Are governments close to maxing out their fiscal wells?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• COVID-19 sent the debt ratios of many governments spiralling, nearing levels seen during major world wars. While some debt can benefit economies and investors, a tipping point exists 
• However, determining the exact limit for sustainable government debt is tricky. Our research suggests that debt issuance can still benefit primary balances up to around 170%-180% of GDP
• In judging whether debt issuance is sustainable or not, and if fiscal wells are close to running dry, two factors are worth bearing in mind – the gap between economic growth and debt servicing costs, and investor confidence in a country’s fiscal prowess  
• Despite the recent debt-financed spending splurge, US bonds still seem to be a desirable investment. However, structural weaknesses in European economies could be more of a concern for investors, and prompt them to probe how much longer government debt ratios are sustainable

Government debt ratios are now close to those seen at the heights of world-war financing, after trending higher over the last three decades (see chart). Yet politicians around the world are passing gargantuan bills to fund the coming green economy. 

This article explores how deep the seemingly inexhaustible fiscal wells are. Is there a debt limit for governments? And at which point should investors care?

Public debt financing exploded between the global financial crisis and the COVID-19 pandemic, perhaps giving the impression that debt ratios can only go up. However, massive funding needs are soon followed by austerity and – in some cases – debt cuts, if history is a guide.

Debt-to-gross-domestic-product ratios need not head up

Historic gross-debt-to-nominal-gross domestic product ratios in the US, Japan, the UK and Italy suggest that wars and pandemics have been the most explosive and notable events

Debt-issuance can increase productivity...

The big surges in debt ratios have often been about protecting an economy, whether by expanding the military budget or keeping it afloat during a pandemic. But the green economy bills, like the European Green Deal or the UK’s Net Zero Strategy: Build Back Greener, are planned expenses aimed at growing the economy in the future.

Research on the effectiveness of debt suggests that an economy’s productivity (and therefore attractiveness for investors) reacts well to debt increases – up to a certain point. Investments like digging tunnels or building hospitals and schools can have net-positive effects on government finances by increasing economic efficiency and tax returns. But at some point, fiscal policy may run out of good ideas for stimulative infrastructure projects. Academics call this effect “fiscal fatigue”.

…until fiscal fatigue sets in

Pinpointing when infrastructure projects become more about political goals rather than economic ones depends not only on efficiency gains but also on the cost of servicing the debt. Our research suggests that debt issuance could still raise productivity up to around 170-180% of gross domestic product¹. 

Beyond this point, the costs of additional debt issuance seem to offset the benefits. However, by no means does this mean that a government should aim for this debt ratio, as it would be left ill-equipped to address urgent crises.

Finding the limits of debt financing

But fiscal fatigue is only the tipping point at which drawing water from the well becomes more of a cost than a benefit – it is not the point at which the well runs dry. Finding the limit on debt is even more difficult than fiscal fatigue. In theory, it is related to two factors:

• The point of fiscal fatigue and other influences on investors’ trust in a specific country’s fiscal prowess (such as the oil price for an oil exporter)
• And the difference between the growth rate of an economy (g) and the cost of debt service (r)

Given our estimates for fiscal fatigue and today’s g-r difference, the US could afford debt of eight times as large as gross domestic product (GDP) without it becoming unsustainable. Meanwhile, Greek and Italian debt already appears to be untenable.

Debt limits are moving targets

However, while making some headlines, Italian government finances are currently not the financial world’s main worry. If this was the case, the cost of debt servicing could soar quickly, even hitting growth: a perfect storm that could trigger another European debt crisis. As such, investors should note that g-r is dynamic and today’s estimate does not seem to be at crisis levels.

Investors receive more than the interest paid

Undoubtedly, g-r is a very important metric when assessing government debt. The US administration operated with g-r at around 2.5% in 2023. This means that only primary deficits larger than 2.5% would increase the debt ratio. But why is the US metric so large compared to countries like the UK (see chart)?

Difference in g-r: not all government debt is equal

The difference between an economy’s ten-year average growth rate and the cost of servicing public debt (g-r) reflects a country’s fiscal strength

The answer lies more in low “r” than in high “g”. It is because creditors receive more than just the monetary interest paid. Some debt certificates – first and foremost the US ones – provide a very liquid store of value. 

Most government debt acts as a counterbalance to equities: they appreciate in recessions as central banks cut rates, yields fall and existing government bond prices rise. These additional benefits, which can be strengthened by central bank credibility, put markets at ease and lower the cost of servicing the debt.

Government bond investors need views on fiscal strength

The potential future paths for r and g are what investors should focus on when deciding their asset allocation. Not all government debt is equally safe and none is always “risk free”.  

Despite US debt accumulation being above g-r, the country’s bonds remain a desirable investment, for now. However, European government debt harbours many structural weaknesses that could prompt investors to “probe the depth of the well”. When this point will be reached is uncertain, but probable dates will likely be linked to the years when much debt matures. 

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