The rating agencies are looking closely at the sharp increase in debt-to-GDP — which rose by a previously unthinkable 20 percentage points in under two years — and the outlook for persistently high deficits. In the absence of timely fiscal actions and sustainable high economic growth, debt in the U.S. could get to levels that are no longer compatible with a triple A rating. A downgrade could increase borrowing costs in the U.S., weaken growth prospects, and further undermine the country’s role at the core of the international economic system.

We will see a tug-of-war in interest rates. The continuous issuance of bonds to fund high deficits, as well as concerns in the rest of the world about the stability of Treasury bonds, would argue for higher interest rates and a steepening of the yield curve. At the same time, however, the prospect of muted growth will put downward pressure on rates. The yield on the benchmark 10-year U.S. Treasury bond will bounce around between 2.75 percent to 5 percent until the end of 2011.

So far, the markets have dismissed Greece as too small and isolated to matter.The same thing happened three years ago when the inclination in the markets, and among policy makers, was to treat the sub-prime crisis as being “contained” to a very small area of the housing market. Yet, in our eyes, Greece is part of a broader phenomenon.

What’s happening in Greece, as well as in Dubai last year, is part of a much bigger sovereign debt phenomenon that is going to impact virtually every market in the world. Advanced countries have experienced a huge and simultaneous shock to their public finances, because governments had no choice but to step in to counter the implosion in housing, finance, and consumer spending in 2008 and 2009. They aggressively used the public sector’s balance sheet to minimize the disruptions.

One way to illustrate how dramatic the shock has already been is to look at countries’ debt in relation to their GDP — an important ratio because high debt levels can slow economic growth.

The percentage of countries with budget deficits that amount to more than 10 percent of their GDP has been in the 0 to 5 percent range for the past 30 years, according to Willem Buiter, chief economist at Citigroup. Historically countries with higher deficits were in the emerging world. Today the situation is very, very different. Countries with really high deficits amount to over 40 percent of global GDP, and this number is dominated by advanced economies, including the U.S. and U.K.

Remember, it’s not a question of whether countries will adjust their ballooning balance sheets. They will. It’s a question of when and how. And when they do, their actions will impact every other sector in the economy. They can tax and cut spending. And, if things get really bad, they can try to inflate themselves out of the problem or, at the extreme, default.

Pimco has done detailed debt sustainability analyses. We look at traditional indicators, such as the debt burden and how much it costs to service that debt given different economic growth rates. We also monitor less traditional factors such as demographics and policy flexibility.

When you put it all together for advanced economies, Greece is the most vulnerable country in Europe. Portugal is next, followed by Spain. The least vulnerable country is Germany. The U.S. comes in the middle. It still benefits from the fact that it supplies some key global public goods, including the U.S. dollar as the world’s reserve currency. It also maintains the deepest and most predictable financial markets.

Unfortunately, it is hard to see an adjustment process that does not provide yet another headwind to growth. And remember, this comes when there’s a prospect of increased regulation aimed at limiting the impact of the type of market failures that played out in 2008 to 2009. This will dampen the prospects for high returns for riskier assets, including equities.

Emerging economies entered the crisis with better fiscal conditions and greater policy flexibility. As a result, several of the systemically important ones — such as Brazil — are coming out of the crisis with better prospects, higher growth rates, and stronger balance sheets.

The first part will feel okay, and growth will look fine because the markets will bounce back on the huge stimulus and the traditional inventory cycle. Look for growth rates to be an annualized 4 percent to 5 percent in the first half of the year. Growth will likely slow in the second half to an annualized 2 percent. Unfortunately, we will also have persistently high unemployment. That’s very unusual in the United States, which tends to have a flexible labor market.

Inflation is the trickiest thing to predict, and most people underestimate what inflation can do to their savings. In 2010, the output gap — the difference between the actual output of an economy and its output when it is operating at capacity — will be so large that we should expect a gradual decline in inflation. But in 2011, the gap will close from both sides, namely a slow recovery in demand along with a destruction of supply.

To understand how it will work, look at the airline industry, where these dynamics play out very fast. When demand falls, ticket prices go down. Then planes get decommissioned and put in the desert. As a result, you and I are stuck traveling in crowded planes, paying higher prices.

In 2011, investors will need to start thinking about inflation protection.