the euro zone countries are deeply concerned that the high debt to GDP ratio is causing a slow economic growth in their countries, which in turn is lowering their imports from the rest of the global economy including Korea. Even in China, a growing number of exporters are believed to experience credit pressure and thus demand payment once they ship goods to buyers. No country experienced a greater increase in deficit than the U.S. government following the 2007-09 recession. The U.S. government had an annual budget deficit of only $161 billion in 2007. The government deficit exploded to over $1.4 trillion in 2009, $1.3 trillion in 2010, and to about of $1.6 trillion in 2011. Total cumulative debt of the U.S. government exceeded GDP in 2011.

Importantly, the debt problem is only a symbol of more deep-rooted problems, which may be branded as crippled capitalism. These days, capitalism is burdened with assignments that capitalism is simply not capable of handling. Capitalism has been crippled in many different ways, which include numerous financial innovations that may make money managers rich while adding nothing to the economy, and new rules and regulations that take flexibility away from the market system.

One example of useless financial innovations that fueled debt frenzy is short sales. Suppose that shares in Korea Inc. currently sell for $10 a share. An investor believes that the stock is overvalued and would like to profit from this by selling the stock short. The investor borrows 100 shares and then immediately sells them for a total of $1000. This transaction is usually handled through the investor’s brokerage house, which buys and sells the securities on his behalf and also often arranges the loan of the shares. If the investor is correct and the price later falls to $8 a share, the investor would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit minus transaction fees. Holland banned short sales in 1610, while England banned them in 1733. The U.S. still allows short sales.

Clearly, it is important to reduce the public sector debt, especially in countries where the debt to GDP ratios are approaching or exceeding the 100 percent level. If not, these countries may reach a crisis in which investors refuse to buy their securities, and a sudden cut in government spending leads to massive lay-offs spiraling the economy into a deep recession.

It is also important to make the economy more flexible as one of long-term strategies to lower the public sector debt. Although Korea’s debt to GDP ratio is well below the 100 percent, the Korean economy will still experience slowing exports because the current debt crisis in many OECD countries will cause the global economy to grow slowly for many years to come.

Dr. Chang is a professor of economics and director of the Center for Business & Economic Research at the University of South Alabama. He is a panelist of the CESifo World Economic Survey, and an associate editor of the North Korean Review.