The rise of debt in the G7 economies

Government debt among six of the G7 countries will exceed 100% of gross domestic product this year.

This increase effectively means that only Germany has sufficient fiscal flexibility to respond to an economic downturn without risking a further rise in interest rates along the long end of the curve.

In response to this increase, global investors have pushed interest rates higher as they question the sustainability of this debt and factor in the risks of a downturn, stagflation and geopolitical tensions.

As a result, long-term rates have risen even as central banks have reduced their policy rates.

State of play

Japan breached the once-inconceivable 100% threshold in its ratio of debt to gross domestic product in 1997 and is expected to reach 235% this year.

But Japan largely purchases its own debt domestically and is having issues exiting its yield curve control policy framework as inflation normalizes and rates slowly increase.

The U.S. government allowed its debt to reach 100% of GDP because of the fiscal stimulus during the 2011−12 recovery from the global financial crisis.

That spike was followed by another surge in spending in response to the pandemic. But each of those episodes occurred during times of near-zero interest rates.

Now, American political actors are tempted to artificially push down policy rates to mitigate the rising costs of servicing debt.

Current economic conditions and the direction of inflation, though, are not conducive to moving back to a zero interest rate framework, or really any form of yield curve management.

The countries of the eurozone show similar patterns of fiscal responses to economic crises, increasing spending when the private sector is unable to provide full employment.

Italy’s debt burden has fallen to 137% from 150%, driven by a reduction in its primary budget deficit. Germany’s debt, by contrast, has risen to 65% of GDP this year.

Looking ahead

Is carrying this level of debt unsustainable?

While Japan’s history of carrying high debt might suggest otherwise, that country’s moribund economy has long relied on zero interest rates.

The problem arises when an economy no longer needs the fiscal boost, yet the burden of servicing the debt remains.

An International Monetary Fund paper published last October found that fiscal consolidation in the advanced countries in Europe had a negligible effect on public debt ratios because fiscal consolidation slows economic growth.

The paper also said that to reduce public debt ratios, fiscal consolidation requires a favorable economic environment with a proper mix of tax increases and spending cuts.

But, excluding Italy, we do not see the G7 moving toward fiscal consolidation anytime soon, which suggests that as inflation moves higher, interest rates along the long end of the curve will move in that direction, too.

Any attempts at fiscal consolidation during the transition from stimulus to fiscal balance could lead to economic downturns, or at least stagnation.

That kind of stagnation would only trigger an increase in public debt ratios, risking an erosion of financial market confidence and an accompanying increase in market-derived long-term rates.