Should investors worry about ballooning government debt in advanced economies?

Since the global financial crisis, government debt and fiscal deficits in the world's advanced economies have increased substantially, with little prospect of improvement. While initially a necessary tool to offset the painful effects of the crisis on the economy, and later of pandemic-related shutdowns, higher deficits have become widespread, even as many economies have recovered and unemployment rates are near their lowest in decades.

Record-low interest rates for the past 15 years facilitated this spending spree with little political or investor backlash. In fact, despite mounting debt levels, government interest expense declined as a percentage of gross domestic product (GDP) for most large, advanced economies until 2021. So long-term debt sustainability was not a pressing issue.

Debt service costs creeping higher

Now, however, interest rates have risen, and government debt servicing costs are beginning to climb higher.

The impact has been most visible in the USA, where refinancing needs are frontloaded. Over the past year, the US government has been financing new and maturing debt at short maturities, paying a coupon of roughly 5 % - high compared to its average interest rate on total outstanding debt of 2.5 % to 3 %.

This has had a measurable effect. The average US interest rate has risen between one-half and one percentage point, and catapulted the government's annual interest expense to 3.1 % of GDP in 2024, from 2.4 % in 2023, according to the Congressional Budget Office (CBO). Debt service costs in the USA now exceed annual defence spending.

Elsewhere the effect of rising interest rates has been more muted. Most other advanced economies have higher average term to maturity, which means that they issued more longer-term bonds than shorter ones. It will thus take longer for higher rates to translate into debt service costs.  

There is no magic threshold where government debt becomes bad for economic growth, or where debt becomes unsustainable. As long as investors buy the government bonds at affordable interest rates, debt levels can vary in size. Generally speaking though, where we stand today, we acknowledge that government debt does not have to be repaid in full, but government revenues do need to match spending over time to stabilise debt at current levels. To name a few big economies, France, the UK, the US and Japan, may need to reduce their deficits to stabilise debt-to-GDP levels.

Reducing deficits, or fiscal consolidation as it is termed, is increasingly difficult. Structural government spending needs are bound to increase with rising pension and healthcare costs as populations age. Higher defence spending is essential to cope with geopolitical tensions. And the green energy transition, digitalisation, and infrastructure upgrades are also on the financing agenda.

Rising structural spending

The European Central Bank (ECB) estimates that the fiscal effect of financing this extra spending will be a combined five percentage points of GDP across the region. That's on top of the need to return debt-to-GDP levels to 60 % by 2070, as agreed under EU fiscal rules.

The US CBO projects that under current spending rules, and taking account of the expiration of some 2017 income tax reduction provisions, the US debt-to-GDP ratio will rise by another 20 percentage points from the current level until the mid-2030s. The new Trump administration may add another 20 percentage points on top of the CBO's lofty projection over a ten-year horizon, according to the US Committee for a Responsible Budget. On both sides of the Atlantic, high political polarisation will likely impede politically controversial and unpopular cuts to government spending.

Can governments change course?

The tools available to governments seeking to turn the debt tide are often unappealing. Growing out of debt is the most attractive proposition, but finding higher GDP growth isn't easy. Trend growth rates have been declining over the past decades, and productivity gains from technological progress, such as artificial intelligence, is a mid- to long-term proposition.

Hiking income taxes is similarly difficult to implement, and debt default could lead to dramatic and unsavoury effects on the capital markets.

Less politically unpalatable changes

Other factors could change the debt-to-GDP scenario. For example, higher inflation raises the denominator in this ratio through higher nominal GDP, while also swelling tax revenues and spending. In the USA, the 2021/2022 inflation surge cut the ratio of debt to GDP from 126 % in 2020 to 120 % in 2022.

Another more silent and politically desirable approach is to keep interest rates artificially low and gradually inflate debt away. Coupled with capital controls and regulatory restrictions, this strategy helped reduce US government debt from 120 % of GDP after WWII to 65 % in 1955. This approach did not come without costs, though, as the purchasing power of savings and bond holdings fell sharply.

The current outlook for the long-term debt trajectory is admittedly rather bleak for some countries. For these economies, deficits need to be addressed to avoid a vicious cycle of ever-growing debt and unproductive interest payments.

Nevertheless, we do not believe that a crisis of confidence is looming. Rather, we expect a muddling through, where real GDP growth will not be sufficient to materially reverse the recent rise in government debt and governments will do the bare minimum to keep investor concerns at bay.

Central banks can manage volatility spikes

We do think that there will be more temporary bouts of volatility in the bond markets as and when governments announce excessive spending plans. These will likely be resolved by central banks before short-term liquidity squeezes threaten the ability to finance debt. Eventually, however, debt and deficits must be addressed and resolved.

In the meantime, investors would be ill-advised to sit on the sidelines, preparing for the worst-case scenario. More money could be lost by waiting there for a big crash than could be earned through a carefully considered asset allocation strategy.