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New EU bailout will fuel a debt supercycle

October 24, 2011: 2:07 PM ET

There's an economic theory that more debt is needed to emerge from problems created by each new bubble, which in turn makes the next bubble even worse. Can we stop it?

FORTUNE -- Here's the paradox the developed world faces today: easy credit is the solution to financial problems, and easy credit is the source of financial problems. This is the dilemma European leaders face when aiming to manage the terrible fiscal problems of Greece (and Italy and Spain) at their summit Wednesday. More money is needed to assure the markets everything will be okay, but will that solve the problem or just push out the pain?

In its research note last week, Nomura Capital said it expects EU leaders to accelerate the introduction of the European Stabilization Mechanism (ESM) to replace the current European Financial Stability Facility (EFSF). This alphabet soup mainly had to do with how the EU manages its books. The practical result, though, will be a massive fund of $1.3 trillion (940 million euro) in lending power to throw at weak EU member financial troubles, far more than the $400 billion funds currently uncommitted in the EFSF (an additional $200 billion has already been doled out with decent results to Ireland and Portugal, and not so effectively to Greece). This likely will assure markets there is enough capital to contain the problems in the weaker euro countries, but it only adds to a greater problem all the Western economies are facing: the debt supercycle.

The debt supercycle is an idea that has been knocking around policy circles for the a few years, since it was first elucidated in 2007 by BCA Research, an independent banking research firm that often finds itself at the top of central banker inboxes. The debt supercycle is a simple idea: Sound economic policy requires deficit spending and stimulus efforts to stop financial crises and restore economic growth. But in doing so, it lays the groundwork for even bigger bust later on.

The prime example was seen in the early 1990s, when the S&L crisis was countered with low interest rates. The easy money from that helped spark the dot-com boom. Even looser monetary policy was used to counter the dot-com bust, but lay the groundwork for the housing and related-derivatives boom and bust. A problem is that increasingly larger responses mean at some point at an economy just can't issue enough debt reflate its economy because there is already too much debt.

The big question: where is that level where the debt supercycle must end? Most economists and policymakers see the 100% level of debt-to-GDP as the line where economies become unsustainable: historically, rising above this level is seen as sparking a long, slow economic and political descent (I'm looking at you, British Empire).

A more current example is Japan, with 226% of debt to GDP and its decades-long stagnation. Some economists argue that high level is mitigated somewhat by the fact most Japanese debt is owned by Japanese (think of it as your right hand owing your left hand money -- ultimately, you'll still have that money.) Greece and Italy are about 100 percentage points below Japan's level but much of that is owed outside the country. The euro zone as a whole is at 85% debt to GDP right now, and adding a trillion dollars in bailout funds immediately raises that to 94% judging by latest statistics.

There's little doubt that if we want to avoid another world financial market apocalypse the EU has to do something to make Greek debt more manageable. And it may work now. But will there be wiggle room to tackle the next bubble?

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