Government debt among six of the seven countries in the G-7 will exceed 100% of gross domestic product this year.
This increase effectively means that only the German economy has sufficient fiscal space to respond to any economic downturn without risking a further rise in interest rates along the long end of the curve.
In response to this rise in debt, global investors have pushed rates higher as they question the sustainability of this debt and factor in the risks of a downturn, stagflation and geopolitical tensions
These higher rates have come even as central banks have reduced their policy rates.
State of play
Japan breached the once-inconceivable 100% threshold in its debt-to-GDP ratio in 1997 and is expected to reach 235% this year.
But Japan largely purchases its own debt domestically and is having issues exiting its yield curve control policy framework as inflation normalizes and rates slowly increase.
The U.S. government allowed its debt to reach 100% of GDP because of the fiscal stimulus during the 2011-12 recovery from the financial crisis. That spike was followed by another surge in spending in response to the pandemic. But each of those episodes occurred during times of near-zero interest rates.
This is why it is tempting for American political actors to artificially push down policy rates to mitigate the rising costs of serving past debt.
Current economic conditions and the direction of inflation, though, are not conducive to moving back to a zero-interest rate framework or really any form of yield curve management.
The countries of the euro zone show similar patterns of fiscal responses to economic crises, increasing spending when the private sector is unable to provide full employment.
Italy’s debt burden has been reduced to 137% from 150% as it has reduced its primary budget deficit. Germany’s debt, by contrast, has risen to 65% of GDP this year.
Looking ahead
Is carrying this level of debt unsustainable?
While Japan’s experience on the surface might argue otherwise, Japan’s moribund economy has long relied on zero interest rates.
The problem comes when an economy no longer needs the fiscal boost, yet the overhead of maintaining the debt remains.
An International Monetary Fund paper last October found that fiscal consolidation in the advanced countries in Europe had a negligible effect on public debt ratios because fiscal consolidation slows economic growth.
The paper also said that successful reductions in public debt ratios by means of fiscal consolidation should be expected under a favorable economic environment and a proper mix of tax increases and spending cuts.
But, excluding Italy, we do not see any move toward fiscal consolidation in the G-7 anytime soon, which suggests that as inflation moves higher, rates along the long end of the curve will move in that direction, too.
Otherwise, fiscal consolidation during the adjustment period can lead to economic downturns or at least stagnation.
That kind of stagnation would only trigger an increase in public debt ratios with the risk of an erosion of financial market confidence and an accompanying increase in market-derived long-term rates.
