The Hidden Crisis: Why Government Debt Is a Bigger Threat Than You Think

 

Vast government debts are nothing more than ticking time bombs, set to explode and devastate future generations.

When it comes to the soaring levels of government debt, the saying “what goes up, must come down” might take on a new and alarming meaning. Governments around the world have been racking up debt like there’s no tomorrow, but what if tomorrow arrives with a vengeance? Vast government debts are often touted as manageable and necessary for economic growth, but recent events suggest that the risks associated with these debts are far more treacherous than they appear.

 

The recent Jackson Hole meeting of central bankers may have been bathed in sunshine, but the clouds of debt are gathering on the horizon. As Jerome Powell and other central bankers basked in the success of taming inflation and celebrated the prospect of lowering interest rates, a more troubling narrative was brewing beneath the surface. A paper presented by Hanno Lustig from Stanford University offered a sobering reminder that government debt, once considered the safest of all assets, has taken on a riskier persona.

 

During the COVID-19 pandemic, American Treasuries, typically seen as the gold standard of safe investments, experienced a dramatic fall in value. The mix of rising inflation and increasing interest rates caused the real value of outstanding Treasuries to plummet by 26% between January 2020 and October 2023. Investors, who were once confident in the safety of these assets, suddenly found themselves in a “risky debt regime,” where the old rules no longer applied. The typical assumption that Treasuries are immune to economic upheavals was shattered, as bondholders faced the stark reality of eroded returns and heightened risk.

 

This shift in the perception of government debt should serve as a wake-up call. The events of recent years are not anomalies but rather reminders that history has a way of repeating itself. The notion that government debt is a reliable and low-risk asset has been challenged before, notably after wars and financial crises that triggered surges in inflation. The COVID-19 pandemic is unlikely to be the last global crisis, and the response from governments has set a precedent for massive fiscal interventions that may not be sustainable in the long run.

 

One need only look at the recent turmoil in the United Kingdom's gilt market to see the potential consequences of fiscal recklessness. The short-lived government of Liz Truss announced unfunded tax cuts in late 2022, leading to a panic in the bond market and a sharp sell-off. The incident was a stark reminder that markets are not always forgiving when it comes to government debt. Investors are quick to react when they perceive fiscal policy as irresponsible, and the repercussions can be severe.

 

Moreover, the implications of quantitative easing (QE) cannot be ignored. Central banks have used QE as a tool to stabilize markets during times of crisis by purchasing government bonds. However, this practice has blurred the lines between monetary policy and fiscal policy, shifting some of the risks from bondholders to central banks—and by extension, to taxpayers. The once-profitable strategy of QE has become a double-edged sword, as central banks now face the challenge of managing the fiscal consequences of their actions. Andrew Bailey, Governor of the Bank of England, acknowledged the tarnished reputation of QE, hinting that its future use would be approached with far more caution.

 

But the most profound concern is that central bankers might soon find themselves at the mercy of fiscal policy decisions. While central banks have been able to control inflation through interest rate adjustments, their effectiveness hinges on governments keeping their debts in check. In a scenario where fiscal policy becomes unhinged, no amount of interest rate manipulation can rein in inflation. This is a scenario Brazil knows all too well, where high interest rates have only exacerbated deficits as the government borrows more to cover soaring debt interest payments. As the United States continues to run a deficit of 7% of GDP despite not being in a recession, it is only a matter of time before this problem escalates.

 

Despite the relative calm in bond markets today, the lessons of recent history should not be forgotten. The optimism in bond markets, reflected in the modest 4.1% yield on thirty-year Treasuries, may be misplaced. The risk premium has all but vanished, yet the underlying risks have not. Investors are once again lulled into a false sense of security, ignoring the very real possibility that history will repeat itself. The next crisis, whether it be another pandemic, a geopolitical conflict, or a financial meltdown, could easily trigger a similar response from governments, leading to another round of inflation and devaluation of government debt.

 

In the end, the irony is that the very institutions designed to protect the economy—the central banks and governments—may be the ones sowing the seeds of the next crisis. As the world becomes more accustomed to large-scale fiscal interventions, the risks associated with vast government debts will only grow. While central bankers may deserve a moment of celebration for their recent successes, the bondholders and taxpayers who will ultimately bear the brunt of these risks should remain vigilant. After all, when it comes to government debt, the sun might be shining today, but the forecast calls for rain. And if history is any guide, it could be a downpour.

 

In a world where governments have mastered the art of kicking the can down the road, one has to wonder: what happens when they run out of road?