It's the global debt, stupid

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In the 1976 movie "All the President's Men," Washington Post reporters Bob Woodward and Carl Bernstein were told to "follow the money" if they wanted to find the real source of the Watergate cover-up. One has to wonder whether something similar might not be said about global financial crises. If one wants to determine where the next global financial crisis will start, one might be well advised to follow the debt, since normally, the primary source of financial and economic crises is over-indebtedness in the economy.

In today's global economy, following the debt should dispel any complacency about the world economic outlook. According to a recent McKinsey & Company study, seven years after the bursting of a global credit bubble resulted in the worst global financial crisis since the Great Depression, global debt has continued to grow at a troubling rate. In fact, rather than reducing indebtedness, today practically all the world's major economies have higher levels of overall borrowing relative to gross domestic product (GDP) than they did in 2007.

Of particular concern has to be the over-indebtedness in key regions of the global economy. Among the more vulnerable of these regions has to be the formerly rapidly growing emerging-market economies, which now account for around 40 percent of world GDP. Since 2008, corporate indebtedness of the emerging market economies has more than doubled to around $23 trillion, which makes that debt market approximately the same size as the U.S. high-yield debt market.

More troubling yet, as the Bank for International Settlements keeps reminding us, is the fact that over the past seven years, these emerging-market corporations have increased their indebtedness in U.S. dollar terms by over $3.25 trillion. This makes the emerging market economies particularly vulnerable to crises at a time that their currencies have plummeted and at a time that they are being hit by a major bust in international commodity prices.

It also has to be of major concern that non-financial enterprises in China, the world's second largest economy, have gone on a borrowing spree of historic proportions. Indeed, it is estimated that over the past seven years, the debt of these enterprises increased by a staggering 90 percent of China's GDP. This rate of credit expansion is very much more rapid than the private-sector credit expansion which preceded the bursting of the Japanese credit bubble in the late 1980s or which occurred before the bursting of the U.S. housing bubble in 2006.

It also hardly a source of comfort that sovereign debt to GDP ratios in the European economic periphery, and in key European countries like Italy, remain at disturbingly high levels. This is all the more so the case considering the fact that European politics now appears to be fragmenting and European banks continue to hold a disproportionate amount of their countries' sovereign debt on their balance sheets.

High levels of global indebtedness might not be a matter of major concern in the context of a rapidly growing world economy and of one that is not beset by major economic risks. However, today's global economy is anything but rapidly growing. More troubling yet, it would seem that rarely before has the global economy been confronted with such a confluence of major risks in so many different parts of its economy.

The United States, the world's largest economy, could be headed for a period of political uncertainty ahead of its November elections. China, the world's second largest economy, is currently struggling to reorient its economy away from an investment- and export-led model at the same time that it is being challenged by a capital outflow problem of epic proportions. Japan, the world's third largest economy, is stalling yet once again and slipping back into deflation at a time when credibility in Abenomics is rapidly dwindling.

Meanwhile, Britain, the world's fifth largest economy, is to have a closely fought referendum on continued European membership later this June, at a time when it has close to a record external current account deficit. A "yes" vote in that referendum would see the United Kingdom well on the way to leaving the European Union, which would almost certainly trigger a sterling crisis. And Brazil, the world's seventh largest economy, is in the grips of the deepest of political and economic crises that could put the country well on the path to defaulting on its debt.

With global debt at such a high level and with so many risks currently characterizing the global economy, one has to hope that world economic policymakers are not lulled into a false sense of security by the present calm in global financial markets. Rather, one would hope that they do not succumb to the temptation to engage in a premature normalization of interest rates. One must also hope that those countries that do have the room to engage in fiscal stimulus use that room wisely to help put the world economic recovery on a sounder footing.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.