The Harsh Realities of Government Debt

The market’s move yesterday is another reminder that for all of the “green shoots” one might see in the economy, there’s the tricky issue of the looming black cloud of government debt that is about to replace the soon-to-be-behind-us black cloud of financial mayhem in the banking system. This note from RBC’s U.K.-based Fixed Income and Currency Strategy Research Group hits the high (and low) notes:

· Budget deficits are rising rapidly in the major economies.

· The damaging effects on public finances of the deepest downturn in global activity for seventy five years are being reinforced by a combination of the loss of exceptional revenue flow related to asset price booms, discretionary fiscal policy easing and large scale financial sector bail outs.

· As a consequence, net government debt/GDP ratios have begun to soar. Even on optimistic assumptions, in a number of industrial economies, debt burdens stand to be rise by anything from a third to almost 100% over the next five years. On less optimistic assumptions, the prospective debt dynamics are truly explosive.

· The greatest concerns relate to the US, the UK and Japan, while Canada, Australia and New Zealand appear to be in rather better shape. The Eurozone stands somewhere in between.

· The prospective surge in public sector debt will swell interest payments, limit the further use of fiscal policy for the purposes of macroeconomic stabilisation, exert upward pressure on Treasury bond yields, boost the risk premia on currencies and increase the incentive for governments to monetise debt and boost inflation.

· The markets need reassurance in the form of credible strategies to bring fiscal positions to heel. But such is the extent of the problem that any attempt rapidly to return debt ratios to pre-crisis levels through discretionary fiscal policy tightening would require a range of painful, if not suicidal, political decisions, particularly given the growing claims on resources of ageing population structures. It would also involve considerable output costs, slowing the pace of recovery, if not killing it altogether.

· The consolidation of OECD public finances will therefore probably prove a long-term project.

· In the meantime, the risk is of more high profile sovereign downgrades, with the US and UK very much in the firing line, the further erosion of the US dollar’s reserve currency status, and significant upward pressure on the equilibrium level of government bond yields.

MRM