Government Debt: A Potential Hidden Grenade

A recent opinion piece from the Financial Times expressed concerns about the significant built-up of government indebtedness and the potential risks of ballooning costs to maintain it.  The risk is characterized as follows:

“The trigger now may be a lethal combination of rising inflation and financial instability. The difficulty is that central banks cannot take away the punch bowl and raise rates without undermining weak balance sheets and taking a wrecking ball to the economy.”

The concern is legitimate, especially when you look at these two graphs that the IMF included in their April 2021 Fiscal Monitor:

Advanced economies are carrying debt comprising approximately 120% of GDP (Figure 1.1). Given historical low in general interest rates (Figure 1.3), the debt burden (expense) appears manageable at the moment holding roughly about 1.8% of GDP. But what will happen when rates go up? The obvious, of course, is debt expense will increase.    

By any historical standard it is unreasonable to expect that at some point interest rates will not go up. In other words, it is unreasonable to expect the current trend to continue without running into significant problems. The effects of that reversal when compared to the current trend could be consequential, and one which may take a lot of economic pain if not dealt properly.