Government debt surge: Economic optimism meets fiscal reality

U.S. President Donald Trump’s pro-business policy proposals—the shrinking of government through tax cuts and deregulation—have injected renewed economic optimism into the U.S. outlook. The Institute for Supply Management’s Purchasing Managers’ Index rose in December, lodged firmly in expansionary territory. Small business optimism returned to 2021 levels, and the Business Roundtable’s CEO Economic Outlook Index continued its upward climb.

Confident businesses are more likely to increase investment and hiring. More jobs mean more personal income, leading to increased spending, which boosts corporate profits, creating a virtuous cycle.

But economists are worriers. Despite positive sentiment, concerns are rising over the very pro-business policies driving this optimism. Lower corporate tax rates are raising questions about the U.S. budget deficit and ballooning public debt.

At 120% of GDP, U.S. government debt has surpassed its 1946 peak, just after the Second World War. Unlike then, when wartime spending was expected to end, today’s budget imbalances have no clear resolution, with a projected deficit of 6.2% this year, according to the Congressional Budget Office. 

Global debt trends

But it's not just happening in the United States. Global public debt has been rising for more than 15 years. With revenues still depressed and additional spending on new priorities such as the energy transition, remilitarization and caring for aging populations, deficits in developed markets remain elevated. As a result, government debt reached $95 trillion in 2024, nearly the size of the global economy.

But why are markets suddenly concerned? For more than a decade, developed market governments benefited from historically low interest rates, as central banks responded to the global financial crisis and COVID-19 shocks. But those days are over. While monetary authorities maintain an easing bias, concerns about persistent pricing pressures in some developed markets are pushing up longer-term government bond yields—the interest rates governments must pay to borrow. Basic math tells us that if inflation-adjusted interest rates exceed real GDP growth, governments need to run a budget surplus to stabilize debt-to-GDP ratios.

Apprehensions about debt management

Higher yields also reflect apprehensions about the size of public debt and governments’ ability to manage it over time. Lenders are demanding higher premiums for the increased risk of non-payment, despite central bank easing biases. While there’s no reason to doubt the U.S. government’s borrowing ability, given the lack of alternatives to U.S. Treasuries (famously described as the “exorbitant privilege of the U.S. dollar”), countries, like Brazil, Russia, India, China, and even closer allies such as Malaysia, are eager to reduce their dependence on the dollar.

As the long end of the yield curve becomes less sensitive to policy rates, market-watchers are questioning whether some governments may be headed toward a negative debt spiral, borrowing more to service rising interest costs. These concerns are most acute for governments with structural vulnerabilities and cyclical headwinds, making them susceptible to bond vigilantism.

With a projected budget deficit of 4.8% of GDP, the United Kingdom is struggling with its debt size. In November, political crises and budget struggles in France drove French government risk premiums above those of Greece for the first time. The U.S. government will spend more on debt servicing this year than on defence. 

The bottom line

While the U.S. economic outlook is solid, higher yields raise the risk of disorderly financial market repricing. From a macroeconomic perspective, higher yields are tightening financial conditions for businesses and consumers, which isn’t consistent with the current economic cycle. This is also pushing up yields globally, as other borrowers adjust to attract international capital, putting pressure on the most vulnerable.

The Institute of International Finance projects that by 2030, government debt will nearly double to close to $200 trillion. This led the Bank for International Settlements to warn in December that rising debt levels are one of the biggest threats facing the global economy.

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