Dire States

What's in graph (3): The Iran war is shocking a highly indebted world. Since the last financial crisis major economies have abstained from serious financial consolidation. Stay tuned for a reckoning.

In the years after 2008 I was frequently asked a tough question: „When is the financial crisis going to be over?“ Working as an economics editor back then, I had written about the issue extensively and was in frequent contact with officials and executives, so that some people deemed me an expert. Yet, how was I to know? I adopted a standard answer. It went like this: the crisis will only be resolved when debt levels have normalized. Substantial deleveraging would be needed to overcome financial vulnerabilities. “Normal” levels would mean: total gross debt (including governments, non-bank corporates and private households) coming down to something like 200 per cent of gross domestic product, maybe.

To achieve this the world economy, or at least the part that used to be called “the West”, would have three options: grow, inflate, or retreat to financial repression, most likely a mix of all three. Growing out of debt (in nominal terms, including elevated inflation rates) would be a reasonable option. Additionally, regulation would force insurance companies, banks and other financial companies to buy up government debt, while central banks would hold real interest rates at very low or even negative levels. After all, this is what happened in the US and the UK in the decades after World War II.

Getting back to normal would require a prolonged period of fiscal restraint, toughened up regulation and somewhat higher inflation. However, what sounded like a reasonable narrative turned out quite differently.

Money for nothing

Debt-levels have kept rising ever higher, pausing only briefly in the mid-2010s. In the OECD countries alone, nominal government debt is now three times of what it was in 2007, the year before the financial crisis. Relative to gdp, the new norm in Western countries is 100 per cent with many countries approaching even higher levels, the US and France being among them. Before, government debt of around 60 per cent used to be the old normal.

According to the Bank of International Settlement (BIS), gross debt is now at 250 per cent of gdp for the average reporting economy (see chart); advanced countries are a bit above that level, emerging ones slightly below. Before 2008, the average total debt ratio was 200 per cent. During Covid debt rose even higher, later came down to pre-pandemic levels. Most recent data https://data.bis.org/topics/TOTAL_CREDIT/tables-and-dashboards show that Hongkong (413 per cent), France (325 per cent) and China (296 per cent) are among the most highly indebted economies.

The sums outstanding are massive. By the end of 2025, global bond markets for sovereign and corporate debt had reached a valuation of 109 trillion US dollars, the OECD reckons. As long-term interest rates are no longer ultra-low, governments are spending more and more on interest, with debt-service overtaking defense spending as a budget item in many countries, most notably in the United States. Debt sustainability is becoming an issue particularly for highly indebted emerging markets, but also increasingly for slow-growing, highly indebted mature economies.

This is the financial world’s dire state as we encounter the next major shock: the unnecessary and misguided attack on Iran by US and Israeli forces starting on February 28 and Teheran’s blockage of the Strait of Hormuz and partial destruction of the oil and gas infrastructure in the Gulf region. Severe scarcity of fossil fuels, and accordingly sky-high energy prices, are strangling growth and fueling inflation. (As I’m writing this, news is out that the US and Iran have agreed a ceasefire. But uncertainty about the future of the region, and energy markets, remains elevated.)

I’ve come to ask myself whether the old narrative is still intact – whether debt ratios ultimately need to come down substantially before a new period of financial stability could be ushered in.

Almost two decades after the financial crisis of 2008 it looks like we are in for another one.

Sultans of Grim

For one, most countries have run out of fire-fighting gear. Whenever there was a whiff of panic in financial markets in recent decades, governments and central banks would rush to the rescue by ramping up government spending and propping up financial markets through yet another central bank bond-buying program. Both instruments have reached their limits. Government finances are stretched while central banks are confronted with ongoing inflationary pressures – the former meaning that more sovereign borrowing will likely raise long-term interest rates, crowding out private investment, while the latter puts limits on monetary policy accommodation. It seems that the official sector is running out of road. Macro policy buffers are all but exhausted.

The contrast with the last crises could hardly be starker. The financial breakdown of 2008, the Covid-19 pandemic and Russia’s invasion of Ukraine all triggered a broadly similar macroeconomic response. Governments resorted to massive deficit spending. Central banks subsidized this course of action by keeping interest rates at ultra-low levels and buying up bonds and other assets (thereby lowering long-term interest rates and hence government financing costs). Fiscal restraint was scarce and rather short-lived. Government deficits rose, staying high even during periods of reasonable growth. In the US fiscal deficits have been above six per cent of GDP, even with the economy close to full employment – hardly a viable stance going forward.

The reckoning is yet to come. For now, governments seem to pretend that they can continue to act as they used to. The US is still running massive deficits, while EU governments are pondering another round of subsidies shielding households and firms from high energy prices. However, central banks have changed track. Leading central bankers, including Christine Lagarde of the ECB and Jerome Powell of the Fed, have proclaimed vigilance, as the current energy shock hits price dynamics that haven’t completely calmed down since the most recent inflation episode of 2021-23 central banks. In many countries inflation was still above the 2 per cent target when the Iran war sent energy prices sky-rocketing. And even where inflation had come down to target, particularly in the Euro area, service inflation was still running at 3,5 per cent. Also, inflation expectations are still elevated, at three per cent in the Euro area over the next three years, as ECB surveys conducted before the attacks on Iran show. Hence, underlying inflation pressures are still elevated, by themselves raising long-term interest rates and borrowing costs.

Industrial Disease

Then there is the private sector. While corporate investment was sluggish during the last crisis, this time is (somewhat) different. The AI race is pushing tech giants to record financing operations. Corporate borrowing reached its highest level ever in real terms in 2025 at about 13,7 trillion dollars, the OECD notes. There’s more to come: „Given the scale of capital expenditure required to finance the expansion of AI, corporate borrowing needs are expected to continue increasing substantially.“ It’s a spending spree that is bound to contribute to the rise in interest rates, in addition to increasing government financing requirements.

Where does this scenario lead to? The bright-side narrative might go like this: AI-induced productivity gains will raise real growth, thereby improving debt sustainability and dampening inflation pressures. Interest rates would stay lowish, even as spending remains lavish. In these circumstances, central banks would still have some room to maneuver should bond markets be rattled by temporary nervousness, as they were during Britain‘s mini-budget crisis of 2022 and America’s bond market stress following the collapse of Silicon Valley Bank in 2023.

If the productivity miracle is not going to materialize, prepare for a rough ride. In my view this is the central scenario. Adoption of AI will hardly outweigh the economic effects of the accumulated debt burdens, in particular given the dampening effects of political uncertainty, a fragmenting world economy, and an adverse demographic outlook. Governments will need to signal that they are serious about servicing their obligations, or else face debt sell-offs. In highly-indebted poor countries the number of distressed sovereigns is set to rise. At best this will usher in a new era of structural reforms raising potential growth from very low levels, while scaling back government spending somewhat. Central banks need to keep inflation expectations in check, while allowing inflation rates to drift a bit higher to support fiscal consolidation. This is a delicate balancing act. Falling off the highwire would be disastrous.