The culmination of this journey: a staggering $49 trillion in developed-world public debt, roughly equivalent to these economies’ collective annual economic output, that led to a rash of sovereign-debt ratings downgrades and speculation that many nations were on the cusp of insolvency.
Today the reality is that these fears simply haven’t materialized. There are a few exceptions to be sure, and acute debt risks still exist in other realms such as Chinese private-credit excesses, emerging-market external debt and oil-oriented leverage.
But most of the countries that prompted such distress in 2009 are now actually faring just fine. Their government debt loads have finally stopped rising, the cost of servicing this debt commands an unusually small share of GDP and very little sovereign debt is falling into default. U.S. political dysfunction has temporarily made an issue of approaching budget and debt ceiling deadlines, but these concerns will soon fade, as they always do. Rather than insisting on enlarged risk premiums, investors have rewarded developing-nation borrowers with the lowest interest rates on record.
In retrospect, the decision to deliver fiscal stimulus during the worst of the economic downturn was inspired. Not only have bond markets reacted well, but international evidence has also congealed around the conclusion that every dollar borrowed generated two in economic benefits.
So far, so good. However, investors cannot afford to dwell solely in the present. A glance toward the future reveals that while the near-term risks associated with public debt loads are small, the medium-term outlook is a bit less friendly, and the long-term challenges are downright frightening.
Over the medium term, three things challenge the happy narrative of affordable, well-deployed public debt. First, a sizeable fraction of the world’s copious appetite for bonds has been the artificial result of central bank and foreign-exchange reserve buying. Both of these groups are now looking to begin unwinding their positions. Second, bellwether central banks such as the U.S. Federal Reserve and the Bank of England are tilting toward higher policy rates. These factors are set to increase public debt-servicing costs, diverting resources from more productive ends.
Fortunately, these first two headwinds have a limited reach. The world’s debt markets are remarkably deep, such that every $30 billion pulled from the U.S. Treasury market can be offset by a mere one basis point increase in the 10-year yield. There is also reason to think that the Fed and FX reserve managers will manage their exit gingerly, and furthermore that other potential buyers can plausibly backfill for them thanks to an aging population, de-risking pension funds and more conservative financial institutions. All of this is to say that borrowing costs are unlikely to fully revive to pre-crisis norms. What’s more, the relatively distant maturity dates of sovereign debt make for a very slow transition toward higher servicing costs.
The third medium-run challenge is more difficult to downplay: high public debt loads limit the ability of policymakers to lend a helping hand when the next recession or crisis emerges from the mist . As a result, future downturns could be larger or more frequent.
But the greatest risk lies over a multi-decade period. Absent concerted action, deteriorating demographics are set to blow a hole in developed-world government finances. With slower population growth and an aging population, economic growth diminishes and revenues rise more slowly. On the other side of the ledger, expenses rise more quickly due to pressures on health spending and other entitlements. The IMF calculates that, unaddressed, these forces will push developed-world government debt up from around 100% of GDP today to an unfathomable 186% by 2050.
This clearly presents a massive risk. Fortunately, there are a few potential solutions. At the optimistic end of the spectrum, productivity growth could surge on accelerating technological innovation, allowing stronger economies to keep debt burdens in check. In contrast, a more pessimistic take is that myopic politicians could blithely ignore the threat until markets eventually force their hand, resulting in widespread defaults or sudden severe austerity.
More likely is a mix of two less extreme scenarios. First, recognizing the risk, policymakers may simply opt to continue repressing borrowing costs much as Japan has done, keeping the effective public debt burden much lighter than normal. Second, politicians may gradually deliver a mix of entitlement reforms – for instance, reducing the indexation of benefits or means-testing beneficiaries – in a way that would materially slow the spending growth freight train.
In short, public debt risks are fortunately low today, and markets are unlikely to raise a fuss any time soon. But that does not mean public debt should be ignored altogether: the risks rise with time, initially slowly and then much more quickly. Here’s hoping that politicians notice, and have the courage to act before it is too late.
This article first appeared on Forbes.com on Oct.16, 2015.