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Remember when politicians pointed to “historically low interest rates” to justify spending more because the “debt-servicing costs will be low?”

Everything seemed possible in the era of easy money. Governments could borrow endlessly with nary the blink of an eye by bond traders. Loose monetary policy after the 2008 financial crisis made debt accumulation seem painless, even virtuous.

The easy-money epoch reached its apex during the pandemic, when central banks ramped up quantitative easing (purchasing government bonds to drive down long-term interest rates) and governments spent at previously unimaginable levels to blunt the economic impact of the crisis. It turns out, those same actions hastened the end of cheap borrowing by unleashing the inflation genie.

Suddenly, central banks found religion again. After years of blissful insouciance toward the asset-price inflation their easy-money policies had begot, central banks have responded with singular purpose this year to crush consumer-price inflation. Interest rates have surged, undermining all the assumptions of the easy-money era.

Welcome to era of tight money, where borrowers must beware. In this brave new era, markets impose swift and ruthless verdicts on governments that think they can borrow like they did before. Former British Prime Minister Liz Truss discovered this the hard way. Her downfall should serve as a warning for big-spending governments everywhere, including in Canada.

Economists are divided about whether central banks will be able to achieve their goal of bringing inflation down without causing a deep and painful recession. But almost all agree that the mountains of public and private debt built up during the easy-money era will make achieving a soft landing much harder. Rising debt-servicing costs and declining currencies are threatening several developing countries with debt crises reminiscent of the 1980s. European governments seeking to insulate consumers against soaring energy costs with big subsidies are being warned to tread carefully.

“Tight money is gripping all asset markets, including stocks and currencies, punishing governments of the right and left and posing a practical question about whether countries can pay their bills without easy money,” Rockefeller International chairman Ruchir Sharma wrote recently in the Financial Times. “In the new tight money era, markets can turn swiftly against free spenders, no matter how rich.”

As Mr. Sharma pointed out, leftist governments in Chile and Colombia elected in recent months on big-spending platforms have been quickly forced to pivot toward the centre after financial markets balked at their plans. Brazilian president-elect Luiz Inacio Lula da Silva is facing pressure to follow suit as markets worry about his campaign promise to scrap spending caps adopted by his predecessor.

While debt-strapped Italy is considered Europe’s most vulnerable borrower, it is hardly the only EU country that needs to worry about the bond market vigilantes.

Standard & Poor’s last week cut France’s credit outlook to “negative” to reflect “rising risks to France’s public finances, amid tightening monetary conditions.” The credit rating agency said that massive energy subsidies the French government has promised consumers and business will drive its deficit to 5.4 per cent of gross domestic product in 2023, forcing France to borrow more than anticipated.

“To finance the deficit, the government will issue new debt in commercial bond markets, on top of refinancing, while the [European Central Bank’s] policy shifts toward withdrawing monetary stimulus,” S&P said. “These opposing directions of fiscal and monetary policy raise uncertainty about the government’s cost of new debt.”

Canada is in better shape than most of its peers, with the federal deficit-to-GDP ratio projected to fall to 1.3 per cent in the fiscal year that ends next March. But it would be a mistake for policy makers here to believe Canada is immune from the kind of market revolt that hit Britain this fall. It would not take much for the deficit to swell again if a recession saps tax revenue. Without a hard commitment from Ottawa to cut spending, bondholders could bail.

Some analysts see a silver lining in the current inverted yield curve – a phenomenon that is typically a precursor to a recession in which short-term interest rates are higher than longer-term rates – suggesting that markets believe central banks will win their fight against inflation. But the devil is in the details of what happens between now and a return to lower short-term rates.

“Unlike in the 2008 financial crisis and the early months of COVID-19, simply bailing out private and public agents with loose macro policies would only pour more gasoline on the inflationary fire,” warns New York University economist Nouriel Roubini. “That means there will be a hard economic landing – a deep protracted recession – on top of a severe financial crisis.”

Whether you agree with Prof. Roubini or not, this is no time for complacency. For governments everywhere, 2023 will truly be a year of living dangerously.

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