EUROPE´S ONGOING DEBT THREAT / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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MARCH 7, 2010, 1:56 P.M. ET.

Europe's Ongoing Debt Threat .

By SIMON NIXON

Europe may have successfully navigated the latest phase of its sovereign crisis, following last week's oversubscribed bond auctions by Greece and Spain. But the region's fiscal challenges—and those of other highly indebted countries including the U.S.—have only just begun.

Attention so far has rightly focused on how far countries need to reduce their deficits to achieve debt sustainability—the point at which debt is no longer growing faster than GDP. That process in itself is likely to take several years in many developed countries. Longer term, a debate is needed over what is a reasonable level of debt to GDP.

Key to that debate will be whatever policy makers decide to do about the banking system. The financial crisis has revealed society's clear preference that governments bear the costs of failure in the banking system. Yet governments can only provide this catastrophe insurance if their balance sheets are strong enough to absorb the extra borrowing when the crisis hits. As Paul Tucker, deputy governor of the Bank of England, pointed out in a recent speech, historically governments borrowed heavily to go to war but repaid the debt in peacetime to be ready to fight again. Modern societies must similarly decide how much debt to repay. As Mr. Tucker says, "the higher the steady-state level of debt society chooses, the more resilient our financial system would need to be."

That's ominous for many Western countries as they try to make banking systems safer without restricting the flow of credit needed to fuel growth. The U.K. government predicts debt will stabilize at close to 80% of GDP in 2014. Many other industrialized countries will have debt-to-GDP ratios as high as this, according to the International Monetary Fund. That is too high if governments are to be in a position to provide insurance against future catastrophes, including those from outside the financial system. So either governments need to reduce debt or they need to make their banking systems safer, potentially stunting economic growth. Either way, the consequences of this crisis will be felt for a generation.

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