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Where are the fiscal hawks?

This year every G7 country is projected to run government deficits larger than pre-Covid. That’s despite unemployment rates at or near multi-decade lows. The deficits are mostly substantial too: France, Italy, Japan, the UK and the US will all run deficits over 4% of GDP according to the IMF. When the economy is at full employment governments would ideally be running surpluses or at least only small deficits to bring down the debt ratio.

GDP has been stagnating over the last year in most G7 countries (except the US) so perhaps some of these deficits can be attributed to automatic stabilisers such as lower tax revenues. But IMF data shows that most countries (not Canada or Italy) were actually stimulating their economies in 2023. In other words their deficits were increasing even when adjusting for the cycle. Which doesn’t make any sense at all because central banks were busy trying to slow economies to deal with inflation. It seems that fiscal policy has gone off the rails, as we document in our latest Tricio Focus report (for a copy please email

This is a worry for two reasons. First, debt ratios rose during the Covid period. Not as much as they might have done because the unexpected inflation blow-out boosted the denominator, nominal GDP. Still, debt ratios are up and now stand close to or above 100% of GDP in five of the G7 countries (exceptions are Canada and Germany).

Secondly, to add to the long-running upward trend in health and pension spending, we now have three new (or relatively new) demands for higher spending: Defence, net zero and industrial subsidies.

For G7 countries with their own currencies there is no reason for bond-holders to fear default. But the easiest way for governments to escape high debts is inflation. The risk of higher inflation in coming years appears to have risen.

As long as central banks are independent this fear may be muted. Governments cant use inflation to reduce debts if central banks respond with higher interest rates. That said, it is only 4 years since the Fed published its new operating framework which suggested that if inflation was below target for a period, they might tolerate it above target for a while, to average 2% over time. I don’t hear anything now about running inflation below target for a while, despite inflation hitting 9% in 2022. There is a clear upward bias.

If you bought US bonds 5 years ago expecting inflation to run at 2% you will have been sorely disappointed – it has averaged 4.2% since April 2019 (geometric average for CPI). 

The US is the country perhaps most at risk of losing central bank independence, if President Trump wins in November. Talk of him, or the White House, trying to intervene directly in Fed policy meetings is hopefully fanciful. But he could appoint a new Chairman with different priorities – like keeping government interest costs down.

The title of this blog is ‘Where are the fiscal hawks?’ But perhaps the fact that 10-year bond yields are much higher than pre-Covid says they are already circling around. Most estimates of the ‘term premium’ – the difference between buying one 10-year note and rolling over 3 month T-Bills for 10 years – suggest that it has risen.

Of course, the term premium is unobservable since we don’t know what T-bills will actually pay over the next 10 years. There are various ways to estimate it including surveys of expectations. But if you think T-bills might pay 3% on average, the current US 10-year yield at about 4.5% will pay you 1.5% more, a much steeper yield curve than pre-Covid. This is generally good news for investors. Not so much for taxpayers.

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