Image: Anthony Mirhaydari

Anthony Mirhaydari

If you're like most Americans, you've got a love-hate relationship with debt.

On one hand, its wide availability in the modern era has enabled expanded homeownership, compensated for stagnant wages and kept the country from having to make hard choices on things like taxes, federal spending and entitlements.

On the other, our deep-down fiscal Puritanism knows that too much debt is a bad thing. It encourages blatant consumerism and me-too, right-now gratification. It greases the skids of pork-barrel spending out of Washington. And it fueled the housing bubble.

What's worse, after years and years of credit-fueled indulgences, the bill has come due. It's big. Really big. And it's acting as a drag on growth. According to Credit Suisse strategist Andrew Garthwaite, excess debt in the developed world now totals $8 trillion, or 20% of rich-world gross domestic product.

Until that chunk of change is dealt with -- until we start paying it down, default on it or grow the economy so that it doesn't look so big -- the recovery's not going to take flight, the job market won't normalize and home prices will stay down.

And the only way out is through more debt, at least in the short term. That may seem counterproductive. But here's why it's true.

The risk of runaway debt

First, a review of the overall problem is needed. Over the past few months, I've talked a lot about risks related to the West's debt burden. It's a big deal. Further, it underpins the problems we're facing now: the eurozone crisis; the August downgrade of America's AAA credit rating; and the shrinking effectiveness of extraordinary monetary policy out of the Federal Reserve and other rich-world central banks.

Too much debt? © MSN Money

In the United States, as shown in the chart above, the rise in debt was driven first by consumers during the housing boom. Now, it's the government.

You can also see this in the feebleness of the current recovery. Credit Suisse economists point out that GDP growth in 2011 was the weakest in a non-recession year since 1947. Job growth was moribund as the number of Americans participating in the labor force continued to shrink, falling to levels not seen since the early 1980s. And corporate investment has "rebounded" to the lows seen in the depths of the 1991 and 2001 recessions. Not exactly worthy of a spike-the-football touchdown celebration.

Malaise in the West

Late last year in "Investing for a year of chaos," I highlighted studies by Nomura Research Institute's Richard Koo, who is based in Hong Kong and is an expert on Japan's long, debt-driven malaise. Koo believes that Western economies face something similar to the post-1990 Japanese experience -- namely, a prolonged slump caused by persistent deleveraging.

This happens as large parts of the economy focus mainly on minimizing debt -- a change that throws many of the economy's natural motivators into reverse. Businesses delay buying equipment that would help boost profits, governments don't fund new infrastructure projects to increase competitiveness, and households put off buying the latest gadgets.

In the corporate sector, you can see it in the growing cash hoards on balance sheets. In households, you can see it in the falling levels of mortgage debt as people give their devalued homes back to their lenders. The banks see this in meager demand for new loans. The government hears it in political clamoring over debts and deficits.

The risk, according to Koo, is that households become too poor to save and repay their debts and the economy falls into a depression in a downward spiral of lower home prices, loan losses and layoffs. This is the debt-deflation spiral (.pdf file) that Irving Fisher warned about during the Great Depression. The gist of it is that lower asset prices (for things like housing) encourage debt liquidation, which weakens the economy, encouraging even lower asset prices, a weaker economy and yet more liquidation.

Until households start to recover, businesses will be loath to spend on expansion and investment. And the weaker economy that results further damages the government's finances. The cycle feeds on itself.

The other risk is that governments, which act as the borrower and spender of last resort in these situations, tighten their belts prematurely. This, as I've said before and has been borne out in the economic research (.pdf file), was responsible for the 1937 double-dip that extended the Great Depression. And it was also responsible for the 1997 and 2001 slowdowns that extended Japan's deflationary spiral.

Spending money to repay money

Koo's solution is massive borrowing and spending by the public sector on the scale of what was seen during World War II. Not only did this put an end to the Great Depression, imperial Japan and Nazi Germany, it also led to a new era of middle-class prosperity and U.S. manufacturing prowess.

Instead of supercarriers and cruise missiles, the hope now is that we'd spend the money on new schools, energy technologies needed to end our dependence on foreign oil and health-care breakthroughs that improve care and reduce cost.

Japan's experience shows that this can work. The Japanese government's debt-to-GDP ratio swelled by 92% between 1990 and 2005, or around $6 trillion. Koo points out that, assuming the economy would've returned to its pre-bubble 1985 level without this support, the Japanese spent $6 trillion to prevent the loss of nearly $30 trillion in economic output during that period. That's because Japan largely prevented Fisher's debt deflation cycle from playing out. (Some suggest Japan's gains would have been better had it not tightened its budget in 1997 and 2001.)

The point is that the only escape from the debt-deflation trap is growth with moderate inflation catalyzed by government support -- giving the private sector the strength it needs to repay its bills. The strengthened economy will, in turn, result in better public finances as tax revenues rise and spending on things like unemployment benefits falls.

There's a way but no will

And the only way to engineer all this, outside of a Chinese invasion of Taiwan or some other catalyst for World War III, is through the political will to reinvest in the country's future. We certainly could use the help as we fall behind our peers in metrics like student learning, infrastructure quality and public health. The key is to grow the economy as fast as or faster than the government borrows, providing the cover fire households need to cut their debt.

Then, when normality returns, it'll be time to attack the national debt. That is something that should be done during times of wealth and prosperity; not in the maw of a new depression.

It's a balancing act. And it's counterintuitive. But there is no other way, outside of inciting deep social unrest and turmoil -- something I explored in a recent column, "Why all signs point to chaos."

Unfortunately, given the obsession with fiscal austerity here at home and in Europe, this isn't going to happen. This dynamic is driving the Fed and other central banks into potentially hyperinflationary extremes of low interest rates and cheap money out of desperation -- the subject of my most recent column -- to compensate for the lack of action by the public sector. And it's driving the likes of Greece and Portugal toward bankruptcy and an exit from the eurozone.

Jeremiah Sullivan, professor emeritus of international business at the University of Washington, highlights this fact using data on the money supply and loan growth. Back in 2000, the Fed increased the monetary base by about 3%, boosting loan growth by 8%. It's increasing the monetary base at a 31% annual rate right now to get the same amount of loan growth.

In the process, the Fed has increased the monetary base from around $850 billion to more than $2.6 trillion. We still don't know what the aftereffects of such an unprecedented surge in the number of dollar bills floating around will be. But the history of Germany's Weimar period and of Zimbabwe in the last decade suggests it won't be good.

It's like this: The Fed's economy-boosting weapon, encouraging borrowing, is rendered largely inert because of the debt-deleveraging dynamic. Households don't have the capacity for new borrowing, while businesses have neither the need nor the desire to take out new loans. A dearth of demand and a massive supply in loanable money from the Fed have combined to push down the government's borrowing costs into negative territory (after adjusting for inflation).

We need sustained and powerful fiscal policy stimulus instead. The bond market is practically begging Washington to borrow and borrow big and is willing to pay for the benefit of lending money to Uncle Sam. We aren't getting it.

The really scary thing is that we're running out of time to get it right. If we maintain our current path of economic weakness and ignoring the structural budget problems (things like health care spending), because of our obsession with the economically driven portion of the budget deficit (unemployment benefits and food stamps, for example), the debt-to-GDP ratio will just keep growing. The bond market won't be so willing to hand over the cash we need.

Once we lose the ability to service our debts, it'll be game over.

The troublesome trajectory

Credit Suisse economists put the day of reckoning in 2024. It is then that, based on current trajectories, the Congressional Budget Office projects that the cost of entitlement programs plus interest payments in the United States would absorb 100% of tax revenues. Even more dire, it's the year when Japan's interest payments alone would exceed national tax revenues.

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The day of reckoning has already arrived for the weaker members of the eurozone as the likes of Greece and Portugal lose the ability to borrow in the open market. And there are growing doubts about core European countries like France, Italy and Spain. The European debt crisis is a case study in how difficult solving the debt deflation cycle becomes when governments lose the ability to support their economies.

So the rich economies have an $8 trillion debt hole to fill before we return to the kind of prosperity and growth that marked the 1980s and 1990s. And the United States, as the world's most powerful nation, has 12 years to fix it by restoring its economic vigor.

The clock is running.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.