The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand. According to the OECD, total industrialised country public sector debt is now expected to exceed 100% of GDP in 2011 - something that has never happened before in peacetime.2 As bad as these fiscal problems may appear, relying solely on these official figures is almost certainly very misleading. Rapidly ageing populations present a number of countries with the prospect of enormous future costs that are not wholly recognised in current budget projections. The size of these future obligations is anybody's guess. As far as we know, there is no definite and comprehensive account of the unfunded, contingent liabilities that governments currently have accumulated.

Should we be concerned about high and sharply rising public debts? Several advanced economies have experienced higher levels of public debt than we see today. In the aftermath of World War II, for example, government debts in excess of 100% of GDP were common.3 And none of these led to default.4 In more recent times, Japan has been living with a public debt ratio of over 150% without any adverse effect on its cost. So it is possible that investors will continue to put strong faith in industrial countries' ability to repay, and that worries about excessive public debts are exaggerated.5 Indeed, with only a few exceptions, during the crisis, nominal government bond yields have fallen and remained low. So far, at least, investors have continued to view government bonds as relatively safe.

But bond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly ageing populations, for many countries the path of pre-crisis future revenues was insufficient to finance promised expenditure.

The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt; rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if. When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways? In some countries, unstable debt dynamics, in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels, are already clearly on the horizon.

It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk. It will also complicate the task of central banks in controlling inflation in the immediate future and might ultimately threaten the credibility of present monetary policy arrangements.

While fiscal problems need to be tackled soon, how to do that without seriously jeopardising the incipient economic recovery is the current key challenge for fiscal authorities. In this paper, we do not address this issue, but we note that, in our view, an important part of any fiscal consolidation programme is measures to reduce future liabilities such as an increase in the retirement age.6 Announcements of changes in future programmes would allow authorities to wait until the recovery from the crisis is assured before reducing discretionary spending and improving the short-term fiscal position.

The remainder of this paper is organised in four sections. In Section 2, we present an examination of the recent build-up of public debt. Following the facts, we turn, in Section 3, to a forward-looking examination of the public debt trajectories in industrial countries. In Section 4, we discuss the challenges these possible future debt levels pose to both fiscal and monetary authorities. The last section concludes.

David Fuller's view Regarding the last two sentences in the second paragraph above, I maintain that western government bond yields have only remained low because, 1) governments have been the biggest buyers of their own debt via quantitative easing and, 2) investors felt that medium-term deflationary pressures exceeded longer-term inflationary risks.

The remainder of BIS' introduction deals mainly with the conundrum faced by western policymakers. Tighten monetary policy and cut public spending too soon and economies could easily slide into a double-dip recession. Delay too long and inflationary problems will almost certainly arise.

Given Japan's deflationary experience, not to mention the 1930s, I maintain that politicians will err on the side of inflation, which they fear less than deflation given Paul Volcker's successful tenure as Fed Chairman from August 1979 to August 1987. Also, political incumbents may calculate that future inflation will not arrive on their watch. Therefore it is more palatable for democratically elected leaders to pay lip service to prudence and frugality, while behaving like a charity dispensing public money.


In the manner of a wannabe lucky gambler's calculation, officials will hope that something else suppresses a damaging inflationary spiral, enabling then to devalue the real cost of debt, floating away what they cannot pay. Perhaps it could be manufacturing competition, or a breakthrough on energy costs, or the collapse of China which so many fearful pundits have long predicted and hoped for. Meanwhile, money printing remains a preferred strategy, especially if everyone is doing it. No wonder prices of precious metals are resuming their secular uptrends.

I commend the remainder of BIS' report to you. Not least the compelling table on page 3. The right-hand column is the most interesting bit and I know which three I prefer. How do we plan for the widely varied "Public debt/GDP projections" shown on page 10? This commentator tries not to worry about it, although most of us do, even though we know that it seldom helps. Most of us think about the future quite often. I know that I do but from a practical investment standpoint, I prefer to live with events one day at a time, guided by the price charts.