It’s all about debt from here on out, and probably will be for many years. That’s old news, of course, but it’s still relevant, as we’ve been discussing, including here and here. A new research paper from the Bank for International Settlements is the latest contribution to the literature that rings the warning bells.
“The future of public debt: prospects and implications” (published last month) lays out the basic challenge, explaining:
The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand. According to the OECD, total industrialised country public sector debt is now expected to exceed 100% of GDP in 2011 – something that has never happened before in peacetime.
Is this reason for concern? So far, the paper’s authors report, bond markets have shown a high tolerance for future liabilities in the new age of red ink. But the fixed-income market is “notoriously short-sighted,” they warn. “We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point.” In other words, “the question is when markets will start putting pressure on governments, not if.”
The central issue, according to the paper:
…the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk. It will also complicate the task of central banks in controlling inflation in the immediate.
The rise in government debt is, by itself, reason for concern. But the problem is compounded by expectations that we’re facing an era of higher spending related to aging populations. The study explains:
…the current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts.
In addition, the full hazards have been muted in recent years thanks to low interest rates and low inflation. Under those conditions, the burden is considerably eased for financing and refinancing debts. But the times they are a changing. In particular, real (inflation-adjusted) interest rates have been rising lately, as the chart from the study below shows.
“Real borrowing rates rose through 2009, and are poised to continue increasing with the reversal of the current zero interest rate policy,” the authors predict. “It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far,” they write. “In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly.”