Persistent budget deficits may trigger the next global financial crisis, as investors could lose confidence in government debt, warned John Simon, the outgoing head of research at the Reserve Bank of Australia (RBA), in his final remarks. Dr. Simon identified the “bank-sovereign nexus” as a significant medium-term risk to global financial stability. This scenario involves investors abandoning the assumption that government debt is safe, potentially leading to a financial market meltdown.
The Role of Government Debt
Government debt plays a crucial role in the financial system by providing liquidity, serving as a benchmark for asset pricing, aiding in financial risk management, and offering a low-risk investment option. A loss of trust in government bonds could severely disrupt the global financial system, especially since regulators have required banks to hold significant amounts of sovereign debt post-Global Financial Crisis.
Potential Calamities
Dr. Simon emphasized that the risk is not confined to the United States, where government debt levels have surged with little bipartisan support for deficit reduction. He expressed concerns about the global scenario where banks and sovereigns might collapse simultaneously without any backstop.
“I think there are a lot of places where there could be shocks in the future that mean suddenly the banks and the sovereigns go down and there’s nobody there to be a backstop, and then I’d be really worried,” Dr. Simon noted.
Budget Deficits and Financial Stability
While Dr. Simon is not currently concerned about existing government debt levels, he is worried about the prevalence of budget deficits. The Parliamentary Budget Office warned in June that recent federal budget surpluses would give way to a decade of deficits due to increased spending on the National Disability Insurance Scheme (NDIS) and a shrinking revenue base.
Persistent deficits might lead investors to question the public sector’s ability to repay debt. “Deficits matter. Can you say that the public sector has a sustainable way of getting back into balance? I think that is increasingly being questioned, as there are a lot of governments running primary deficits – they’re basically spending more money than they’re bringing in, quite apart from any of the interest costs,” Dr. Simon stated.
Future Financial Instability
Wayne Byres, former chairman of the Australian Prudential Regulation Authority (APRA), shared the panel with Dr. Simon and expressed a more optimistic view about Australia’s government debt. He highlighted Australia’s triple-A rating and a relatively strong balance sheet compared to other nations. Mr. Byres predicted that future financial instability might stem from operational issues rather than traditional credit market breakdowns, citing potential geopolitical events, rapid policy shifts, cyber events, or failures in critical financial infrastructure as possible triggers.
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