The world got into debt last year. There could be a bad hangover

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Spurred on by extremely low rates, governments issued $ 16.3 trillion in debt in 2020, and they are expected to borrow an additional $ 12.6 trillion this year, according to S&P Global Ratings. But fears are growing that an explosive economic return from this summer, it could generate inflation, potentially forcing central banks to raise rates earlier than expected.

If this happens, the cost of servicing mountains of sovereign debt will soar, swallowing up public funds that might otherwise be spent on essential services or rebuilding weakened economies. U.S. lawmakers on Wednesday approved a gigantic $ 1.9 trillion stimulus package that could spike prices and increase pressure on the Federal Reserve.

Many economists believe the threat of inflation may be overestimated. But political leaders, worried about having to make difficult compromises in the years to come, are monitoring the situation closely.

Waiting for inflation

Concerns about rising interest rates have come to the fore as investors offload government bonds. The benchmark 10-year US Treasury yield recently surpassed 1.6% to its highest level in over a year. Meanwhile, the UK 10-year bond yield climbed above 0.8% at the end of last month, a sharp rise of less than 0.2% at the start of the year.

These movements were sparked in part by growing confidence in the next phase of the pandemic. Since vaccination campaigns allow governments to lift some restrictions, consumers would have to rush to restaurants and get on planes. This could push up prices, which central banks have pledged to keep in check.

Policymakers downplayed the threat. Federal Reserve Chairman Jerome Powell, speaking last week, said he expects inflation to rise as the economy reopens, but stressed that the Fed will try to make the difference between a “one-time price surge and continued inflation”, indicating that there is no rush to do so. to change direction. European Central Bank President Christine Lagarde is expected to send a similar message later Thursday when she speaks to reporters.

Still, S&P Global Ratings highlighted inflation as a potential concern in a sovereign debt report this month, noting that it “could push central banks to raise interest rates, partially reversing the benefits of the weak. debt service costs “.

“A sharp rise in interest rates would be very costly,” said Ugo Panizza, professor of international economics at the Institute for Advanced Studies in Geneva. “Central banks will have to face very, very complicated trade-offs if inflation rises.”

UK sounds the alarm

The Congressional Budget Office predicts that the US public debt will reach nearly $ 22.5 trillion by the end of fiscal 2021. This equates to 102% of annual gross domestic product. In Italy, the ratio stood at 154% at the end of September, while Greece was almost 200%.

High debt levels make public finances more vulnerable to interest rate hikes. Take the UK, where public sector debt has also soared to a level where it almost equates to the size of the economy.

UK says bigger companies must pay more taxes

The Office of Fiscal Responsibility estimates that if short-term and long-term interest rates increased by just 1 percentage point, interest expenditure on debt would increase by £ 20.8 billion ($ 29 billion) during the 2025-2026 fiscal year.

While this is not necessarily unsustainable, it is certainly not desirable, according to Isabel Stockton, an economist at the Institute for Fiscal Studies in the UK.

“Everyone would rather give these 21 billion pounds to the [National Health Service] or [to] improve the social protection system or infrastructure, ”she said.

Interest charges are even more sensitive to inflation and rate hikes due to the pandemic response.

The UK government borrowed £ 270.6 billion ($ 377 billion) between April 2020 and January 2021, and higher interest rates mean higher payments on that debt.

About a quarter of Britain’s public debt is linked to inflation, according to the Institute for Fiscal Studies, which means payments automatically rise if prices rise. On top of that, the Bank of England bought huge sums of government debt as part of its quantitative easing program. The central bank pays interest on the reserves it creates to make these purchases.

If interest payments rise as economic growth slows, politicians are left with difficult choices: raise taxes to cover the budget deficit or cut spending.

Sunak made the country’s debt burden a central issue when unveiling his spending proposals last week, which included plans for a sharp tax hike on the biggest British companies in 2023.

“Just as it would be irresponsible to withdraw [economic] too soon, it would also be irresponsible to leave future borrowing and debt unchecked, ”he said.

A global problem

A similar dynamic could occur around the world.

The Organization for Economic Co-operation and Development said in a report last month that although interest charges are currently low, high levels of existing debt, combined with continued borrowing needs, have increased the risks of refinancing. About a quarter of member countries’ market-traded debt – or $ 14.1 trillion – will fall due within a year, the agency said.

“This is a real concern,” said Randall Kroszner, who served as governor of the Federal Reserve from 2006 to 2009. If US debt payments suddenly drop “from a fairly low level to a fairly large level,” this could weigh on the recovery and slow the economy. activity, he added.

Countries that do not control their own currencies could find themselves in particularly tight positions, Panizza said. Italy, which uses the euro, is one example.

Panizza said Italy needs to refinance or extend the due date by about one-seventh of its debt each year. If interest rates were to go up 2%? That would add about half a point of GDP, or about $ 9.9 billion, to the cost of servicing the debt each year. This is a “substantial” amount, he stressed.

Emerging market economies like Turkey or Brazil could also be vulnerable. Higher interest rates tend to strengthen the dollar, a move that has already started. This can increase maintenance costs. Meanwhile, the public revenues of these countries may be affected by the continued weakness of the tourism sector.

Peak inflation may never materialize; for decades, global inflation has remained stubbornly subdued. And a booming economy would also increase the amount of money governments raise from taxes, helping to alleviate some deficit concerns.

But it is undeniable that central banks could face a series of difficult choices as the global economy emerges from an unprecedented shock, and a wide range of outcomes remain on the table.

“It’s not something we’ve had a lot of experience with,” Kroszner said.

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