How governments can avoid a debt crisis as rates rise
This is the fourth column in a Heard on the Street series on the end of zero interest rates.
Low interest rates have made it easy to sustain the astronomical amounts of debt that the United States and other countries have issued in recent years. So what will happen when interest rates rise?
A decade ago, following the massive spending that governments unleashed in an attempt to contain the global financial crisis and the European debt crisis, many were convinced that government IOUs were too high. In hindsight, the worries seem overblown and the debt levels everyone is concerned about seem odd.
At the end of 2011, the American public sector had a debt of 15,000 billion dollars, according to the Organization for Economic Cooperation and Development, or 99% of gross domestic product, a record after the Second World War. Last year, it had risen to $30 trillion, or 131% of GDP. In Japan, anemic growth pushed public debt to 242% of GDP. In Europe, the indebtedness of Great Britain is 156% and that of Italy 183%.
Yet the amount of money needed to pay interest on this massive pile has plummeted across the board. In the United States, it fell from 4.4% of GDP in 2011 to just 3.6% a decade later. Subtracting certain types of interest the government receives, the net figure is even smaller at 2.5% of GDP.
With central banks in advanced economies now pushing rates higher – the Federal Reserve expects the midpoint of its overnight rate range to reach 2.75% by the end of next year – the costs of service should increase again. Will it matter? One worry is that governments, if they have to cover interest payments with more debt, will stoke inflation or be forced to raise taxes, which will drag the economy down.
But there is no reason to panic: the latest projections from the OECD underline that the interest burden is not about to skyrocket over the next two years. On the one hand, increases in benchmark interest rates take time to translate into higher borrowing costs for governments. Of course, the upside surprises that inflation continues to deliver – due to post-pandemic shortages and a war in Ukraine – mean that these forecasts are under threat, and a 4% Treasury yield no longer looks so ridiculous. In addition, rate hikes by the European Central Bank could draw particular attention to heavily indebted countries that do not issue their own currency, such as Italy and Spain.
On the other hand, government largesse has helped households and non-financial firms to hoard cash and reduce their own, arguably more dangerous, net debt. This was particularly the case in the United States after the pandemic.
Before we jump into predictions that the developed world is about to enter a debt spiral, however, it’s important to remember that a world of higher rates may also be different to others. respects. Higher inflation pushing rates higher will also translate into higher tax revenues, making it easier for governments to repay past debt.
Heard on the street
A series on the end of zero interest rates.
The era of ultra-low rates of the past decade began, in part, because low productivity was undermining economic growth. If productivity improves as interest rates rise, faster economic growth will make it easier for governments to repay their debt. Finally, the long period of falling interest rates that began in the 1980s was associated with an increase in economic inequality. If, in a rising rate environment, the opposite turns out to be true, the amount of money governments spend on welfare programs could decline.
It is of course also possible to imagine the worst-case scenario of a stagflationary environment, in which inflation remains high, economic growth is weak and unemployment rises. In this case, high interest rates would force countries to devote a larger share of their budget to paying bondholders.
It’s the kind of saving that accompanies these higher rates, however, that will determine how difficult the government’s job will be.
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