JUST as the massive build-up in private debt helped precipitate the sub-prime mortgage and the related financial system crisis, so now a huge and rapid accumulation of government debt threatens a major crisis in government bond markets.
To make matters worse, central bank balance sheets are approaching a critical state. It is not only German Chancellor Angela Merkel who is protesting against what she sees as profligate fiscal spending by governments in the Anglo-Saxon world, and the supine attitude of central banks in accommodating these governments. Bond markets too are threatening to rebel and in the process precipitate an interest rate surge that could abort economic recovery.
Governments in the US, Britain and elsewhere (including Japan) are suddenly being challenged to explain their exit strategies. The reaction to the onset of recession - in Washington, Tokyo, London, and to a lesser extent in some European capitals - was to open fiscal spigots fully and to pressure central banks to open the monetary taps fully too.
Resultant government debt and financial liquidity could be mopped up at a later date - or so it was believed. But instead crisis has been pushed from one part of the system to another. Collapsing banks and corporations have been bailed out, liquidity restored to frozen financial markets, and a measure of consumer and investor confidence restored. The problem is that some party has to pay for this, and that party is bond markets, since taxpayers are in no position to do so during a recession.
Central banks - the US Federal Reserve, the Bank of Japan, and the Bank of England in particular - are also being pressured into stumping up new money to finance huge government deficits. This has provoked the fiscally conservative German leader Ms Merkel to take the unusual step of warning the European Central Bank to avoid following suit. If central banks are to acquire more assets in the shape of government bonds (plus the large volumes of financial and corporate sector debt they are purchasing under current unorthodox monetary easing), they need to fund this by issuing more liabilities: ie, by printing money. An inflationary spiral could ensue and bond markets appear to be sensing this danger.
Should long-term interest rates rise even further, following their very rapid run-up in recent weeks, the impact of monetary easing will be partly lost, necessitating further easing and creating a vicious cycle that courts high inflation. That might be good for eroding the real value of debt but it would also threaten to kill the green shoots of economic recovery.
Western governments are, meanwhile, threatened with catching the Japanese disease of incurring ever-rising fiscal deficits. A fiscal time bomb is ticking around the world (except in reserve-rich China) and needs to be defused before there is a bond market blow-up.
