Are world governments in hock to bond markets?
Experts examine how huge debt levels among developed nations is giving bond markets more sway over political spending decisions.
LONDON — How much national debt is too much?
Rachel Reeves, the British finance minister, was attempting not to put that question to the test during her latest budget on Wednesday by wrestling back the country’s debt levels, which are close to reaching 100% of national income.
The country is not an outlier among wealthy Western nations. The ratio of debt to gross domestic product in the U.S. is 125%, according to the International Monetary Fund, while fellow Group of Seven member Japan has a ratio of 229%.
Those eye-watering debt levels have caused a rise in the influence of those who own the debt of national governments and trade it on the bond market.
So just what is a bond? Professor Marianna Koli, an economist at Northeastern University, explained that bonds — or gilts as they are known in the U.K. — resemble an “I-O-U” from a government. “A government borrows money and issues a document that states a repayment plan, the interest rate, and the time period for the loan,” she said.
When a government cannot cover all its investment plans through its usual revenue streams, such as tax receipts, ministers look to sell bonds in order to borrow money, the London-based academic said.
Countries that have allowed their debt to pile up have made themselves more vulnerable during times of economic turmoil, Koli said.
She added that “if a country has a shock that makes their government seem less reliable in the eyes of the wider market, then the interest rates the country will need to pay on their borrowing going forward will be higher.”
During her budget speech, Reeves said the U.K. was using £1 in every £10 of public expenditure to pay back the interest on the national debt, which stands at £2.6 trillion, or $3.4 trillion.
The chancellor of the exchequer, Britain’s equivalent of the U.S. secretary of the treasury, blamed the U.K’s former Conservative Party government for “doubling the national debt” and said her fiscal plans would deliver on her pledge to reduce debt as a share of the economy by 2030.
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Reeves had felt the pain of bond market shocks even before budget day. In the weeks prior, the Treasury appeared to pitch for an income tax rise before deciding against the idea. The U-turn caused the gilt yields to spike, adding an additional £5.5 billion ($7.2 billion) in future interest payments, making Reeves’ debt-busting plan more difficult.
This fluctuation is part of an expensive trend, according to the Institute for Fiscal Studies, with the price of 30-year U.K. gilt-yields coming with 5.7% interest, their highest level since 1998. “This increase in the cost of borrowing is an important contributor to the difficult outlook for the public finances,” said the British economic think tank.
Internal critics of the Labour Party government accused it of being “in hock to the bond markets” with its fiscal policies. Pablo Calderon-Martinez, an associate professor in politics and international relations at Northeastern, said bond holders, particularly in Britain, are “dictating” political spending plans.
“You cannot escape that,” he said. “If borrowing goes a little bit higher, that has huge consequences for the government and can even bring the government down.”
Calderon-Martinez pointed to the example of Liz Truss’ premiership, when her “mini-budget” in September 2022, with its proposal to fund tax cuts through borrowing, sparked a selloff of bonds. Truss resigned less than a month later, becoming the shortest-reigning prime minister in British history.
Low interest rates have been a “historical advantage” for countries in western Europe, Calderon-Martinez added. Those purchasing debt from stable economies, which are seen as likely to be able to afford to stick with debt repayment plans, are looking for a safe investment, albeit with smaller returns than can be expected in other markets. “But that does mean you have to keep those borrowing costs low because, if they go up, then the whole house of cards falls down,” said Calderon-Martinez.
Politics in the U.S. is not immune to the looming shadow of the bond market. James Carville, a former aide to former President Bill Clinton, described it as one of the most powerful forces in the world.
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter,” Carville told The New York Times in 1994. “But now I would like to come back as the bond market — you can intimidate everybody.”
Mark Hooker, a teaching professor of economics, said Carville’s comment speaks to the disruptive force that bond markets can wield when their rules are not followed. The Northeastern academic said defaulting on debt repayments can lead to recessions and changes of government. After Argentina defaulted on $93 billion of sovereign bonds in 2001, foreign investment bailed, the government lost its majority and inflation rose to 40%.
Large debt piles do not automatically lead to a loss of support from a country’s bond market, however, Hooker remarked. “Those markets are really powerful,” he continued. “If they have a big negative response to a policy change, then that can be fatal to a government. But at the same time, there are also lots of cases where there are budget deficits that are enormous but the bond market shrugs it off.”
G7 debt-to-GDP ratios: Germany 64%, U.K. 94%, Canada 113.9%, France 116%, U.S. 125%, Italy 136%, Japan 229%.
Sources: IMF and the U.K.’s Office for National Statistics
U.S. debt has mounted in the aftermath of supporting the country through the coronavirus pandemic but the dollar’s status as a reserve currency — one of the world’s major trading currencies — means it remains an attractive place for foreign investors to buy government bonds, Hooker argued.
Debt interest repayments in the U.S. stand at about 5% of public expenditure — half that of the U.K., despite having a higher debt level. Japan has the highest debt-to-GDP ratio of any G-7 country but enjoys low interest rates.
The difficult thing about bond market economics is that it can be hard to explain why some are stable and others swing with every budget rumor and announcement. “These markets are hard to predict,” Hooker said. “There’s a breaking point somewhere, but nobody quite knows where.”
