Global government debt levels have been growing rapidly over
the last 25 years and are now expected to exceed $100 trillion
by the end of this year. For developed countries, the
average ratio of public debt to GDP is back to where it was in
1945, when public debt rose above 100% of GDP after two
world wars and the Great Depression.
The recent surge in borrowing was driven by a series of
shocks. First the global financial
crisis, then the pandemic, and then the Russian invasion of
Ukraine. For most of that period,
interest rates were low and falling.
But since the pandemic, we've seen a spike in inflation
globally, which pushed interest rates up, meaning that any new
debt being issued is much more expensive.
But that has in no way stopped governments from borrowing and
spending. A quick glance at the news shows
that even as rates are rising, budget deficits around the world
are projected to grow. Government spending in most
countries has been high since the pandemic for a few reasons.
For one thing, politicians tend to spend a lot more in election
years. And 2024 was the biggest
election year in world history, where 72 countries that
encompass half of the world's population held elections.
Governments spent a lot to win re election, and newly elected
leaders are now spending a lot to fulfill their campaign
promises. So what is the money being spent
on? Globally, there's been a lot of
climate change spending, which is expected to continue or
possibly increase. And in Europe, we saw high
government spending to shield consumers from a spike in gas
prices. Geopolitical tensions all around
the world mean that military spending is expected to grow in
the years too. Last year, government spending
around the world was the highest it's ever been outside of a
crisis, with the biggest driver of increased spending being the
rising interest rates on government debt.
This week, the US Treasury Department saw soft demand at a
$16 billion twenty year bond auction, which caused stocks and
the dollar to sell off while Treasury yields rose, according
to Reuters. The weak auction shows
intensified investor worries about the ballooning U.S. debt,
which could spur bond market vigilantes who want more fiscal
restraint from Washington. This came after Moody's
downgraded the US government's credit rating, citing the
growing debt and little progress towards resolving it.
The move was not a huge surprise as Moody's was the last of the
big three rating agents to take the step and had warned 2 years
ago that this might happen. The 30 year U.S.
Treasury yield rose above 5% earlier this week and has stayed
there. In Japan, events were even more
dramatic when the weakest demand seen at a government debt
auction in more than a decade drove the 20 year government
bond yield up to the highest rate in 25 years.
The yield on 30 year Japanese government bonds climbed to the
highest level seen since that maturity was first sold in 1999,
so an all time record. Yields on the 40 year Japanese
government bond rose to a record high too of 3.7%, which is a
full percentage point higher than at the start of April.
As the FT points out, a sharp move like that from such a low
starting point means that investors who owned that bond
have lost almost 20% of their investment in just a few weeks.
To highlight how ugly the Japanese government bond market
is right now, we have to look at the less liquid bonds which
investors are keeping well away from for fear of being stuck in
a difficult to sell bond as prices collapse.
The Japanese yield curve is not just upward sloping, it's the
steepest upward sloping yield curve in the developed world.
This means that longer maturity bonds pay higher interest rates.
But in the market chaos, the 35 year bond, which was issued as a
40 year bond five years ago, now yields over 100 basis points
more than the 40 year bond. This makes no sense in such a
steep upward sloping yield curve.
But the reason this is happening is that the 35 year bond is a
lot less liquid than the more recently issued 40 year bond.
It's what's known as an off the run bond, and it's trading at a
surprisingly higher yield because investors are so afraid
of buying a bond that might be difficult to sell. the FT
describes this as pretty stark evidence of the evaporating
demand for longer term Japanese debt.
This kind of drama in high grade developed market government
bonds, where bonds are supposed to be the safe asset class, is
an example of how things can go wrong when investors back away
from lending to highly indebted nations.
Japan today has the highest public debt to GDP ratio in the
world at over 240%. This ratio was only at around
50% of GDP in 1990. Over the same period, the US has
gone from a debt to GDP ratio of around 40% to around 100% today.
So why have governments around the world become addicted to
debt? And can they deleverage?
The surge in Japan's debt to GDP ratio over the last 35 years was
driven by a combination of huge government spending aimed at
reviving A stalled economy combined with a collapse in GDP
growth. So debt grew and grew while GDP
didn't. Over that period there've been
huge stimulus packages including infrastructure spending and
social welfare spending, all in an attempt to end persistent
deflation and low growth. Japan's rapidly aging and hyper
aged population is part of the problem too, as retirees
demanded spending on healthcare and pensions, significantly
adding to the debt burden. The growing debt never really
caused a problem over that period simply because the
government was borrowing at such low interest rates.
The problem is that when interest rates start to rise,
Japan has to either stop borrowing and start paying down
it's debt, or it's class of borrowing will become
unmanageable. Japan's Prime Minister told
parliament this week that he disagrees with the idea of
funding tax cuts with bond issuance, signalling caution
over new government spending now that the nation's borrowing
costs are rising. The surge in Japanese bond
yields highlights the concerns of bond investors globally about
the risks of unsustainable government spending.
These higher yields in Japan are part of a global trend where the
government borrowing costs in the world's largest economies
are rising as investors question the ability of governments to
cover massive budget deficits. The yield on the UK's 30 year
government bond spiked as high as 5.54% this week, up 40 basis
points a year to date. The UK is expected to post a
budget deficit equivalent to $185.5 billion this year, which
is slightly lower than last year's levels.
They expect the budget to remain in a deficit through the end of
the decade. China's debt to GDP has been
growing over the last 15 years and is expected to continue
growing as the country runs deficits to stimulate the
slowing economy. China has for decades aimed to
keep the official deficit at no more than 3% of GDP, but has
breached that figure 3 times since 2020.
The government set this year's fiscal deficit target at 4% of
GDP. the US hit its debt to GDP record in late 1945, when U.S.
National debt was briefly larger than the entire U.S. economy.
After a three decade decline, by the mid 1970s debt had fallen to
around 1/4 the size of the economy.
Since then, it's been steadily growing under both Democratic
and Republican presidents. It really took off in the wake
of the global financial crisis where it hit around 75% of GDP,
and again in early 2020 when the pandemic struck, it soared close
to 100% of GDP. When you look at the chart, you
can see the debt has generally grown during times of war or
financial crisis when unemployment is high and
economic growth is low. Overall, the US has the eighth
highest public debt to GDP ratio in the world.
Right before the pandemic, the US economy was in its longest
expansion in modern history. But at the same time, U.S. debt
was quite high and growing, which was unusual at the time,
as normally that deep into an expansion you would expect to
see budget deficit shrinking. But the US budget deficit was
instead growing and at a faster and faster rate.
Even before the pandemic hit. In April 2020, the federal
government delayed tax payments, meaning that money stopped
coming in. And the Treasury announced that
it would borrow $3 trillion in the second quarter alone.
Who would buy all of this debt? Well, the Federal Reserve was
the biggest buyer. It expanded its Treasury
holdings by nearly $2 trillion in a matter of two months.
That month, Americans received their first stimulus checks in
the mail. The Congressional Budget Office,
a nonpartisan federal agency whose role is to provide
Congress with objective analysis and estimates related to
economic and budgetary decisions, is now predicting
that America's debt to GDP ratio will rise from 98% where it is
today to a record 125% in the next decade.
There's no war or recession right now to easily explain the
rapidly increasing pace of borrowing and the the US
unemployment rate is near an all time low because the US
government has been spending more than it collects in taxes
since the global financial crisis, the national debt has
been growing. Even without President Trump's
planned deficit spending as part of his budget, the US debt to
GDP ratio is expected to exceed the 1945 high in nine years if
Trump's One Big Beautiful Bill Act makes it through the Senate.
The Committee for a Responsible Federal Budget, a nonpartisan
group that favours debt reduction, estimates that U.S.
National debt will reach 129% of GDP by 2034.
Now, on the campaign trail, Trump claimed that he would not
be running a massive budget deficit.
He instead said that he would balance the budget.
I want to do what has not been done in 24 years, balance the
federal budget. We're going to balance.
Trump's team claim that the legislation, when combined with
his pro growth policies, will have the US fiscal deficit from
its current level of 6.4% to 3% by the end of his term.
His Council of Economic Advisers claims that the bill will boost
real economic growth by up to 5.2% over the next four years,
creating or saving up to 7.4 million jobs and raising
investment by up to 14.5% over the next four years.
Not everyone agrees with that. While many agree that the tax
cuts might boost economic growth, they argue that the
increased borrowing and the inflationary effect of Trump's
trade policies will drive up interest rates on government
bonds while slowing the US economy.
The Center for American Progress, a liberal research
group, have published projections which assumed that
all of the bills temporary provisions get permanently
extended. They say that in such a
scenario, government debt could reach about double the size of
the economy by 2055, compared with 156%, without any changes
to the existing law. The weak U.S.
Treasury auction this Wednesday highlighted investor fears over
America's rising debt burden in the lead up to the vote on
Trump's big, beautiful bill in the House of Representatives.
The 30 year Treasury yield rose to 5.1% as the price of bonds
fell. It extended its rise to 5.12%
after the bill passed the House of Representatives by a single
vote. The recent debt downgrade by
Moody's has also been putting upward pressure on US interest
rates. So if every government is
borrowing, who's buying all of these government bonds?
Well, pension funds are amongst the biggest buyers of government
bonds because they're considered a safe investment.
Investment funds, central banks, other governments, and
individual investors also buy bonds.
According to the US Treasury, 80% of U.S. government bonds are
held by Americans and 20% by other governments.
When we look at the breakdown of that 80%, we can see that almost
1/4 is held by the Federal Reserve, with the rest held by
mutual funds, state and local governments, pension funds,
insurance companies, and banks. So what does the US government
spend all of the money on? Well, the federal budget is
divided between mandatory spending, discretionary
spending, and interest payments on the debt.
More than 60% of the budget goes towards mandatory spending,
which is automatic unless Congress changes the legislation
authorizing it. Social Security, Medicare and
Medicaid make up 75% of mandatory spending.
About 28% goes towards discretionary spending, which
Congress has to authorize each year through the appropriations
process. About half of the discretionary
spending goes to defence related agencies and programs.
The rest is spent on things like health education, veterans
benefits and transportation. About 12% of the budget goes on
interest payments on the national debt.
As you can see, this has risen over time as both the scale of
borrowing and interest rates have gone up.
This is projected to continue rising in the future.
Interest payments were $880 billion last year, which is more
than was spent on Medicare and the military.
The financial historian Niall Ferguson told the FT that any
great power that spends more on debt servicing than on defence
risks ceasing to be a great power unless debt is paid down.
That $880 billion interest expense can be expected to grow,
as most of the borrowing was done when interest rates were
much lower than they are today and when the US still had a AAA
credit rating. Even if the amount borrowed
stays the same as old bonds expire and are replaced with new
bonds, the interest rate on those new bonds will be higher
than the interest rate was on the bonds that expired.
While nonpartisan research groups are estimating that
Trump's budget will add more than 2 1/2 trillion dollars to
the federal debt over the next decade, White House Press
Secretary Caroline Leavitt says that the budget will actually
save the federal government $1.6 trillion.
She said this bill does not add to the deficit.
It is the largest savings for any legislation that has ever
passed Capitol Hill in our nation's history.
The $1.6 trillion figure seems to refer to the spending cuts in
the bill, but it ignores the fact that the government will
still be spending significantly more overall than it brings in
in taxes, which means borrowing at whatever the prevailing
interest rate is. In their downgrade announcement,
Moody's predicted that the US budget deficit would rise from
6.4% last year to just under 9% by 2035.
So is the Trump administration right that the new budget will
spark growth and that the US can outgrow the deficit?
Well, during the global financial crisis, the US
Treasury issued huge amounts of new debt, a lot of which was
bought up by the Federal Reserve, a lot like what
happened during the pandemic. Some economists predicted huge
inflation at the time and businesses being crowded out of
the debt market, but that didn't actually occur.
Economists then started rethinking many of their
theories around how much borrowing is too much.
In 2019, Olivier Blanchard, an MIT professor and the former
chief economist at the IMF, used his last speech as president of
the American Economic Association to put forward a
provocative idea. In a world where interest rates
are very low, he said governments can afford to take
on a lot more debt. In a speech titled Public Debt
and Low Interest Rates, Blanchard laid out the theory
that as long as the interest rate on government debt is lower
than the growth rate of the economy, that governments can
tolerate a lot more borrowing than it previously seemed
reasonable. He argued that big government
debt may not be as dangerous as they were previously believed to
be. Trump's bet is that he can grow
the US economy faster than he grows the national debt and that
way he can move towards a balanced budget.
The worry is that his whipsaw approach to trade policy, which
has included massive tariff announcements followed by
delays, exemptions and reversals, has undercut
businesses ability to plan and invest.
This Friday, just hours before trade talks were scheduled to
start with the EU, Trump threatened a 50% tariff on EU
goods, while also warning Apple that he would impose a 25%
import tax at least on iPhones not manufactured in the United
States, later widening the threat to any smartphone being
imported. On Trump's Liberation Day in
April, he announced a 20% tariff on most EU goods, then halved it
to 10% for 90 days to allow time for negotiations.
It's not obvious how huge tariffs and constantly changing
trade policies would boost U.S. economic growth.
There's a real risk that these policies are inflationary and
kill economic growth, which would mean higher interest rates
on the debt than the current 5% rate with no offsetting growth.
Bond investors who lock up their money at a fixed rate hate
inflation as it eats into their returns.
They equally hate if the currency the bonds are
denominated in depreciates. The term bond vigilante was
coined by the economist Ed Yardini in the 1980s.
He used the term in a letter to describe investors who reacted
to government policies, particularly those perceived as
inflationary or excessive spending, by either selling off
bonds they owned, which drove up yields, or by just declining to
buy them. The idea was that politicians
can't mess with the bond market and that when politicians get
out of line, the bond market reminds them of the need for
fiscal responsibility. In the UK, Liz Truss's proposed
mini budget was quickly abandoned a few years ago when
the bond market reacted badly to its announcement.
And in the early 90's the 10 year bond yield rose from 5% to
over 8% in what was known as the Great Bond Massacre over
concerns about federal spending. Clinton political adviser James
Carville remarked at the time that he would like to come back
as the bond market as you can then intimidate everybody.
Robert Armstrong made a very good point in his unhedged
newsletter a few weeks ago about Trump's plan to onshore
manufacturing, where if a big chunk of human, financial and
physical capital is to be deployed in manufacturing and
exports, they have to be redeployed away from what
they're currently doing. And it's very possible that
redeploying to manufacturing and exports will make that capital
less productive. After all, there's a reason that
this capital is not deployed in manufacturing today.
And less productive use of capital in the United States
means that the country gets poorer, not richer.
Another difficulty that the US will face in trying to grow its
way out of high debt is that its aging population and low birth
rate means that the working age population is in decline.
And without immigration, there will be no one to work in all of
the factories that Trump's tariffs are supposed to bring
back on shore. Despite the claims that Elon
Musk would be able to slash $2 trillion of wasteful government
spending by eliminating waste, fraud and abuse, the DOGE
website is now only claiming $170 billion in savings, much of
which has been disputed, as many of the contracts that DOGE
claimed to have cancelled had either already been cancelled or
would never have cost as much as DOGE are claiming.
Researchers from the BBC could only verify 32 1/2 billion
dollars from the wall of receipts, which had less than 2%
of what was promised. Doesn't do much to balance the
budget. According to CBS, there are
offsetting costs of $135 billion when you add up the cost of
rehiring mistakenly fired workers, defending lawsuits,
layoff packages, and so on. Reductions in government
spending can be fact checked by going to the Treasury Department
website, where they publish U.S. government monthly spending data
broken down by agency and program.
Despite the big claims, total federal spending is about 7%
higher over the last two months than it was during the same
months a year ago. So no cost cutting has shown up
in the data so far. Most of the research I can find
shows that governments only cut spending in response to a
crisis, and the problem with that is that these forced
spending cuts can be indiscriminate and make a
financial crisis worse. The problem is that politicians
love borrowing and spending because the paying back comes in
somebody else's term. Since the turn of the
Millennium, interest rates started out low and fell lower
and during that period of declining interest rates,
governments have grown addicted to borrowing and spending, which
they got away with because the low interest rates meant that
economies could outgrow the interest rate on the debt.
With US 30 year rates above 5% and anti growth policies being
pitched by politicians, this becomes a lot more difficult.
Trump's tariffs could of course cause problems in other
countries too. According to JP Morgan research,
the impact of the trade war will be focused on the US, but the
rest of the world will not be immune to the damage.
They say that the trade war could reduce global GDP by 1%.
In a world with such elevated levels of government debt, lower
growth can only be expected to make the situation worse.
In its October Fiscal Monitor report, the IMF warned about the
enormous surge in public debt over the last five years, with
the global debt to GDP ratio now 10 percentage points above its
level on the eve of the pandemic.
Their research showed countries with debt that was not expected
to stabilize accounted for more than half of global debt and
about 2/3 of world GDP. The UK, Brazil, France, Italy
and South Africa were among the countries where debt was
expected to continue rising. They said that in countries
where debt is projected to increase further, delaying
action will make the required adjustments even larger.
And they called for cumulative fiscal adjustment tax rises, or
spending cuts of 3% to 4 1/2% of GDP to bring down debt across
the world. They added that government
spending to fund the transition to greener energy, together with
aging populations and security concerns, were likely to add
fiscal pressures over the coming years.
Government may wish to inflate away the debt in the coming
years where they allow high inflation to reduce the real
value of their outstanding debt. But higher inflation, as we've
seen in recent years, is very unpopular and can lead to
governments being thrown out of office.
Thanks again for tuning into this week's podcast, with a
special thanks to my supporters on Patreon who make this happen.
Have a great day and talk to you in the next podcast.
Bye.