After the excessive expansion of new forms of private sector credit over two decades of disinflation, a huge pyramid of global liquidity was accumulated. That sparked a boom in asset prices (stocks, bonds and real estate) way beyond anything experienced in the growth of production, investment or consumption. Eventually the bubble burst and along came the credit crunch and the ensuing Great Recession. Desperate to avoid a meltdown in global financial institutions and another Great Depression, governments have dramatically increased sovereign debt issuance to fund bank bailouts and provide fiscal stimulus to the real economy. Monetary authorities have generated huge increases in liquidity to finance this debt. So, instead of the private sector deleveraging, there has been a massive increase in public sector leverage heaped on top of existing private sector debt. Soon central banks will have to withdraw this liquidity largesse or face a major acceleration in global inflation and another credit bubble. This poses a new stage in New Monetarism as sovereign debt competes with the private sector for available global savings.

At best, the global cost of capital is going to rise sharply, pushing economic growth of the major countries below trend for a decade ahead. At worst, there is a serious risk of a succession of sovereign debt defaults that could plunge the world back into depression. Sovereign debt is being discredited. There is a way out, but governments need to take painful, but necessary, actions.