Did you know that 15 EU member states and, in particular, all major EU economies fail to meet their own debt targets? While one might have believed that the debt situation would ease after the outbreak of the 2008 financial crisis, and that some rebalancing would ensue, unfortunately the opposite has happened.

Debt is usually recorded on the liabilities side of the balance sheet. In order to check whether someone is over-indebted, debts are set in relation to assets (the asset side of the balance sheet) and to equity.

If, relative to the debts, there are insufficient or insufficiently sound assets, and if equity capital is too low to absorb setbacks from asset or earnings defaults, an economic entity is considered to be over-indebted. Organisations with volatile business development have to equip their balance sheets “more reliably” – i.e. in order to absorb potential shocks they have to provide more equity capital than firms operating in more stable environments.

Debt collection

Behind every debt there is a creditor who needs to reflect loan defaults, should they occur in their books. That’s why lenders and investors normally spend much time and energy developing a nuanced and detailed understanding of their debtors and, more importantly, of their balance sheets. However, these relationships do not apply to public sector debt, as most countries neither publish nor maintain meaningful business reports or financial statements.

Creditors of sovereign bonds are therefore left in the dark and rely on credit rating agencies. These agencies face similar challenges and are forced to rely on rough approximations. The most common and popular of these “crutches” is the comparison of government debt with national income, i.e. gross domestic product (GDP), which is part of the national accounts. The idea is that the state, in theory, could levy taxes and skim off all its GDP to pay off its debts.

However, this is a rather feudal interpretation of the modern state’s role. The GDP does not belong to the state, and it is unusual to compare one’s own debt with something that one does not own. Moreover, in practice the government cannot confiscate the entire annual income of its citizens – what would they live on? The alternative, therefore, is to have the state generate budget surpluses and reduce its debt for a very long period – a scenario which is similarly unrealistic.

The problems with GDP

Guidelines such as ESA, the European system of national and regional accounts, can help us calculate GDP. However, GDP implies innumerable assumptions, estimates and models. It has no relation to the state’s annual accounts or performance. “GDP is merely a ‘synthesis of statistics’ based on various surveys, samples, extrapolations, internal statistics. etc,” as a senior civil servant in the Swiss National Bureau of Statistics put it.

From an economic point of view, therefore, the comparison between GDP and debt is simply nonsensical. That applies not only to the level of government debt but to its growth, too. Without a balance sheet reference, it is not acceptable to condone debt growth that is caused by budget deficits. This applies even if debt growth is less than GDP growth,

As a result, rather than managing their balance sheet proactively, politicians are doing everything they can to achieve growth and inflation, regardless of the consequences for future generations, if growth and inflation just won’t happen.

However, that concept has worked in the past, as it has helped to dilute the value of current debt. Government offices and parliaments hope that there will be no need to tackle their own balance sheet and business management problems. These would become apparent if public sector debt were to be brought into a balance sheet context and analysed in terms of equity. Unfortunately, we are far from doing this in all major economies.

So, how can the debt crisis be solved? Business discipline and long-established management principles such as cost management systems and incentives for high-performing staff hold the key to a sustainable future – that and the abandonment (for all time) of absurd benchmarks such as the comparison of debt with GDP.