Sean O'Grady: The all-too-real chance of an economic nightmare

As a collection of horror stories, the IMF's Global Financial Stability Report is right up there with the best of Edgar Alan Poe or Stephen King. Except, of course, that the IMF's tales have rather more chance of turning into terrifying reality.

The most blood-curdling is the possibility of an American sovereign debt crisis, possibly coinciding with one in Japan. This may seem far-fetched given the world's apparently insatiable desire for American government bonds. The US has been able to borrow astonishing sums at astonishingly low rates of interest. Yet, as the IMF has been suggesting strongly, this cannot continue indefinitely.

The magic formula in all this is "R minus G", that is the interest charged on a nation's debt less the growth rate. If R is much more than G, then a nation will soon find itself insolvent. Thus, if Ireland has debt of 120 per cent of GDP, and the cost of servicing that debt is 5 per cent, the debt burden is 6 per cent of GDP. If her economy grows at just 2 per cent, then she will go into a sort of death spiral. Default is inevitable.

The same calculation applies to the US (debt-to-GDP ratio approaching 85 per cent) and Japan (200 per cent). What happens when rates rise, and if growth stays sluggish, both more than likely trends?

Thus far the US and Japan have been able to fund their deficits for special reasons. Japan's hard-saving workers have provided the necessary cash there, but they are now retiring and the flow of funds will gradually dry up, while her economy is still gripped by stagnation. Meanwhile, the Chinese, and latterly the US Federal Reserve, have mopped up the US Treasury paper.

Consider now if the Chinese, in another IMF horror story, suffer a crash, increasingly a realistic event. If China had to sell much of her nearly $3 trillion pile of US assets, or just slow her bond purchases down, then the consequences would be too horrible to contemplate.

IMF publications are often dry enough to send you to sleep; this one looks certain to give you economic nightmares.