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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is 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. These concerns, it turns out, were largely misplaced. 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 the post-pandemic financial strain. The stock of government debt is now close to record highs. Borrowing remains elevated and interest rates have increased, compounding the cost of servicing deficits.
The fiscal outlook understandably raises concerns, but it shouldn’t raise alarm. In most developed countries, government debt levels are still too low to pose any immediate threat to fiscal credibility. The outlook is more precarious in countries with higher debt, such as France, Spain, Italy, the UK and Japan. These will probably have limited fiscal capacity to address future downturns. But their fiscal dynamics still appear broadly sustainable, conditional on planned fiscal tightening. While debt levels may not fall in the coming years, they are unlikely to rise dramatically.
The outlier is the US, where debt is on a sharply increasing trend. Its budget deficit is wider than that of most other countries. Worse, unlike other developed markets, there appears to be little appetite to tighten the fiscal stance. But dig deeper and the picture looks more benign. While debt relative to GDP has surged in 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 the supplier of the global reserve currency and perceived safe assets, it enjoys higher demand for its liabilities than other countries.
Moreover, the US tax burden is low compared with other countries and its own history. Contrast this with many European countries, where the tax burden is much higher, leaving less room to adjust taxes if needed. As a result, investors are likely to grant more fiscal credibility to the US.
What does that mean for US debt in coming years? The overall baseline outlook is probably one of status quo: The deficit remains high, debt continues to climb, and demand for US Treasuries stays robust, in part because of the dollar’s status as a global reserve currency.
Debt cannot rise infinitely, however, and at some point policy or prices will probably need to adjust to make the US fiscal path more sustainable. The most benevolent prospect would be if the US debt path improves thanks to higher inflation-adjusted growth. Policymakers could also resort to high inflation (and keep interest rates artificially low) to erode the nominal value of the debt stock. The most disruptive case would be a sudden and disorderly loss in fiscal credibility, with demand for US Treasuries drying up and the term premium — the extra returns sought by investors for holding longer-term debt — rising sharply.
All of these scenarios are unlikely. While economic growth may pick up over time, trend GDP growth would have to more than double from current levels to flatten the debt trajectory. The institutional credibility around independence of the Federal Reserve appears strong, as evidenced by long-term inflation expectations anchored around the central bank’s target. And the dollar’s role as global reserve currency, the general dynamism of the US economy and less binding fiscal constraints make a disorderly fiscal crisis improbable.
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 when federal interest payments (as a proportion of total outlays) reached similar levels as today were followed by fiscal consolidation — after the second world war, under Ronald Reagan in the late 1980s and under Bill Clinton in the 1990s.
Nonetheless, more generally, investors should be prepared for more volatility ahead. Financial markets are likely to become more sensitive to fiscal and political shocks. Limited fiscal space will probably constrain fiscal policies in future downturns. Coupled with fatigue over quantitative easing programmes, this will also add to a more volatile macro 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.
