Hamish McRae: Generation gap: Who will pay for today's European borrowings?

Suddenly Europe has woken up to the truth that it has a budgetary crisis. But the method chosen to tackle it – easing the EU's so-called Stability and Growth Pact – merely emphasises how serious the problem has become. It does nothing to solve it. Until Europe tackles its debts, it will continue to underperform in economic terms and run huge long-term political risks. Here in Berlin we have just had an example of how voters have little appetite for radical change. But that will make the change bigger when it comes.

It is perfectly sensible to relax the limits on the amount that Europe's governments can borrow at this stage of the economic cycle. To force Germany to cut public spending and increase taxes when it is, in all probability, in recession is silly and, from the point of view of the European Commission, unwise. Silly because Germany's overall public debt is lower than several other EU countries, so some rise is surely acceptable. Unwise because Germany is the largest net contributor to the EU budget, which presents an obvious area where savings could be made. You should not be rude to the person who pays for your lunch.

But making an over-rigid agreement a little looser does nothing for the underlying problem. The fiscal position of several European governments is unsustainable. To borrow at all now, given their demographic profile, is madness, because the number of people who will be of working age to repay that debt will be too few to bear the burden. So in one sense the Stability and Growth Pact may be too tight, in that it does not allow for the swings in the economic cycle. But in another it is too loose in that it does not allow for known and inevitable demographic change. Rolling back the date at which EU governments are supposed to balance their budgets may be the only realistic thing to do but the longer the move to surplus is delayed, the greater the shift will have to be.

To warn that governments may renege on their debts is not a polite thing to do. (Mind you, to warn that giant telecom companies might renege was not a polite thing to do three years ago and look what has happened.) Government bonds are being snapped up by investors on the grounds that they are safer than corporate bonds or equities. But as it happens, in the last week there has been an example of buyers going on strike – in Japan. The auction for 10-year debt was not fully subscribed, raising the possibility that the Japanese government might not be able to finance its huge deficit, now running at around 7 per cent of GDP each year.

At some stage, in some way, Japan will indeed have to default on its debts. We don't yet know whether that will be an explicit default, or whether the country will be able to create enough inflation to whittle away their real value. Inflation was the thing that enabled Britain to repay the ruinous cost of the Second World War, basically by stealing from savers. But what was socially acceptable in time of war may not be acceptable in time of peace. But that will be a problem for the Japanese, who hold virtually all the debt.

In Europe, if you look at the Commission's figures for surpluses and deficits the problem does not appear too bad (see left graph). Mercifully, it is not as bad as Japan. The only country that clearly breached the 3 per cent deficit last year was Portugal. But France, Italy and Germany were all in the red, with Germany in the most serious position. Portugal's position is not so bad, for it ought to be able to grow its way out of the problem. It is close to recession but it managed very fast growth in the 1990s and has low costs by European standards.

Germany and Italy are serious worries. Germany is serious not because of its high absolute level of public debt (around 60 per cent of GDP) but because of its slow growth. Growth was less than 1 per cent last year, and will be less than 1 per cent this year. (See right graph .) German business sentiment has deteriorated for the fourth month in a row. The Ifo index declined to 88.2 in September from 88.8 the previous month. The very idea that Germany might default on its debts is almost unthinkable – I could not think it. But here in Berlin the local authority is supposedly bankrupt and, I presume, will have at some stage to be bailed out by the federal government. Add in the fact that Germany's population is likely to decline by at least 10 per cent in the next 50 years and the debt burden becomes very serious.

I saw a projection that the decline might be even greater: the current population of 82 million falling to 67 million by 2050.

As for Italy, the situation is worse still. Growth is similarly sluggish; the projected drop in population is greater, with a fall of 27 per cent by 2050; and government debt is much higher, at more than 110 per cent of GDP. The country has great talent and of course an enormously powerful and attractive culture. But it is a country in which you should spend, not lend. I find it very hard to see how it can dig its way out of its debts.

There is a further snare. Relaxing the Stability and Growth Pact so that it allows for cyclical movements in the economies sounds sensible. Budgets ought to balance when an economy is at full capacity, not when it has under-used resources – good textbook stuff. But suppose economies cannot get to full capacity because that capacity is no longer needed. It is plausible, too, that economies can run above capacity, because calculations of full capacity are too rigid. The EU may be kidding itself when it suggests there is spare capacity in much of the eurozone and accordingly it is OK for governments to run deficits.

You can see something of this in the former East Germany, which is still struggling with 16 per cent unemployment. There is plenty of human capital but for reasons of education, wage rates and so on, it is impossible to use it productively. The really alarming thought is that the deficits of severalEuropean governments, including Germany, France and Italy are structural rather than cyclical – as happened in Japan.

Government borrowing transfers an obligation from present taxpayers to future ones. Lavish public spending can produce buildings, roads and services that look impressive. But in Europe much of the price will have to be paid by the next generation and that generation will be smaller than the present one. So by relaxing the Stability and Growth Pact, the EU will be saying it is all right to increase the size of that transfer. In the past, large increases in public debt have generally been accumulated because of wars; several European nations, including Germany, are doing this in peacetime. At some stage the savers who are supplying the capital will decide it is not such a good idea and credit ratings will be downgraded. Then really tough decisions will have to be made and this little skirmish over a pretty badly designed agreement will seem a very mild foretaste of the explosions to come.