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On Monday, Gillian Tett wrote an article in the FT speculating on whether the latest asset bubble is sovereign debt. Since the onset of the financial crisis, financial institutions have been flooding to (and indeed have been encouraged to) government bonds because they are 'safe' and 'low-risk' assets. That they are perceived to be safe and low-risk is also reflected in their prices. But as Gillian explains, this sense of safety may be misleading:

[C]ould this flight to the "safety" of government bonds in itself be creating subtle new dangers? Government debt, after all, has soared to levels not seen in peacetime for centuries, if ever, in many countries, not least the US and UK. Fiscal deficits are swelling across the western world. And the level of political commitment to curbing those deficits remains uncertain - not least because with yields currently so low there is less pressure on politicians to push through reform.... it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation.

Gillian's concerns reflect the main message of a book I am currently reading: This Time is Different, by Carmen Reinhart and Ken Rogoff. With a tag-line reading "Eight centuries of financial folly," the book uses a wealth of data to demonstrate just how frequently countries default on their domestic and external loans. The answer is: often.

One of the trends they identify is that banking crises are usually a precursor to sovereign debt crises. This is particularly true for emerging market economies, regardless of whether the banking crisis occurred in their country/region or the rich world, because of their reliance on funds from external sources. Since the rich world just went through a banking crisis (as part of the wider financial crisis), and levels of global trade have collapsed, this is something to watch out for.

But Gillian isn't talking about emerging markets: she's talking about large, wealthy countries like the US and the UK. Rich countries are very unlikely to default straight up. But there are other ways to partially-default on your loans, like inflation (as noted above). This works particularly well when both your domestic and external debt is denominated in your own currency (as it is in with the US).

The problem boils down to this: financial institutions just spent a lot of time & taxpayer money replacing now-worthless financial products like CDOs and commercial paper with government bonds. Now the value of those government bonds is at risk due to the huge sums of money governments spent bailing out those very same financial institutions. Unless governments (or more specifically, the wider public) are willing to make difficult spending choices to tackle national debt problems, we risk repeating this cycle a few years down the road.

And in case there's any doubt that governments have been loading up on debt, I will again point to the Economist's global debt calculator. Add to this the short-term costs of lost productivity from the financial crisis and the long-term costs of a massive demographic change in Western countries, and it's a sobering picture indeed.