Brewing Government Bond Market Crises

Herb Stein famously observed that if something cannot go on forever, it will stop. We have to wonder what he would have made of today’s unsustainable world public finances. Not only is the United States on a clearly unsustainable public finance path. So too are a number of major European countries and Japan. The question is not whether these unsustainable public finances will end in tears but rather when and how. As Kenneth Rogoff and Carmen Reinhart reminded us in their classic book This Time is Different: Eight Centuries of Financial Folly , when it comes to unsustainable public finances, it is a dangerous delusion to think that this time is different from the many earlier such cases that ended in crises. Start with the United States. Ever since Bill Clinton ran small budget surpluses in the late 1990s, successive administrations have put the US public finances on today’s dangerous trajectory. Democratic administrations have done so by increasing public spending at the same time as being loath to raise taxes. Republicans have done so by cutting taxes without cutting public spending to fund those tax cuts. Trump’s One Big Beautiful Bill Act of unfunded tax cuts is the latest example of this sort of fiscal irresponsibility. According to the Congressional Budget Office, the US government budget deficit is set to exceed six percent of GDP, or more than $2 trillion a year, as far as the eye can see. That, in turn, will cause the debt held by the public to surpass the historical high of 106 percent of GDP in 2030. The United States is highly dependent on foreigners to finance its budget and external current account deficits. Indeed, foreigners currently hold $8.5 trillion or around 30 percent of all outstanding US Treasury bonds. This would seem to set the country up for a government bond market crisis should foreigners come to believe that the US was on the way to inflate its way out of its debt problem or that the US could further weaponize financial policy.   Three of Europe’s four largest economies are drowning in debt. While in 2010 the Eurozone debt crisis was centered on Portugal, Ireland, Italy, Greece, and Spain (the so-called PIIGS), today it is France, Italy, and the United Kingdom about which we need to be worried. Each of those countries has a public debt to GDP ratio in excess of 100 percent, while France and the United Kingdom are running budget deficits of around five percent of GDP. One reason to worry that these countries could experience bond market crises is that a sclerotic European economy is currently being hit by a series of shocks that could throw it into recession. Not only is the European economy being hit by an energy and food price shock in the wake of the Iran war.  It is now having to contend with a 25 percent US import tariff on its automobile sector. Another reason to fear a renewed European sovereign debt market crisis is that its highly indebted countries, France in particular, do not have the political will to address their deficit problems. Additionally, France and Italy remain stuck in a Euro straitjacket, which denies them the use of an independent monetary and exchange rate policy to stimulate exports as an offset to the contractionary effect on the economy of budget belt-tightening. With a public debt to GDP ratio of around 230 percent and an expected primary budget deficit, Japan appears to be well on the way to a bond market crisis. Heightening this possibility is the fact that Japan is among those countries most vulnerable to the Iran war-induced oil price shock. That shock could precipitate a Japanese economic recession and cause a further deterioration in the country’s public finances as the government responds to the oil price shock with additional energy subsidies. Anyone doubting that a Japanese government bond and currency market crisis is brewing has not been paying attention. Since March 2024, when the Bank of Japan’s (BOJ) yield-curve control policy ended, the 10-year Japanese government bond yield has approximately tripled from 0.75 percent to 2.5 percent. That rate is the highest in the past 20 years. Meanwhile, over the past nine months, the Japanese yen has weakened by around 10 percent with respect to the dollar. The poor public finance trajectory of the United States, Europe, and Japan would suggest that corrective measures should be taken in each of these economies soon. The urgency of the need for such action is underlined by the fact that there appears to be government bond market problems brewing in each of these three major economies and that could have contagion effects should a bond market crisis occur in any of these economies. The post Brewing Government Bond Market Crises appeared first on American Enterprise Institute - AEI .