Public Debt: Is the Next Crisis Looming?

Jörn Quitzau

Bergos AG

Joern Quitzau is a Geoeconomics Non-Resident Senior Fellow at AGI. He is Chief Economist at Bergos, a private bank based in Switzerland. He specializes in economic trend research and economic policy. Joern Quitzau hosts two Economics podcasts.

Prior to his position at Bergos, Joern Quitzau worked for Berenberg in Hamburg (2007-2024) and Deutsche Bank Research in Frankfurt (2000-2006) with a special focus on tax and fiscal policy.

Dr. Quitzau (PhD, University of Hamburg) was a Visiting Fellow at AGI in April 2014 and September 2022 and an American-German Situation Room Fellow in April 2018.

Debt sustainability has a lot to do with trust. There are early warning indicators for sovereign debt crises that can indicate an incipient loss of confidence. However, fiscal and monetary policy measures can override the early warning indicators by postponing the financial policy problems into the future. It is therefore difficult to predict the onset of a debt crisis. This applies in particular to the highly indebted United States.

How long can countries afford to take on debt? The answer is simple: as long as the lenders have confidence in the state’s ability to repay. However, no one knows when lenders will lose confidence. When confidence in the financial markets collapses, things can change quickly. A country that was just considered creditworthy can suddenly find itself in a debt crisis.

After the global financial crisis of 2008/09, financial markets were concerned about the sharp rise in government debt: Would countries still be able to service their debt? After initial nervousness, the situation gradually eased as the central banks purchased parts of the government bonds, loosened their monetary policy, and thus reduced the interest burden on governments. In many cases, however, the lower interest rates were not used to reduce debt and restructure public finances. Instead, many countries used the favorable financing conditions to take on even more debt. In particular, there was a veritable debt surge during the pandemic. The debt ratios of many countries even rose above the levels seen during the financial crisis.

As interest rates were initially still low, many observers did not see debt as a major problem. On the contrary: as borrowing could solve many acute problems in the short term and the high public debt hardly seemed to have any negative side effects, some economists, market players, and politicians declared borrowing to be a virtue. According to the so-called Modern Monetary Theory (MMT), countries with their own central bank can issue virtually unlimited amounts of money because the money needed could be provided by the central bank. Before this thinking became acceptable, however, the great inflationary surge came and put the danger of expansive monetary policy and high government debt back into perspective. High inflation also led to a rise in interest rates: in the United States, interest rates on ten-year treasuries temporarily fell below 1 percent during the pandemic. Since then, interest rates have risen sharply, even reaching 5 percent at times.

In its “Global Debt Report 2024” the OECD pointed out that 40 percent of global public debt will mature in the next three years and require refinancing. The higher interest rates will then impact these debts to be refinanced and increase the financing burden for finance ministers. How quickly the higher interest rates are reflected in public budgets depends on the maturity structure of the respective country’s government debt. The shorter the remaining term of the outstanding government bonds, the faster the increased interest rates will be a burden, as the government bonds must be refinanced at the end of their term at the now-higher interest rate. The United States’ average residual term of 5.8 years is quite low.

Emerging and developing countries with unsound economic and financial policies are usually more at risk of falling into debt crises. Currently, however, some of the world’s largest economies have piled up huge mountains of debt. Japan is the lone leader with a debt ratio of around 255 percent of gross domestic product (GDP). With a debt ratio of around 125 percent and continued deficit spending, the United States is no longer beyond reproach either. The question arises: How long will the financial market players be willing to finance the high debt?

It is a question of trust. There are early warning signs, such as the interest rate. The higher the estimated risk of default, the higher the lenders’ interest demands. In other words, risk premiums rise, meaning that higher interest rates can be an indicator of unsound public finances. However, the indicator is not reliable because central banks and governments can intervene in the markets and postpone emerging risks into the future.

Rating agencies also attempt to assess the repayment capacity of countries and issue corresponding credit ratings. There is a problem inherent in the system: rating agencies assess whether a country will meet its obligations fully on time. The repayment of a loan taken out is assessed in nominal, not real terms. This means that the rating agencies only assess the probability that a country will repay the loan amount in full at the agreed time. If this amount has been partially devalued by inflation in the meantime, this does not play a role for the rating agencies.

Moreover, the ratings only indicate relative but not absolute probabilities of default. In the specific case of the United States, it should be noted that a potential U.S. default would not be an isolated event. If the world’s largest economy and the most important international financial market player were to suffer a sovereign default, this would have massive consequences for the international financial markets. Other countries would be drawn into the downward spiral. The United States is “too big to fail” and “too interconnected to fail.” If the rating agencies downgrade the United States, it would be rational to downgrade all other countries affected by potential contagion effects as well.

The overall conclusion is that the early indicators for a debt crisis in the United States are unlikely to have any impact. Should the United States one day get into serious financial difficulties, the sentiment in the financial markets is likely to change relatively quickly. The past has shown that so-called multiple equilibria are possible in the financial markets. This means that the same economic data can lead to different market results. How concerned market participants are about a certain level of debt and how high the resulting interest rates are depends largely on the confidence of the participants, which in turn is influenced by the dominant narratives on the market. In this respect, it is important to keep a close eye on U.S. financial policy and form one’s own opinion on debt sustainability.

For the time being, however, confidence in the United States does not appear to have been particularly dented, because when the world experiences crises, international investors continue to seek the U.S. dollar as a safe haven. And should there be a loss of confidence or even a buyers’ strike, the Federal Reserve would be forced to step in again and purchase government bonds in order to push down interest rates and reassure market participants. This would not be a sound and sustainable financial and monetary policy approach, as it would once again increase the risk of inflation. However, inflation can reduce the burden of government debt. And in case of doubt, the United States will likely opt to inflate away its national debt rather than risk an international financial crisis.