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When the Sovereign Debt Bubble Bursts, Things Will Get Nasty

08/05/2013 15:22 BST | Updated 08/07/2013 10:12 BST

What do Greece and an unemployed homeowner in Arizona have in common? They are both bankrupt with no hope of ever being able to pay back what they owe.

As I wrote this, I realised it sounded as though I were making a joke (and a bad one at that). The reality is, unfortunately, not funny in any sense, but actually far more worrying.

When Lehman Brothers fell off the proverbial cliff, everyone suddenly realised that lending money to people who have no money doesn't make a huge amount of sense. Due to central banks having decided that they could 'end' the normal business cycle, they decided to make a lot of money available in the early 2000s thinking this would avert a recession. It did, for a few years. Bankers, in the search for money to pay for their ferraris, lent this free money from the central banks to anyone who asked for it.

On that dark day back in 2008, it suddenly became apparent that not only did this money never really exist in the first place (because it was printed out of thin air by the central banks) but that this fake money would never get paid back.

Cue the recession, soaring unemployment and successive attempts, with mixed results, to encourage people to pay down debt.

How does this relate to Greece? In much the same way that banks were give incentives to lend to people who had no money, countries like Greece suddenly looked a whole lot more attractive after the introduction of the euro.

One happy European family, all sharing a (fake) currency! Its introduction led to countries suddenly being able to go to the bank to borrow a lot of dosh at ultra low interest rates. This belief was based on the clearly misguided impression that a common currency would lead to a common way of running a country, i.e. like Germany.

And then the crisis hit. As with individual homeowners who had no money, suddenly it became apparent that Greece (and Cyprus, Italy, Spain, Portugal, Ireland, France, Slovenia and much of the rest of Europe) had no money either.

Cue the sovereign debt crisis, soaring unemployment and successive, definitely failed, attempts by governments to pay down debt.

The sinister thing here is that whereas an individual going bankrupt won't really have much impact in the long run on the global economy, a lot of individuals doing so will. This is why banks are being so kind and generous in letting individuals pay back the money they owe in stages over longer period of times.

In fact it's simply because banks are sh*t scared of what will happen to their share prices if it becomes apparent that a lot of money they lent to people is never coming back.

And the same principle goes for countries. The reason our wise and level-headed politicians decided to 'save' Greece from bankruptcy was simple. The banks who had lent money to the Greek government would have gone insolvent overnight, which would have required other governments to bailout their banks, which would have in turn led to those governments becoming insolvent as well.

Instead we have austerity programmes being implemented in most countries that are designed to bring their finances onto sustainable footings. In the same way a bank will sometimes give an individual a second chance to repay their credit card bill, this is what is happening in Europe. Future growth, induced by that catch-all term 'structural reform', means more tax revenue, which means the ability to pay off these massive debts.

However let's look at the facts. Europe is in decline. Its population is ageing and shrinking, which means ever more expensive healthcare systems and less tax revenue. Its industries are gradually migrating to warmer climes to take advantage of cheap slave labour in China and elsewhere. Where is the money to pay back so much debt going to come from?

The answer, at the moment at least, is 'the central banks'. It is they who are keeping the whole system afloat. But with what? The money they create has no intrinsic value, only the value we place on it. It isn't real.

Why then are stocks and shares the highest they've ever been? Why are countries able to borrow at such low interest rates? Europe is mired in the deepest recession, let's call it a depression actually, since the 1930s. How can this be?

A glance over the past few decades would suggest that, if we look hard, we might spot a bubble developing. A bubble is simply when a group of investors become willing to spend more money on something that it is actually worth. On this basis, sovereign debt is the new bubble.

Are we really claiming that Italy, after several months without a government, deserves to be charged next to nothing to borrow money to pay for the debt it already owes? The intrinsic value of Italy is pretty hard to identify these days. Similarly with most of the developed world, we are living beyond our means and the only thing that's keeping us afloat is a credit card given to us by the central bank.

Who knows when investors will wake up and realise that the money they have lent to the governments of the western world is not coming back. But when they do and the sovereign debt bubble bursts, as the mortgage bubble did in 2008, and the tech bubble in 2000, things could get rather nasty.