What is the Deficit Endgame?

REYKJAVIK – No one yet has any real idea about when the global financial crisis will end, but one thing is certain: government budget deficits are headed into the stratosphere. Investors in the coming years will need to be persuaded to hold mountains of new debt.

Although governments may try to cram public debt down the throats of local savers (by using, for example, their rising influence over banks to force them to hold a disproportionate quantity of government paper), they will eventually find themselves having to pay much higher interest rates as well. Within a couple years, interest rates on long-term US Treasury notes could easily rise 3-4%, with interest rates on other governments’ paper rising as much, or more.

Interest rates will rise to compensate investors both for having to accept a larger share of government bonds in their portfolio and for an increasing risk that governments will be tempted to inflate away the value of their debts, or even default.

In research that Carmen Reinhart and I have done on the history of financial crises, we find that public debt typically doubles, even adjusting for inflation, in the three years following a crisis. Many nations, large and small, are now well on the way to meeting this projection.