For most Americans, the European Debt Crisis is anything but riveting. Sure, Wall Street has been bouncing up and down in response to news about the Euro bailout fund, but Greek sovereign debt is a pretty esoteric subject for almost everyone else. Yet the cover of this week’s Economist magazine advises, “be afraid.” What are they worried about?

First, of course, there’s Greece. Its government debts total 140% of the nation’s GDP, with predictions that debt levels will balloon to 180% by year’s end. Italy isn’t far behind, at 120%. The weakest European nations must pay exceptionally high interest rates (yields on 10-year Greek bonds are well beyond 20%), but their economies are growing slowly, if at all. According to a number of analysts, in order to reflect reality, Greece should default on its debt to the tune of at least 50%, and possibly more. The problem is that Greek debt is owned by a number of European banks, with German banks holding about $40 billion. While some European banks have already marked down the value of their Greek debt by 50%, others have assumed devaluations as small as 6%, suggesting undue optimism.

But that’s not all. If Greece defaults in a “messy” (i.e. unplanned) way, that could easily cause the financial markets to panic about the debts of other economically weak European nations: Portugal, Italy, Ireland, Spain. When the debt of all five nations (sometimes referred to collectively as the PIIGS) is considered, German banks hold about $700 billion of their bonds.

Although Italy and Spain – two of the largest economically weak Eurozone countries – are solvent (their assets exceed their debts), they are “illiquid,” meaning that they’re running rather short of the cash or easily-sold assets needed to pay their debts. So an unplanned Greek default would send a shock wave through the world financial system, crippling the assets of multiple financial institutions. It would affect creditors who own Greek debt directly as well as large financial institutions holding credit swaps that would be dented by a Greek default. In fact, the effect might not be unlike the failure of Lehman Brothers in 2008.

Because of its wide-ranging consequences, the situation in Europe has been subjected to a great deal of economic study in recent weeks. I’ve seen a couple of economic analyses that highlight some of the numbers that are prompting The Economists’ Eeyore-like tone.

In “The Real Effects of Debt”, three economists with the Bank of International Settlements (an organization of central banks for 58 nations) ask, “how much debt is too much?” Debt, used prudently, can promote growth and investment, but if a nation’s debt rises too fast relative to its economic output, it will be forced to spend more paying off debt and less on investing in growth. At some point, this produces an economic death spiral. Looking at data on debt and growth from 18 nations, they attempted to quantify levels above which a nation’s debt can be expected to have a negative impact on its economic growth.

Their conclusion, in rough terms, is that increasing debt becomes an economic millstone when:

Government debt exceeds 80 – 100% of GDP,

Nonfinancial corporate debt exceeds 90% of GDP, or

Private household debt exceeds 85% if GDP.

According to their analysis, any one of these conditions leads to unpleasant consequences for economic growth.

Looking at the existing debts of several developed nations, they conclude that “the debt problems facing advanced economies are even worse than we thought.”

Picking up on this study, the Boston Consulting Group, in “Back to Mesopotamia?,” has considered how much debt reduction would be needed in order to restore developed economies to safe territory. By assuming GDP growth of 3%/year and average long-term interest rates of 5%, they suggest that 60% of GDP would be a sustainable level of debt for the government, corporate, and household sectors, producing a total debt load of 180% of GDP. How does that “sustainable” level compare with the present situation? Looking at the Eurozone as a whole, they observe that its total debt load is 248% of GDP. Reducing aggregate debt to the desired 180% would require Eurozone debt reductions of $8.3 trillion.

Currently the Eurozone is seeking to handle the debt crisis with a TARP-like entity called the European Financial Stability Facility (EFSF). This past week, Germany, the strongest economy in the EU, agreed to boost the lending capacity of the EFSF to about $600 billion. The increased EFSF is already being criticized as too small, but the current political climate in Germany is such that a request for more money would fall on deaf ears. In fact, some of the members of Angela Merkel’s own party refused to support her in making the increase. For the most part, northern Europeans don’t perceive that a default by Greece would cause big trouble for the whole Eurozone.

Partly, this is because European leaders have so far failed to acknowledge the magnitude of the debt crisis. Moreover, the EU nations are severely divided on the question of how to solve the debt crisis, yet any actions taken by the Eurozone as a whole must have the agreement of 17 sovereign states. Each “strong” country wants to limit its financial commitment to any bailout, and the ones with the weakest economies are reluctant to have others telling them how to manage their internal finances.

The worst-case scenarios for the Eurozone would involve one or more nations deciding to throw in the towel and return to a separate currency. Although there is technically no legal way for a country that has adopted the Euro to abandon it unilaterally, a country might decide to do it if its internal political and social strife became too great for its politicians to bear. The estimated cost of a break-up of the Euro would be in the trillions, whereas the best-case scenario (a controlled, selective handling of the defaults needed to stabilize the worst economies) is estimated to cost – hundreds of billions. And even that estimate assumes prompt, orderly, sizeable write-downs of Greek debt, something that’s not yet clearly in view.

To make matters worse, Eurostat, the EU’s statistics agency, announced yesterday that consumer prices in Europe have been rising even as the region’s economy is stalling. That creates a bind for the European Central Bank: should it lower interest rates to stimulate the economy, or raise them to fight inflation?

The prospects for a neat and orderly solution to the Eurozone Debt Crisis are thus rather poor, and the magnitude of the Euro problem gets bigger and bigger as more time passes without a decisive solution in place. A messy resolution could easily cause a worldwide financial crisis, from which US banks and financial institutions would not be exempt. So, yes, we should be concerned about how the European debt problem shakes out, because an unhappy outcome there will spread here.

Unfortuately, that’s not all that should concern you about the world economy. Things in Europe are pretty bad…but the state of US debt is actually worse, in some ways.

The Boston Consulting Group paper that I mentioned also takes a look at US debt levels, and concludes that total government, corporate, and household sector debt in the US is 257% of GDP. In order to reach their recommended “acceptable” 180% level, the United States would need to write down about $11 trillion in debt somehow. Now to be sure, the problem is less complex because the US is only one nation. But the Economist frets that not only are American politicians grid-locked, they’re also too focused on short-term fiscal tightening. With an economy that’s moping along, the means to grow out of our present troubles is not at hand, and spending cuts alone won’t create new jobs. Public and private debt are unsustainably high, and until that is addressed, the US economy remains quite vulnerable.

Barring substantial progress on the debt front in both the US and Europe, what’s likely to happen?

Economic Growth

Both the emerging and developed nations are expected to grow more slowly in coming years. It’s also likely that higher levels of unemployment will become the norm for the next several years.

Inflation

My friend David Merkel over at the Alephblog has been warning about the possibility of “stagflation” for a long time. If you don’t remember the 1970s, stagflation was the term used to describe a stagnant economy in which there are also high levels of inflation. I think David could be right, especially since governments are easily tempted to reduce the impact of their debt via inflation. I’m not completely convinced, though, that we should expect to see 70’s-style inflation. What we may see are “pockets” of inflation in certain commodities.

Home Prices

Eleven million households in the U.S. owe more on their mortgages than their homes are worth, and estimates of excess housing supply range from 1.2 to 3.5 million units. Distressed properties accounted for a third of all housing sales in August. With 4 million home loans in some state of foreclosure and home-purchase mortgage applications at a 15-year low, expectations for the national housing market are not bright. Barring some sort of forced mortgage forgiveness program (unlikely, but not impossible) that would reduce consumer debt significantly, the aggregate housing market is likely to be soft. This doesn’t mean that housing prices can’t rise in specific locales where the economy is strong and demand is increasing, but it won’t be the case for the nation as a whole.

Asset Returns

Returns on “risky” assets are likely to be below-average for some time in most of the world. While some assets will do well in relative terms, the returns on stocks, bonds, and other financial instruments are likely to be lower than what we’ve been used to in the last thirty years. This is an environment that will favor the largest, most financially stable businesses rather than thinly-capitalized ones. Until banks and financial markets see evidence that risks are waning, it will be difficult for risk-seeking businesses to obtain capital, and financially weak companies may not survive.

Given all this, what should you be thinking about in your personal financial planning?

Reviewing your household’s financial strength is a must. Is your current employer in strong financial shape? If not, maybe you need to increase the size of your emergency fund. Are you living well within your means? If not, your margin for error is getting smaller, and you need to look for ways to reduce your cost of living.

With regard to investments, it makes sense for most investors to reconsider the aggressiveness of their current investment posture. You still need to take risks in order to get a decent return, but revisit whether the risks you’re taking now are prudent. If you have more than enough capital, of course, you can take bigger risks.

As always, you should be diversified across different kinds of assets. Should you own some gold (people seem to be obsessed with gold these days)? Certainly, if your portfolio is large enough to make room for it, do so, but I’m not a fan of having more than 5% or so of one’s risk assets in gold. Rather than making sure you own this or that asset class, it’s probably more important that you review your asset allocation and make sure that you rebalance your assets periodically – assuming you’ve settled on suitable allocation targets.

Obviously, the whole picture would be brighter if the governments involved decided to move quickly and decisively to address these debt problems. That could still happen, but it doesn’t look likely.

