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FT editor Roula Khalaf selects her favourite stories in this weekly newsletter.
The author is a senior vice president and economist at Pimco.
As the world emerged from the pandemic, many feared that higher interest rates would cripple the private sector. It turns out that these concerns were largely unfounded. Tight monetary conditions have not triggered broader financial instability. Systemic risks to global banking and non-bank financial markets appear contained, and households have borrowed less.
Instead, the public sector has borne the brunt of post-pandemic financial strain. Government debt stocks are now near historic highs. Indebtedness remains elevated and interest rates have risen, exacerbating the cost of servicing deficits.
The fiscal outlook is understandably worrisome, but it should not alarm us. In most developed countries, public debt levels are still too low to pose an immediate threat to fiscal credibility. The outlook is more precarious in the most indebted countries, such as France, Spain, Italy, the United Kingdom and Japan, which are likely to have limited fiscal capacity to cope with future downturns, but their fiscal dynamics still appear broadly sustainable, provided planned fiscal adjustment is implemented. While debt levels may not decline in the coming years, they are unlikely to rise sharply.
The outlier is the United States, where debt is on a marked upward trend. Its budget deficit is larger than most other countries. Worse, unlike other developed markets, there appears to be little appetite for tightening the fiscal stance. But look deeper and the picture looks more benign. While debt relative to GDP has risen over the past decade, growth in the economy’s net national wealth has outpaced public borrowing. The United States also faces less binding fiscal constraints than other countries. As a provider of the global reserve currency and perceived safe assets, it enjoys greater demand for its liabilities than other countries.
Furthermore, the US tax burden is low compared to other countries and its own history. This is in contrast to what happens in many European countries, where the tax burden is much higher, leaving less room for tax adjustments if necessary. As a result, investors are likely to give more tax credibility to the US.
What does this mean for US debt in the coming years? The overall outlook is likely to be one of business as usual: deficits remain high, debt continues to rise, and demand for US Treasuries remains strong, in part due to the dollar’s status as the global reserve currency.
However, debt cannot rise infinitely, and at some point policy or price adjustments will likely be necessary to make the US fiscal path more sustainable. The most benign scenario would be for the US debt path to improve thanks to higher inflation-adjusted growth. Policymakers could also resort to high inflation (and keep interest rates artificially low) to erode the face value of the debt stock. The most disruptive case would be a sudden and disorderly loss of fiscal credibility, with demand for US Treasuries declining and the term premium (the additional returns investors seek for holding long-term debt) rising sharply.
All of these scenarios are unlikely. While economic growth may recover over time, trend GDP growth would have to more than double from current levels to flatten the debt trajectory. Institutional credibility around the Fed’s independence appears strong, as evidenced by long-term inflation expectations anchored around the central bank’s target. And the dollar’s role as the global reserve currency, the overall dynamism of the U.S. economy, and less binding fiscal constraints make a disorderly fiscal crisis unlikely.
Instead, the most likely long-term solution is some form of debt consolidation through spending reforms or higher taxes. That seems unlikely now, but attitudes may change over time, especially if inflation and interest rates remain at uncomfortably high levels. Previous episodes in which federal interest payments (as a share of total spending) reached levels similar to the current ones were followed by fiscal consolidation: after World War II, under Ronald Reagan in the late 1980s, and under Bill Clinton in the 1990s.
More broadly, however, investors should be prepared for increased volatility going forward. Financial markets are likely to become more sensitive to fiscal and political shocks. Limited fiscal space will likely constrain fiscal policies in future downturns. Coupled with fatigue from quantitative easing programs, this will also contribute to a more volatile macroeconomic outlook. As a result, the term premium may gradually increase. Varying fiscal dynamics across countries also create relative value opportunities. We see value in diversifying a bond portfolio beyond the US.