How governments are financing big deficits

Funding pressures are substantial, which is why many central banks are ending QT

In recent posts, I’ve talked a lot about the high level of government debt across many advanced economies, which is putting upward pressure on longer-term interest rates. Debt is a “stock” variable and is the cumulative outcome resulting from many years of budget deficits in the past. An added dimension, which I’ve neglected to talk about so far, is what deficits are doing now, i.e. how bad is the “flow” of new debt that’s hitting markets and has to be absorbed. Today’s post kicks off a series examining this “flow” dimension and how large budget deficits are being financed.

The chart above looks at debt issuance and how it’s being financed across 16 advanced economies. The black diamonds show net new debt issuance - what you can basically think of as the budget deficit - from Q3 2024 to Q2 2025 in percent of GDP, where I’ve sorted countries in descending order. The red bars show the extent of foreign buying, the blue bars show quantitative tightening (QT) by central banks, i.e. the reduction in their holdings of government debt, and the pink bars show other domestic buying, a residual category that includes domestic banks and any other domestic buyer. All of these sources of demand are also in percent of GDP over the same period.

Several points are worth making. First, the US deficit is bad, but - in this international perspective - the US occupies a middle ground. Finland (FI), Canada (CA), the UK (GB) and France (FR) are worse. Second, not everyone is running big deficits. Australia (AU) is basically in balance and the Netherlands (NL) runs a very small deficit. Third, Italy (IT) and Spain (ES) are seeing exceptionally strong foreign buying reflecting things the ECB did in 2022 to cap both countries’ yields, including large bond purchases and the introduction of the TPI anti-fragmentation tool. These inflows are therefore artificial. Markets are simply following the lead of the ECB, which - through its past actions - has created an expectation that it backstops these countries in bad shocks.

The chart above shows four-quarter rolling sums of foreign flows into government bonds in Spain (ES), Italy (IT), Germany (DE) and the Netherlands (NL). Spain and Italy are getting foreign inflows on par with the aftermath of Draghi’s “whatever it takes” in 2012 and - from a market perspective - that’s understandable given that TPI is a major step in terms of backstopping these countries’ debt. Whether this is in the interest of low-debt countries like Germany is a different matter. ECB actions are distorting markets and removing any incentive for Italy and Spain to bring down debt.

The last and most important point is this. Many central banks are either slowing or ending QT in the face of upward pressure on longer-term interest rates from wide budget deficits. The Fed is the most prominent example of this. That may feel good in the moment, as it reduces upward pressure on yields. But this also means less pressure on governments to get their acts together and is really just fiscal dominance.