Countries around the world have shut down their economies in order to stop down the spread of Covid-19.  In order to prevent a humanitarian disaster they are implementing aggressive fiscal stimulus.   Prior to Covid-19 debt levels were already high.  In coming years they will reach levels never before seen in peacetime.  Average deficits in the developed world are around 11% of GDP this year, and developed world public debt could reach over 122% of GDP by the end of this year, according to The Economist.  This debt will have major consequences for the world economy in coming decades. 

Broadly speaking, there are three ways a country can deal with debt:

1. Adjust taxes and spending
2. Default on it.
3. Grow/inflate out of it.  

Each scenario has very different implications for financial markets.

Adjust taxes and spending

Governments couldeither raise taxes or cut spending.   However this is the least likely scenario.  Raising taxes is politically extremely difficult.  And in a globalized world, companies nad rich people can leave if taxes are too high.  Cutting spending is also difficult.   Bureaucracy is an entrenched interest in most countries. Populism is on the rise globally.  In a coronavirus world, more spending on healthcare is likely necessary.  IF growth is weak, government austerity will only worsen the problem. 

Default

Sovereign debt defaults are usually an emerging market issue.   If a country defaults on debt they will likely be  cut off from financial markets for at least a few years.   Sovereign countries rarely default on debt unless it is denominated in a foreign currency.   

Growth /inflation

If real  growth inflation is higher than the interest rate on debt, the debt will shrink as a percentage of the economy.   The US had a lot of debt coming out of World War II.  However, the economy grew rapidly in the following year,s and the relative size of the debt shrunk.  Its possible that economists and policymakers learned the wrong lesson from this.   Current US demographics, and Covid-19  make such a growth spurt unlikely. 

High inflation also shrinks the relative size of the debt burden. In the old days, sovereigns would literally debase coins by reducing the percentage of gold and silver. In modern times the process is more subtle.   Printing money drives inflation.   If the treasury issues debt in order to give money to consumers or businesses, and the central bank buys that debt, the impact is like printing money.  The central bank can buy financial assets from the private sector, driving asset price inflation.  The Federal Reserve is doing all of these things right now.    This could potentially stoke higher nominal GDP growth, due to higher prices.   Over time this would cause the amount of debt to become a smaller percentage of the economy.

 The practical consequences of high inflation for the wealth of lenders are very similar to a default.  If the inflation rate exceeds the interest rate, the real return is negative.  At the end, the principal amount returned buys less stuff.   Throughout history every systemically important country that borrowed a lot of money has printed money in order to effectively restructure debt.  The Dutch and the British Empires are two examples.