Large, growing budget deficits and rising public debt-to-GDP ratios in advanced economies are rattling markets. With interest rates on government debt having gone from near zero (and even negative, in some cases) to much higher levels, rising short- and long-term bond yields have cast doubt on the sustainability of some public debts and led many to ask if a crisis might be looming.

There is no simple answer to this question. In some cases, a country will have large stocks of financial assets—such as foreign reserves held by the central bank, or assets held by sovereign wealth funds or other public funds—that leave net debt below gross debt. But in many aging societies, implicit liabilities of unfunded pension funds and health-care systems are already larger than a country’s formal public debt, which means that the situation is worse than it appears.

A second crucial consideration is economic growth. If the average yield on public debt is lower than the nominal GDP growth rate, and if the primary budget (net of interest payments) is not too negative, the public debt-to-GDP ratio will fall over time. Growth can therefore resolve most debt problems. The United States and other economies that can boost their potential growth with advances in AI and related technologies will have a more sustainable path than those, like the eurozone, where growth is likely to remain slower.

That said, higher growth usually leads to higher real interest rates, which can make debt dynamics less sustainable. And if AI were to cause permanent technological unemployment for large segments of the labor force, the need for a much broader safety net (or even a universal basic income) would create additional fiscal and debt challenges unless it is financed by higher tax revenues.

A third consideration is that issuing a global reserve currency or borrowing in one’s own currency helps. The US dollar’s global reserve status underpins consistent global demand for Treasury bonds, thus allowing the US to borrow longer for less. But this privilege can eventually become a problem if a lack of market discipline leads to unsustainable deficits and debts.

Most other countries are in a different category. Emerging and developing economies tend to borrow in a foreign currency, leaving them with no option to wipe out the real value of sovereign debt via unexpected inflation. By contrast, eurozone members technically borrow in their own currency—the euro—but they all rely on the same independent central bank. As such, they cannot be bailed out unless the European Central Bank sees fit—or is forced—to come to their rescue.

A fourth consideration is market discipline imposed by so-called bond vigilantes. A rise in bond yields or country spreads can force fiscal authorities to cut spending or raise taxes before a crisis occurs. In some cases, the market heads off a deeper crisis, as happened during UK Prime Minister Liz Truss’s historically short tenure. But in other cases—namely, Greece—it takes a formal debt crisis to force the kind of fiscal austerity and debt restructuring or reduction that is required.

A salient question now is whether current market discipline will lead whoever wins France’s presidential election next year to pursue austerity before a debt crisis occurs. Even the far-right populist Marine Le Pen has presented a plan for fiscal consolidation (albeit one that relies on some smoke and mirrors). Moreover, the US itself is not immune. Bond-market discipline became a major factor last year following US President Donald Trump’s “Liberation Day” tariffs and again this year following the start of the war with Iran. In both cases, surging bond yields and corrections in other assets forced Trump to back down.

It also matters for debt sustainability whether we are in a world of fiscal or monetary dominance. When deficits and debts are not sustainable, a credible central bank committed to stable inflation can nudge fiscal authorities to make the necessary adjustments. But if monetary policymakers find themselves merely reacting to fiscal authorities’ decisions, a weak central bank may end up monetizing deficits (“printing money” to buy government debt) and wiping out nominal long-duration debt via unexpected inflation.

Still, you can’t fool all the people all the time. As public debt matures, short- and long-term rates will rise to reflect the higher actual and expected inflation. Fiscally errant countries always end up with higher long-term inflation and still-high public debt-to-GDP ratios—a lousy equilibrium.
Short of a fiscal adjustment—meaning lower spending and/or higher taxes—various forms of capital levies can also make debts more sustainable. In addition to the “inflation tax” mentioned above, there are wealth taxes or other similar duties; default or restructuring (effectively a levy on domestic or foreign savers holding the public debt); and financial repression, when the state forces banks and other financial institutions to hold more public debt at lower yields (another capital levy on savers). But in open economies, financial repression must go hand in hand with capital controls, which have their own added costs.

Finally, there is always the option of financial gimmickry, like the US Treasury’s recent attempt to lower long-term bond yields through debt buybacks, or similar programs to reduce the relative issuance of long-term versus short-term debt. These schemes are bound to fail, as everyone saw firsthand this year. In the multi-trillion-dollar government debt market, no one can seriously claim to be “the house,” not even the US Treasury secretary.

Over time, only fiscal discipline and higher potential growth driven by technological innovations can produce a happy ending. Delayed fiscal adjustments and other gimmicks eventually lead to outright debt crises, or to levies such as debt default and reduction, high inflation, or various forms of financial repression. One hopes the bond vigilantes can impose ex-ante fiscal discipline before a sudden stop to capital inflows triggers a debt crisis. France is the first country to watch, but it is far from alone.

Project Syndicate