Last year the world suffered a deficit. There could be a nasty hangover

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Driven by fund rates, governments issued $ 16.3 trillion in debt in 2020 and are expected to borrow another $ 12.6 trillion this year, according to S&P Global Ratings. But fears are growing that an explosive economic return will occur from this summer inflation could be generated, which could force central banks to raise rates earlier than expected.

Should this happen, the cost of service to sovereign debt mountains will rise, consuming government funds that might otherwise be spent on essential services or rebuilding weakened economies. U.S. lawmakers on Wednesday approved a huge $ 1.9 trillion stimulus package that could drive up prices and increase pressure on the Federal Reserve.

Many economists think that the threat of inflation can be overcome. But political leaders, concerned about the need to reach difficult commitments in the coming years, are watching the situation closely.

Waiting for inflation

Concern about rising interest rates has been highlighted as investors unload government bonds. The U.S. Treasury’s 10-year benchmark yield has recently risen above 1.6% to its highest level in more than a year. Meanwhile, the yield on ten-year UK bonds rose above 0.8% at the end of last month, a sharp rise of less than 0.2% at the start of the year.

The moves have been triggered in part by growing confidence in the next phase of the pandemic. Because vaccination campaigns allow governments to lift some restrictions, consumers are expected to rush to restaurants and board planes. This could drive up prices, which central banks have pledged to keep under control.

Politicians have 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 differentiate between a “one-time rise in prices and inflation. continuous “, indicating that it is in no hurry to change course. European Central Bank President Christine Lagarde is expected to send a similar message Thursday after speaking with reporters.

However, S&P Global Ratings pointed to inflation as a potential concern in a report on sovereign debt this month, noting that “it could push central banks to raise interest rates, partially investing in government profits. low debt service costs “.

“A big jump in interest rates would be very costly,” said Ugo Panizza, a professor of international economics at the Graduate Institute in Geneva. “Central banks will face very complicated offsets if inflation rises.”

The UK is sounding the alarm

The Congressional Budget Office projects that publicly owned public debt in the United States will rise to nearly $ 22.5 trillion by the end of 2021. This equates to 102% of annual gross domestic product. In Italy, the ratio stood at 154% at the end of September, while Greece stood at almost 200%.

High debt levels leave public finances more exposed to rising interest rates. Take the UK, where public sector debt has also risen to a level almost equal to the size of the economy.

The UK says larger companies have to pay more taxes

The Office for Budget Responsibility estimates that if short- and long-term interest rates rose by just one percentage point, debt interest spending would increase by £ 20.8 billion ($ 29 billion) during the 2025 fiscal year. -26.

While this would not necessarily be unsustainable, it is definitely not desirable, according to Isabel Stockton, an economist at the UK Institute for Tax Studies.

“Everyone would rather give £ 21 billion to the [National Health Service] or [to] improve the welfare system or infrastructure, ”he said.

Interest costs 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 an increase in payments on this debt.

According to the Institute for Tax Studies, around a quarter of UK public debt is related to inflation, which means payments increase automatically if prices rise. In addition, the Bank of England has purchased large amounts of public 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 while economic growth slows, politicians have difficult choices: raise taxes to cover budget shortfalls or reduce spending.

Sunak turned the country’s debt burden into a central issue when he presented his spending proposals last week, which included plans for a major tax hike to the largest British companies in 2023.

“In the same way it would be irresponsible to withdraw [economic] support too soon, it would also be irresponsible to let control of future indebtedness and debt, ”he said.

A global problem

Similar dynamics could be developed around the world.

The Organization for Economic Co-operation and Development said in a report last month that while interest costs are currently low, high levels of existing debt, combined with persistent indebtedness, have raised interest rates. refinancing risks. According to the agency, about a quarter of market-negotiated debt from member countries (or $ 14.1 trillion) will mature in a year.

“It’s a real concern,” said Randall Kroszner, who served as governor of the Federal Reserve from 2006 to 2009. If U.S. debt payments suddenly go “from being quite low to being quite significant.” this could affect economic recovery and slowness. activity, he added.

Countries that do not control their own currencies could be in particularly low positions, Panizza said. Italy, which uses the euro, is an example.

Panizza said Italy needs to refinance or extend the maturity date of about a seventh of its debt each year. If interest rates rose by 2%, this would add about half a point of GDP, or about $ 9.9 billion, to debt service costs annually. It’s a “substantial” amount, he stressed.

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

An increase in inflation may never materialize; for decades, world inflation has remained stubbornly silenced. And a booming economy would also increase the amount of money governments contribute from taxes, helping to alleviate some anxiety about the deficit.

But there is no denying that central banks could face a tough set of elections as the global economy emerges from an unprecedented shock and a wide range of results remains on the table.

“That’s not something we have a lot of experience with,” Kroszner said.

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