Readers Question: How is it possible for countries with massive debt to have a strong currency, e.g Japan and the US?

Sometimes countries can have large debts that are sustainable. In the case of Japan and the US, the general consensus is that there is a very low risk of default.

US debt is very large, but debt interest payments are manageable. The US has had much higher debt to GDP ratios in the past (US Debt history). Also, markets expect the US economy to grow in the future (already first signs of economic recovery in US). This will help reduce debt to GDP ratio in the future.

Therefore, buying US securities is still seen as a fairly safe investment. It is unlikely the US will face inflation or debt default, so investors are currently willing to hold dollar assets.

Japan has an even higher level of public sector debt (over 220% of GDP) But, Japanese bond yields are very low. This is helped by a large pool of domestic savings. There is a high willingness to buy debt. See: Japan debt

In recent months, there has been an increase in demand for Japanese bonds from foreign investors. Foreign investors have been buying short-term Japanese Treasury Bills. A significant reason for this is that investors prefer the idea of holding Japanese bonds to Eurozone debt.

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Despite the weakness of the UK economy, the Pound is forecast to rise against the Euro, due to the ongoing uncertainty surrounding the debt crisis in the Eurozone. With Greece and other countries at risk of default, and even facing the prospect of a Euro break up, the Pound Sterling looks relatively attractive – despite low growth and low interest rates in the UK.

The UK economy is slowly emerging from the worst recession since the Great Depression of the 1930s. The recovery is being helped by:

• A weak pound
• Unprecedented loose Monetary policy – zero interest rates, quantitative easing.

However, the recovery is being held back by

• Fiscal tightening – government spending cuts which have reduced confidence and reduced aggregate demand (AD)
• Slow economic growth in Europe
• Rise in oil prices
• Reduced real wages (inflation higher than nominal wage growth during 2011 early 2012)

In 2012, inflation is likely to fall as cost-push factor expire, however growth is still likely to be anemic and the Bank of England is very unlikely to increase interest rates before the end of 2012 (See: interest rate predictions)

With interest rates of 0.5% and slow growth – this would usually lead to a weak Pound. (Investors would save money in countries offering a better rate of interest) However, at the moment, there are few opportunities for investors to find high interest rates with also security of investment. For example, investors were buying Swiss Francs, but the Swiss authorities had to intervene to prevent the Swiss Franc rising too quickly.

Crisis in the Eurozone

Continued weakness in Euro since the start of 2010

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Readers Question: when I read the EU spends 50% of their GDP, what does that actually mean? That half of Europe’s taxes are spent on government projects like welfare and entitlements, like taking money from the left hand pocket and putting money in the right hand pocket? I’m lost. Could you please use credit cards or something else as an example to help me understand the principles involved in these two problems?

This is a list of government spending as a % of GDP

Some EU Examples

You can see there is a big variance. Countries in the EU tend to have a higher rate of government spending, e.g. France 53% of GDP, UK 47%. US is 38%.

To simplify this. We could assume the average citizen for a country. Let us assume the average citizen receives 20,000 Euros. In France, the citizen would pay to the government 10,000 Euros (assume 50% tax rate).

That same ‘average citizen’ would receive 10,000 Euros of government spending. Free health care, free education, pensions, the benefits of military defense.

In the US, the ‘average citizen who earns $20,000 would pay $7,600 in taxes to the government. In return the US would receive $7,600 in government spending (education, military defense, roads e.t.c).

I put the ‘average citizen’ in brackets to simplify. Of course, people pay different tax rates. Some receive more government spending than others. But, it helps to understand.

What do Governments Spend Their Money on?

• What does UK spend its money on?

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