"Serious Fiscal Deficits in US, Japan, and Europe... Concerns Over Government Bond Market Issues" - US AEI

Concerns have been raised that the United States, Japan, France, Italy, and the United Kingdom may face problems in the government bond markets due to their persistent fiscal deficits.

Desmond Lachman, senior fellow at the American Enterprise Institute (AEI), made this point in an article titled "Brewing Government Bond Market Crises" published on the AEI website on May 11 (local time).

Before joining AEI, Lachman served as chief emerging market economic strategist at Salomon Smith Barney, and prior to that, as deputy director of the Policy Development and Review Department at the International Monetary Fund (IMF).

The following is a summary of the main points.

Herb Stein is famous for saying, "If something cannot go on forever, it will stop." One wonders how he would have assessed today's unsustainable global public finances. It is not only the United States that is clearly on an unsustainable fiscal path; several major European countries and Japan are as well.

The question is not whether such unsustainable public finances will end in tragedy, but rather when and how they will do so. As Kenneth Rogoff and Carmen Reinhart reminded us in their classic work "This Time Is Different: Eight Centuries of Financial Folly," believing that this time will be different from the many past crises caused by unsustainable public finances is a dangerous illusion.

Let's start with the United States. Since the Bill Clinton Administration posted a small fiscal surplus in the late 1990s, successive administrations have put U.S. public finances on today's perilous trajectory. Democratic administrations did so by increasing public spending while hesitating to raise taxes. Republican administrations did so by cutting taxes without reducing public spending to finance them. The unfunded tax cuts in Donald Trump's "One Big Beautiful Bill Act" are the latest example of this kind of fiscal irresponsibility.

According to the Congressional Budget Office (CBO), the U.S. government's fiscal deficit exceeds 6% of GDP and is expected to remain above $2 trillion annually for an extended period. This will ultimately result in national debt surpassing a historic high of 106% of GDP by 2030.

The United States issues government bonds to finance both fiscal and current account deficits and is heavily reliant on foreign investors. Currently, foreigners hold $8.5 trillion, or about 30% of the total outstanding U.S. government bonds. This suggests that if foreign investors come to believe the U.S. is seeking to resolve its debt problem through inflation, or that it may further weaponize financial policy, the country could become vulnerable to a government bond market crisis.

Three of the four largest European economies are struggling with debt. While the 2010 Eurozone debt crisis centered on Portugal, Ireland, Italy, Greece, and Spain—the so-called PIIGS—today the countries to worry about are France, Italy, and the United Kingdom. All three have public debt exceeding 100% of GDP, and France and the UK are each running fiscal deficits of about 5% of GDP.

One reason for concern that these countries could face government bond market crises is that the stagnant European economy is currently being hit by a series of shocks that could push it into recession. Not only is Europe dealing with energy and food price shocks in the wake of the Iran war, but it must now also respond to a 25% U.S. import tariff on the automotive sector.

Another reason to worry about a renewed European government bond market crisis is that highly indebted countries—especially France—lack the political will to address their fiscal deficits. Moreover, France and Italy remain bound to the euro system. As a result, they cannot use independent monetary or exchange rate policies to stimulate exports and offset the contractionary effects of fiscal tightening on their economies.

With a public debt-to-GDP ratio of about 230% and a projected fiscal deficit, Japan appears well on the way toward a bond market crisis. The fact that Japan is among the countries most vulnerable to the oil price shock resulting from the Iran war further increases this risk. This shock could trigger a recession in Japan and, should the government respond with additional energy subsidies, further deteriorate public finances.

Anyone doubting that a crisis is brewing in Japan's government bond and foreign exchange markets is not seeing the situation clearly. Since the Bank of Japan ended its yield curve control policy (which targeted 10-year government bond yields at around 0%) in March 2024, the yield on 10-year Japanese government bonds has roughly tripled from about 0.75% to 2.5%. This is the highest level in two decades. Meanwhile, over the past nine months, the Japanese yen has depreciated by about 10% against the U.S. dollar.

The precarious fiscal trajectories of the United States, Europe, and Japan suggest that corrective measures will soon be required in each of these economic blocs. The urgency of such measures becomes even clearer given that bond market problems appear to be brewing in all three major economies, and that a crisis in the bond market of any one of these could trigger contagion effects across the others.

This content was produced with the assistance of AI translation services.