At this juncture, we might need to take a step back and consider the short- and long-term ramifications of higher bond yields.
In the short term, there are two major causes of concern. First, highly indebted countries might face an actual crisis because of the added debt burden from elevated yields. France and Italy, for instance, might find themselves in an exceptionally tricky (Opens in new window) situation if the yields continue to climb up. Second, given the extremely interconnected nature of the global financial system, a crisis in one country might become a contagion, and spillover into the entire system.
The thing is that the long-term ramification is even more sobering. While the absolute debt-level in some countries like the US is not yet unsustainable, the trajectory is. Given that the average debt-to-GDP in G7 countries (Opens in new window) is over 120% and trending upwards – rising yields mean that over time a large part of the developed world is practically playing with fire.
There is no magical way to get rid of debt. Either a country can grow fast enough and outpace its debt, with some push from good inflation, or raise taxes and cut spending. Here the divergence between countries becomes increasingly glaring. While the US is experiencing rapid growth, Europe isn’t. And even in the US, there is a risk that over time, the rate of debt accumulation would overtake growth. Moreover, given that most countries now feature populists in either the government or as the primary opposition, raising taxes is mostly off the table.
So where does this lead the collective West and its potential options regarding fiscal management? Unfortunately, most of them are increasingly staring at austerity. Cutting spending might be the only credible way for governments to signal fiscal prudence.
In politics, austerity is considered an ugly (Opens in new window) word. After all, the ascendance of populism a decade ago can be attributed (Opens in new window) to the catastrophically mistimed austerity following the 2007–08 global financial crisis – essentially putting aside all the lessons learnt after the Great Depression.
Signs of political anxiety regarding the rising yields and the debt burden are already surfacing. As France gears up for presidential polls next year, the politicians on the far left have suggested (Opens in new window) “cancelling” a chunk of the country’s debt. Cancel is a euphemism for default, and the message is clear: France would rather default than be fiscally sensible.
Regrettably, France doesn’t have that liberty. Today, countries are so enmeshed in the global financial system, and so dependent on it to finance their budgets, that their policy options are practically non-existent. If bond markets are telling politicians to cut spending, then they will have to eventually oblige, or the yields will rise further. Unfortunately, bond vigilantes (Opens in new window) don’t care about the steroidal boost austerity could give an already ascendant populism.
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