In the past, some governments tried to postpone the pain by getting their central bank to buy their debt, which it financed by issuing reserves to commercial banks (a practice known, more colloquially, as printing money). In the process, though, commercial banks’ lending expanded, businesses and consumers spent more, and the ensuing boom pushed up inflation. To avoid galloping inflation, the central bank had to slow the economy sharply by raising policy rates well above the rate of inflation. The end result was a worse fiscal position because the boom and bust damaged the economy, and the government was left paying higher debt-service costs. Eventually, these countries saw the light and prohibited direct central-bank financing of government deficits.
Japan, the US and other countries with sovereign debt at or above total GDP need to shrink their fiscal deficits to keep their debts from growing to terrifying levels. The problem is particularly concerning when a country faces higher real interest rates, since fiscal deficits rise further when the government refinances debt. But even more worrying is the possibility of a doom loop, with higher rates driving higher deficits that in turn produce yet higher rates as investors lose confidence in government finances.
Higher market interest rates could also be a salutary wake-up call if the government, fearing the doom loop, takes steps to cut the deficit. But fiscal consolidation requires painful austerity, and few politicians ever want to subject their voters to that.
