Public finances are becoming an increasing problem
We have been pointing out for some time that, in many countries, public finances are developing in such a way that they will eventually reach a deadlock. This does not mean that the government will no longer be able to meet its interest and repayment obligations, as the central bank can always create sufficient money to do so.
Where things do go wrong, however, is when the interest payable on existing debts begins to crowd out other budget items that are essential for future growth – such as infrastructure, education, healthcare and the like. This creates a downward spiral of declining economic growth, lower tax revenues and higher social expenditure, a wider government deficit, rising interest rates, and so on. It should also be borne in mind that the markets will not wait until the situation actually reaches that point before reacting. They will react as soon as they see such a scenario looming.
It should also be noted that it is not the case that, once a certain debt-to-GDP ratio is reached, the markets will simply demand higher interest rates as a buffer. The level of interest rates, economic growth, confidence in the future, and so on, all play an important role in this, and these factors often vary from case to case. Of course, one could argue that investors need not worry on this point, as governments – as mentioned earlier – are always able to meet their payment obligations.
This is true, but it overlooks the fact that if the central bank starts creating more money, this will drive up inflation. Interest rates will then rise even faster, meaning even more money will have to be created, and so on. So such a policy can be sustained for a while, but not for long.
Markets are sending a clear signal
For some time now, economists – for example in the US, Japan, France and the UK – have been warning that if they do not tackle their public finances quickly, the markets "will rebel". This will manifest itself, in particular, in the form of rising long-term yields. Bond buyers will then demand an ever-higher risk premium. Not just on government bonds, but on all bonds. Primarily as protection against higher inflation in the future, but also, in the case of bonds not issued by the government, because of the increasing risk that they will not be repaid and that interest on them will not be paid on time if interest rates continue to rise (in other words: "credit spreads" will widen).
Unfortunately, long-term yields have indeed been sending out warning signals of late, suggesting growing fears that public finances are spiralling out of control. They are rising even though, from an inflationary perspective, there are not (yet) any major risks. Long-term yields are also rising primarily in those countries where public finances are deteriorating most rapidly.
In previous reports, we have already indicated that the main reasons for the rise in (real) long-term yields are as follows:
- Countries such as the US, the UK, France and Japan have been operating at virtually full capacity for some time. In theory, this should not be accompanied by a government deficit or even a surplus. In reality, however, they have large deficits. This entails two major drawbacks. Normally, in an economy running at full capacity, the demand for capital does not differ greatly from its supply. Now, the government is also demanding a great deal of capital on top of that. Furthermore, investors always prefer bonds issued by governments. In other words: not only does the government deficit drive up interest rates, but there is also a "crowding-out" effect on other parties seeking to raise capital. This is something that, in the long run, slows down economic growth. Of course, the central bank can intervene by creating more money, but after a while this drives up inflation and we end up even further from the solution.
- The supply of capital is no longer increasing to any great extent. This is primarily due to an ageing population. Older people save less and, in fact, spend the savings they have built up. In addition, they significantly increase public expenditure, particularly through higher pension payments and higher spending on healthcare and social care in general. These are all increased costs that must, moreover, be paid for by a relatively smaller workforce.
Another factor is that Washington’s policies are making many foreign capital holders increasingly reluctant to invest heavily in the US.
- Now, all this might not be so bad if the economy were growing more slowly and inflation were falling. However, this is not the case. Firstly, because of the investment boom in everything to do with AI. This is not only stimulating economic growth significantly, but is also creating much greater demand for capital. It is true, however, that interest rates have risen and there are growing doubts as to whether all these massive investments will yield sufficient returns in the future. This could easily lead to a reduction in such investments. For the time being, however, this does not seem likely. It is, in fact, rather unclear how AI will develop. The only certainty is that it will play a very important role in the future. This means that every company involved in the development of AI must invest in it as much as possible right now, even though the future returns on these investments – particularly due to domestic and international competition – remain unclear.
This has a very significant implication for the capital market: the investment boom will continue to drive economic growth for the time being, probably to such an extent that inflation is more likely to remain high than to fall. This is all the more true if oil prices remain high; and demand for capital remains very high for the time being.
Long-term yields need to fall, but how?
For all the reasons mentioned above, long-term yields have risen sharply recently. Given the enormous levels of debt, this is very dangerous, as it means that significantly higher interest rates will have to be paid when refinancing. This, in turn, means that even more borrowing will be necessary. The conclusion, therefore, is that long-term yields must fall. But how do you bring this about?
Bessent is now trying to achieve this artificially in the US by having the government buy up large volumes of long-term bonds. As with currency interventions, there is a good chance that this will fail and will merely slow down the rate of increase. Naturally, a much smaller government deficit would help a great deal, but unfortunately it must be concluded that politicians will only bring this about once a crisis has occurred – probably caused by much higher (real) long-term interest rates.
