“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”Wilkins Micawber a fictional character from Charles Dickens’s 1850 novel, David Copperfield.When one discusses the debts of nations it often becomes a very emotionally charged conversation. A sort of national fervour tends to follow and there can often be periods of rash commentary that borders on hysteria or panic. Fiscal policy is crucial to a nation as it shapes society and tends to have far reaching consequences that impact generations to come.What follows is our attempt to remove some of these emotional biases and look at Bermuda’s debt situation in light of the data and facts. It would be disingenuous to suggest we know for certain the future outcome of Bermuda but we have tried to assess the situation with the use of sound economic principals and analysis.Debt sustainability and the tipping pointCitizens and taxpayers all want a plethora of services with little cost. We tend to want unlimited benefits and prefer to pay very limited taxes. This has always been the fundamental human flaw in government expenditures. There is constant disconnect between the benefit and the cost. As a result, governments tend to run varying levels of budget surpluses and deficits as the balancing act is very difficult and not simply an “economic” decision but one that must consider very important social aspects as well. Bermuda is no different. Over the last few years the outlays have soared in relation to revenues and the debt has escalated at an alarming level.The rapid escalation in this future liability has caused much consternation so we decided to rationally assess the situation. The first aspect we will consider is how to stop the growing debt burden; next what will prevent the debt from continually escalating; and lastly what future risks can one perceive. A debt crisis is hard to predict and is subject to numerous factors. One key factor, however, is the debt-to-GDP ratio. As this ratio escalates, investors tend to require higher levels of interest rates to compensate for perceived risk. The major tipping point tends to occur when the average interest rate on the debt exceeds the countries’ nominal growth rate. When this occurs, the debt-to-GDP ratio will automatically increase unless the country runs a primary budget surplus. A primary budget surplus is the budget surplus excluding interest paid on the debt.The economic equation can be thought of like this:(Average Rate of Interest on Public Debt Nominal GDP Growth Rate) x Public Debt as a percentage of GDP = Required Primary SurplusIn assessing Bermuda’s current situation we will start with the composition of its debt. In exhibit number two, you will see the debt profile of Bermuda.From the calculation above we can note the weighted cost of borrowing currently stands at 5.7 percent. We are cognisant that an additional $200 million is currently being proposed but at the time of this writing the rate to be charged is not yet known.Previously we conducted an analysis on Bermuda’s future growth potential in our article “Bermuda’s New Normal” (http://www.royalgazette.com/article/20111205/COLUMN05/712059976 and http://www.royalgazette.com/article/20111213/COLUMN05/712139957). Our analysis suggests a minus 1.4 percent labour force population trend combined with an assumed 1.4 percent positive change in productivity. The result of this prior exercise has allowed us to come to the conclusion that Bermuda’s current real GDP growth prospects look rather minuscule and we have suggested that its potential future real growth given current assumptions is zero percent.This is not, however, a nominal figure so one will need to add an assumed future inflation rate to this to ascertain an estimated nominal growth rate in the future. In reviewing the historic inflation rate in Bermuda, and being aware that historic patterns do not necessarily equate to future patterns, we have found that over varying periods of five to ten years this rate tends to be about three percent . This analysis takes into account the GDP deflator rate and Consumer Price Index rate.As a result, we feel it is reasonable that Bermuda’s future nominal growth rate in GDP could run at about three percent (calculated as zero percent real plus three percent inflation).As for the calculation of the debt to GDP number we will need to take our estimated 2012 nominal GDP and the assumed total debt level of $1.43 billion (current $1.23 billion plus the anticipated $200,000 million of additional borrowing for 2012). For the sake of simplicity we have assumed that this additional borrowing will be done at the current average weighted rate of 5.716 percent. Using an estimated nominal GDP figure of roughly $5.64 billion we get an estimated debt-to-GDP ratio of 24.24 percent.Taking the components as calculated above we can derive the primary budget surplus that the Bermuda Government will need to run in future years to maintain the current debt level:(5.72 percent three percent) x 24.24 percent = 0.66 percentWhat this essentially tells us is that the government can stabilise the debt level at its current ratio by running a primary budget surplus of 0.66 percent.The next questions one may ask are: Can this be done? And what happens if trends persist? We’ll explore these areas next week.Nathan Kowlaski is the chief financial officer of Anchor Investment Management Ltd.