Government efforts to mitigate the economic consequences of the Global Financial Crisis (GFC) and the Covid pandemic have led to surging government debt. In the United States, for instance, public sector liabilities are approaching levels not seen before in peacetime (Chart above).

And, while I will discuss important differences between countries and regions, the United States is not alone. Goverment debt has risen sharply in virtually every G-20 country in recent decades. Perhaps even more worrisome, however, the failure to address the issue points to the continuation of spiraling debt in the years and decades ahead — the ballon is still expanding (Chart above).

With the 2024 political calendar full of important elections, efforts to reduce large-scale government deficits — the source of rising public sector indebtdness — is unlikely this year. In the United Kingdom, for instance, the prestigious Institute for Fiscal Studies has suggested in the run-up to the July election political leaders are engaged in a “conspiracy of silence” regarding what is needed to curb spiraling debt. The same can be said about the policy debate prior to November’s US election.

What are the consequences of continued inaction? Likewise, what are the implications if policymakers do address the issue eventually? Have markets been too complacent? Are there important distinctions between countries and regions? All considered, read on!

Roadmap to Stabilise Debt: How and Where?

In addressing this situation, the first priority must be to at least stabilise the debt/GDP ratio. What’s needed? To simplify, economists suggest debt stabilisation requires the primary budget deficit/GDP (total shortfall less debt interest payments) be less than the gap between real interest rates and long-term economic growth. Therefore, countries with small initial deficits, strong GDP/productivity growth, and low inflation-adjusted interest rates will be more successful in stabilising debt ratios.

The Chart above indicates that the USA, Japan, China, and Brazil will require the largest fiscal adjustments. Of course, deficit reduction of this scale (4-5% of GDP) need not/should not be implemented all at once. Europe’s experience following the GFC highlighted how painful such “shock therapy” can be. Nevertheless, the longer the adjustment is delayed, the higher the debt burden will become.

In Europe, countries differ widely. France, Italy, and the United Kingdom will require sizeable budget cuts. Meanwhile, Germany has some scope to stimulate policy without increasing its debt level. At the other extreme, reflecting strong GDP growth and small budget deficits, debt ratios in Indonesia, Vietnam, and India are projected to decline in the next decade. These countries, therefore, should be able to boost government spending and pursue economic development.

How’d this Happen: Spending or Taxes?

The contribution of tax versus spending decisions to the spiraling debt burden differs across countries. The path into the problem may offer guidance into the roadmap each nation might follow in the future. In certain Europe countries, e.g. Italy, Spain, the UK, and France, bloated deficits largely reflect much higher levels of government spending compared to historical levels (Chart above). The adverse impact on the region’s public finances, however, has been partially offset by higher taxation: producing the highest tax and spending levels amongst advanced nations. As Europe’s overall debt/deficit situation is healthier than elsewhere, difficult fiscal decisions may not be needed as urgently. In Japan, both government spending and taxation are considerably higher than before the GFC.

In the USA and China, on the other hand, a combination of rising government spending and tax cuts contributed to their surging debt burdens. If stabilising America’s debt ratio necessitates a 5% of GDP adjustment, this is equivalent to eliminating the entire non-defense discretionary spending budget. Clearly, that’s not possible. Therefore, reductions in “mandatory” outlays, e.g. Social security, Medicare, Medicaid, etc., and/or significant tax increases will be required in coming years. Haven’t heard anything about that on the campaign trail!

Strategic Observations and Conclusions

• To stabilise debt ratios, the advanced economies will need to implement fiscal belt-tighening of roughly 0.75% annually for the next five years. The biggest adjustments will be required in the USA, China, and Japan: the world’s three largest economies. This will repesent a modest headwind for global GDP growth. Nevertheless, this would be bullish for financial markets, as monetary policy could be relaxed more aggressive. The period of so-called “fiscal dominance” would be over.
• Financial markets, along with the US Federal Reserve, believe the “natural interest rate” (the inflation-adjusted rate leading to low price growth and full employment) is between 0.5-1%. The IMF, however, estimates unattended debt/deficits could add an additional 1.5% to this equilbrium rate. The consequences would be largest if financial markets lose confidence in policymakers efforts to control debt dynamics. Under such circumstances, bond yields could rise further, even as central banks ease policy. To be sure, bearish for financial assets world-wide.

• Therefore, are markets being too complacent? Yes, probably. In the USA, for example, the increase in bond supply since the pandemic resulting from out-sized budget deficits and QT has been absorbed by private domestic investors (Chart above). Eventually, as the Covid-era rise in household savings disappears, the appetite for US bonds may fade, unless foreign demand picks up further. Without fiscal tightening, US bond yields could approach 5% even as the Fed cuts rates.

• In countries with chronically high government debt ratios, e.g. Japan and Italy, private investment tends to be crowded out (Chart above). Eventually, productivity lags, and long-term GDP prospects suffer (next Chart). Let’s hope this is not a glimpse of the future for China and the USA.

• Overall, Europe’s fiscal situation is healthier than the USA’s. This is one reason I expect European equities to outperform. Moreover, along with Germany, the region’s so-called PIGS — Portugal, Ireland, Greece, and Spain — now have some of the area’s most favourable debt dynamics.

• Likewise, as debt dynamics are better in many Emerging markets compared to advanced economies, I am overweight this asset class once again. Of course, if world-wide debt concerns lead to overall market volatility, EM will suffer. Furthermore, China’s debt situation may become particularly problematic. Brazil, South Africa, and Poland warrant careful attention too. Asia appears best situated, especially Indonesia, Vietnam, and India.

• World-wide fiscal belt-tightening will require governments to shift spending to priority areas: climate, infrastructure, health care/pensions (aging related outlays), and productivity-enhancing public investments. To be sure, all countries will require additional efforts to mitigate the impact of climate change. However, Europe appears relatively better positioned on this issue than China, Japan, and the USA (whose standing could be further compromised by a Trump victory) — Chart above. Meanwhile, while spending requirements of aging populations will increase sharply in many advanced economies. demographics in the USA and many Emerging Markets are superior compared with Europe (ex UK), Japan, and some Asian nations, e.g. Korea, Taiwan, and Thailand (next Chart).