The major countries built up substantial state borrowings before the pandemic struck. The sudden collapse in tax revenues and the increase in expenditures to see people and companies through the lockdowns led to a further explosion in government borrowing. As a result, many countries now have even larger state debts, with many advanced countries borrowing more than their annual GDP. Some now fear the debt burden is too great and look to governments to cut their spending or raise their taxes or both. They think they need to bring down the deficits and then to go on to chip away at the large stock of debt they have amassed.
There is a worry that as interest rates start to increase as money policy edges towards an older normal the states will find it difficult to meet the interest bill. As interest charges increase so the state has to rein in more worthwhile spending or collect more revenue. Before rushing to this conclusion, it is important to look at the experience of Japan and to remember that central banks are not planning a steep rise in rates anytime soon and aim to keep rates low by historical standards.
Japan at the vanguard
Japan was the pioneer of loose money policy, copied by the other advanced countries after the Great banking crash of 2008 and again as the pandemic hit. Japan now has a state debt that is over 260% of GDP, but so far it has proved eminently affordable. Because Japan has embarked on rounds of money creation and bond buying, the interest rate on ten-year borrowings is a very manageable 0%.
Japan is an extreme case. Other countries cannot be sure they will get away with buying up state debt on such a scale.
The central bank has now bought in almost half of the total debt outstanding. The Japanese state owns the central bank, so it both holds the liability and the asset of the borrowing. It is safe to treat differently the amount of the Japanese debt that the Bank owns in any calculations about what could happen to the cost of the debt were rates to rise. With the Bank owning half the debt the state finances are not as exposed as some think.
Japan is an extreme case. Other countries cannot be sure they will get away with buying up state debt on such a scale, nor can they be sure they can keep interest rates around zero for as long as Japan. Inflation could come to spook a country market and force the Central bank’s hand to raise rates and seek to reduce credit.
At the other extreme lie some Latin American countries that have created too much money and borrowed too much, only to discover they experience a run on their currencies, an unwillingness of international lenders to lend and the fast depreciation of the domestic currency they issue. They usually end up having to negotiate an expensive international loan imposing conditions on them to rein in their monetary and spending excesses.
The US with state debt around 130% of GDP is facing the question today of whether it is more like Japan or whether its current rapidly rising inflation means it no longer can get away with short interest rates near zero and with large money creation programmes to buy up bonds.
The debt is affordable at current rates.
The Fed has wished to run the economy hot and think that inflation will be temporary and will subside. Bond markets have put a precautionary higher interest charge on longer-dated US state bonds than Japanese and many European ones, worrying about the pent-up inflation in US policy. The debt is affordable at current rates, and the US benefits from the way the Fed has bought up a substantial minority of the state debt.
It looks as if the Fed will now wind down the amount of new money it creates and slow the pace at which it builds up its bond holdings, allowing rates to move up a bit and trusting that will do enough to curb price rises.
Europe a special case
The leading European states are in a different position to Japan or the US. They have debt to GDP ratios above 100% in the main, but they do not own the bonds the central bank is buying up, because they are each but minority shareholders in the central bank. All the bonds issued by France or Italy are genuine liabilities of the state. If the ECB did go for higher rates they would have to pay the extra interest to the ECB on the bonds the central bank owns and would not be able to get it back as a dividend in the way the US or Japan can.
There is more risk in Euro area country bonds because no individual member state can simply print more Euros to pay them back in the way the USA can print more dollars to meet its obligations, and because any individual member state cannot require the Central Bank to follow a given policy or aim.
For the time being, state debts in the advanced countries are manageable despite the big increase in them. The worry rests with inflation and what that might do to Central Bank policies which have been based on the optimistic view that price rises will stay lower and come back down quickly. We think the state debts of the main advanced countries will be affordable, with rates staying relatively low. Some countries will nonetheless have Treasuries that use the scale of the debt as a reason to resume a tighter fiscal stance.
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