Government Borrowing Costs Face Conflicting Pressures

Governments are facing a complex fiscal environment where borrowing costs are being influenced by competing economic pressures, including high debt levels and rising interest rates. This tension is forcing a reconciliation between fiscal policy and the practicalities of debt financing.

According to a report from the Government Accountability Office (GAO), the increase in government debt is driven by borrowing to finance large annual budget deficits and the payment of growing interest costs. While the President and Congress determine the fiscal policy that dictates how much borrowing is required, the Department of the Treasury is tasked with financing that debt.

The Impact of Rising Borrowing Costs

The International Monetary Fund (IMF) noted on March 26, 2026, that with high debt and rising borrowing costs, governments can no longer postpone making difficult fiscal choices. This suggests a narrowing window for governments to defer structural adjustments to their spending and revenue.

Sovereign default models provide further insight into how higher debt-financing costs affect an economy. When the cost of borrowing increases, governments generally have three options to avoid default: cutting spending, borrowing more, or increasing taxes. In these models, borrowing more is rarely chosen because taking on additional debt at a higher cost is unattractive to a sovereign entity attempting to avoid default.

Instead, sovereigns tend to deleverage. The consequences of this process can be significant and prolonged, including:

• A long-term decline in capital investment.
• A gradual decrease in GDP and labor.
• Sharp drops in consumption.
• Currency depreciation and inflation, often resulting from a depreciating real exchange rate.

While failing to deleverage may dampen short-term costs, it is identified as a factor that creates a lasting drag on the economy.

Market Volatility and Risk Premia

Political instability, specifically gridlock regarding the debt ceiling, has led to questions about the long-term willingness of the U.S. Government to service its debts. This uncertainty has manifested as higher default-risk premia within credit default swap markets, which has the potential to increase future debt-financing costs for the United States.

Historical data also indicates that government bonds may not always serve as safe havens during extreme episodes. Research examining 300 years of wars and the Covid-19 pandemic reveals that government bonds have repeatedly generated substantial real losses during these periods. In some instances, these bonds underperformed assets traditionally viewed as riskier, such as real estate and equities.

While some policy discussions have suggested that low interest rates make borrowing relatively cheap—specifically the argument that debt is easier to sustain when the interest rate is persistently below economic growth—these views primarily focus on peacetime dynamics. Large, unexpected spending shocks, such as major wars, present fundamentally different fiscal challenges.

Global Economic Pressures

External geopolitical conflicts are further complicating the economic landscape for various nations. For example, conflict involving Iran and other countries has driven up oil prices, which has created specific economic challenges for Tunisia.

These combined factors—rising interest rates, geopolitical instability, and the necessity of deleveraging—are creating a tug-of-war in bond markets as governments attempt to balance the need for spending against the increasing cost of financing that spending.