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FT editor Roula Khalaf picks her favorite stories in this week’s newsletter.
The writer 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 those fears were largely justified. Tight monetary conditions did not trigger broader financial instability. Systemic risks to global banking and non-banking financial markets appear contained. And households borrowed less.
The public sector has instead borne the brunt of the post-pandemic financial strain. Government debt levels are now near record highs. Borrowing remains elevated and interest rates have risen, increasing the cost of servicing deficits.
The fiscal outlook is understandably worrisome, but should not cause alarm. In most developed countries, government debt levels are still too low to pose an immediate threat to fiscal credibility. The outlook is more uncertain in countries with higher debt such as France, Spain, Italy, the United Kingdom and Japan. These are likely to have limited fiscal capacity to deal with future downturns. However, their fiscal dynamics still appear to be generally sustainable, subject to the planned fiscal tightening. While debt levels may not decline in the coming years, they are unlikely to increase dramatically.
The outlier is the USA, where the debt is growing rapidly. Its budget deficit is higher than most other countries. Worse, unlike other developed markets, there appears to be little appetite for fiscal tightening. But dig deeper and the picture looks more benign. While the debt-to-GDP ratio has risen sharply over the past decade, growth in the economy’s net national wealth has outpaced public borrowing. The US also faces less binding fiscal constraints than other countries. As a supplier of global reserve currency and perceived safe assets, it enjoys higher demand for its liabilities than other countries.
Additionally, the US tax burden is low compared to other countries and their own history. Compare this to many European countries where the tax burden is much higher and leaves less room for possible tax adjustments. As a result, investors are likely to give the US more fiscal credibility.
What does this mean for the US debt in the coming years? The overall underlying outlook is likely to be the status quo: The deficit remains 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, the debt cannot grow indefinitely, and at some point policy or prices will likely have to adjust to make the US fiscal path more sustainable. The most benevolent prospect would be for the U.S. debt path to improve due to higher inflation-adjusted growth. Policy makers could also resort to high inflation (and keep interest rates artificially low) to distort the nominal value of the debt stock. The most devastating case would be a sudden and disorderly loss of fiscal credibility, with demand for US Treasuries drying up and the term premium – the extraordinary returns investors seek for holding longer-term debt – soaring.
All of these scenarios are unlikely. While economic growth may accelerate over time, trend GDP growth would need to more than double from current levels to offset the debt trajectory. Institutional credibility regarding the Federal Reserve’s independence appears strong, as evidenced by long-term inflation expectations anchored around the central bank’s target. And the dollar’s role as a global reserve currency, the general dynamism of the US economy and less binding fiscal restraints 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 where federal interest payments (as a share of total spending) reached levels similar to today were followed by fiscal consolidation—after World War II, under Ronald Reagan in the late 1980s, and under Bill Clinton in the 1990s.
More generally, investors should be prepared for future volatility. Financial markets are likely to become more sensitive to fiscal and political shocks. Limited fiscal space is likely to constrain fiscal policy in future downturns. Coupled with QE fatigue, this will also contribute to a more volatile macro outlook. As a result, the term premium may gradually increase. Different fiscal dynamics across countries also create relative value opportunities. We see value in diversifying a non-US bond portfolio.