G180

The story of the crisis so far has been one of off-balance-sheet liabilities becoming real: from structured investment vehicles to banks, from banks to governments. Will the next step in the crisis see markets forcing governments' unfunded off-balance sheet liabilities back to center stage?

Western governments will be hoping they don't -- but there are some signs it is happening already.

Eurostat's decision to ask Greece for more details on currency swaps it may have used to defer debt repayments has reminded investors that all governments have huge long-term lurking liabilities not disclosed in their accounts. But the use of swaps, securitizations and private-public partnerships are a sideshow compared with the vast health and retirement costs associated with aging populations.

If all unfunded liabilities were consolidated on national accounts, the fiscal challenges for many countries would look truly daunting: they are close to nine times gross domestic product in Greece, five in Portugal and 4.5 in the U.K., economist Jagadeesh Gokhale estimated in a 2009 paper for the U.S. National Center for Policy Analysis.

While the market is being mainly driven by near-term pressures, it is noteworthy that the countries most exposed long-term are among those that have seen the cost of buying insurance on their sovereign debt rise highest in recent months.

The market is right to be concerned: Even if the demographic challenges are still some way off, some countries may struggle to achieve fiscal sustainability by the time the unfunded liabilities kick in. The International Monetary Fund warned in October that from 2015, population aging will add to pressures on deficits and debt, even as public debt to GDP in the advanced economies is set to top 110% by 2014.

True, demographic trends could feasibly change: A rising birth rate could radically change the outcome. Or, unlikely as it seems, governments may shift tack and get round to adopting policies that address the problem. But this will be a huge challenge: Even assuming bond yields remain at record lows, Japan would require a permanent fiscal contraction of 8% of GDP to stabilize on-balance-sheet debt, according to Societe Generale. Adding in unfunded obligations or factoring in even a slight rise in bond yields makes the task impossible.

In fact, soaring long-term bond yields in developed countries at some stage seems a likely outcome. A Barclays Capital model based on demographic factors forecasts U.S. and U.K. long-term bond yields will climb to 10% by 2020.

By that point, the tension between governments' contracts with the bond market and the overly-generous social contracts offered to their citizens during the boom years will have become impossible to ignore.