Why Bond Markets May Be the Real Brake on the New Big State

The political case for more spending is easy to understand. After years of a rhetoric of austerity, governments now face a very different world: geopolitical confrontation, supply-chain fragility and pressure to protect households from repeated shocks. In that environment, deficit spending looks less like irresponsibility and more like insurance. NATO’s own spending commitments show how dramatically the fiscal conversation has shifted, with allies now pledging to raise defence spending far beyond the old 2% benchmark.

A new spending consensus

Governments across advanced economies are clearly shifting toward bigger public roles, boosting defence budgets, industrial subsidies and social protections to cope with geopolitical rivalry. But the decisive constraint on that “big state” revival may not come from parliaments or voters; it might come from bond markets. Investors will ultimately ask whether extra borrowing builds resilience or simply postpones an unwelcome bill.

The political case for expansion is straightforward. After a decade of fiscal restraint, policymakers now view deficit spending as insurance: strengthening deterrence, securing critical supply chains, and cushioning households against rising energy and transition costs. NATO data show defence spending rising sharply among allies since 2019; the EU’s industrial policy push and programmes such as NextGenerationEU underline a strong tilt toward state-led investment. There are however some lasting differences in the speeds at which countries are increasing their total military expenditure, with some moving a lot quicker than others.

Why markets still matter

All the while, markets still matter, although they are not a single, unified actor. Bond holders range from domestic commercial banks and pension funds with long-term exposures, to foreign official creditors and short term active funds. This heterogeneity matters for timing and intensity: domestic, long duration investors may tolerate prolonged deficits if they higher longer-term growth; non resident hedge funds can trigger rapid repricing. Although not officially a hedge fund, when Lehman Brothers collapsed in 2008, causing the economic crash, experts warned that the institution was essentially operating as a hedge fund. Therefore attention should be paid not only to the headline deficit but also to who holds the debt and how quickly they can sell it.

Monetary policy shapes the choice. The post pandemic era saw investors tolerate larger deficits because inflation fell and central banks signalled easier policy. Today’s central banks face a different reaction function: persistent inflation risks and a greater emphasis on price stability mean they are less likely to provide indefinite accommodation.

Two scenarios matter. If central banks keep rates higher for longer, higher sovereign yields will raise debt service costs and tighten fiscal space. If they ease in response to a growth slowdown, market pressure may abate temporarily, but that could revive inflation risks later, complicating the fiscal monetary trade-off.

Good debt, bad debt and lessons from the past

Not all borrowing is equal. Debt that finances productive, one off investments can enhance long term capacity to service liabilities. By contrast, borrowing that pays for persistent current spending with no clear productivity gains is harder to defend. The IMF’s recent analysis stresses composition as much as size: large deficits are sustainable if they buy higher output; they are not if they entrench permanent entitlements without a growth payoff.

History and recent Euro area experience offer useful lessons for the current situation. During the Euro crisis of 2010–12, sudden shifts in investor sentiment drove Italian and Spanish spreads sharply higher, forcing rapid fiscal and policy adjustments. More recently, episodes in 2022–23 showed that markets can turn quickly when inflation surprises and central banks respond by tightening. These precedents underline how fast perceived “temporary” measures can become permanent budget items, and how investor concern can morph into higher yields that amplify fiscal strain via a sovereign bank feedback loop.

Managing the narrow path ahead

What could trigger a market reaction? The most obvious is an inflation shock that forces wide repricing of future rate paths. Slower-than-expected growth would also hurt fiscal calculations by lowering nominal GDP, raising debt ratios even without new spending. Political resistance to tax reform is another danger: if ambition rises but the revenue base does not, the sustainability of debt will become increasingly difficult.

The most concerning risk, however, is drift: defence procurement, industrial subsidies and social transfers announced as temporary often become permanent features, becoming recurring liabilities.

For the EU, institutional backstops can soften market pressure, but they do not remove the risk. Tools such as the ECB’s support mechanisms or common EU borrowing can help keep spreads in check and give governments more room to act, but they come with conditions, political limits and cannot replace credible national fiscal plans. The political class should therefore make spending more targeted: focus on investments with clear productivity or security benefits, build in sunset clauses for temporary measures, improve transparency around debt holders, and set out realistic plans to restore the public finances once the shock passes.

The new big state is unfolding for good reasons. But market discipline has not vanished; it has simply migrated from political slogans to bond yields and investor portfolios. If governments want to enlarge the state sustainably, they must prove to markets, with evidence, timelines and credible plans, that today’s borrowing genuinely builds tomorrow’s capacity to pay.