3.11 - Government Debt
What government debt is and how it arises
Government debt, also known as national debt, represents the total amount a government owes to its creditors. It accumulates over time from repeated borrowing to cover shortfalls in public finances.
How government debt builds up
Government debt equals the sum of all previous budget deficits minus any repayments from budget surpluses. A budget deficit occurs when government spending exceeds tax revenues, forcing the government to borrow funds.
The role of bonds in government borrowing
Governments borrow by issuing bonds, which are essentially promises to repay borrowed money.
A bond acts as a promissory note, committing the government to pay the bondholder a fixed amount on a set future date, plus interest. Bonds that remain unpaid contribute to the total government debt, which is the combined value of all such outstanding bonds.
The debt-to-GDP ratio and its significance
The debt-to-GDP ratio compares a country's total debt to the size of its economy, offering a clearer view of the debt's manageability than absolute debt figures alone.
Calculating the debt-to-GDP ratio
Where:
- Total government debt = Overall amount owed by the government (£)
- GDP = Gross domestic product, the total value of goods and services produced in the economy (£)
This ratio expresses debt as a percentage of GDP.
Factors that increase the debt-to-GDP ratio
- Debt growing faster than GDP, such as through large-scale borrowing without matching economic expansion.
- GDP falling more quickly than debt, for example during economic downturns where output shrinks but existing debt remains.
Why the debt-to-GDP ratio matters
A high ratio suggests the economy may lack sufficient output to repay debts easily, which can worry investors and lead to demands for higher interest rates to compensate for perceived risks.
Impacts of high government debt
High levels of government debt create several economic challenges, affecting public spending and overall stability.
Debt servicing and opportunity costs
Debt servicing involves repaying the principal (original borrowed amount) plus interest. This carries significant opportunity costs, as funds used for repayments could otherwise support areas like infrastructure, education, or healthcare.
Restrictions on government spending and policy
High servicing costs limit a government's flexibility for discretionary spending (non-essential outlays) and can hinder expansionary fiscal policy, such as increased spending to stimulate the economy during recessions.
Risks of monetising debt
Governments may monetise debt by printing new money to repay borrowings, which can lead to inflation as more money chases the same goods and services. This approach also risks depreciating the currency's value internationally.
Debt from tax cuts and investment outcomes
Borrowing to fund tax reductions, especially corporate tax cuts, is risky. Studies show these cuts often result in limited additional private investment, failing to boost the economy enough to offset the lost tax revenue.
Credit ratings and austerity policies
Credit ratings assess the risk of lending to governments, influencing borrowing costs. High debt can trigger responses like austerity to restore financial health.
Credit ratings
Credit ratings are scores given by agencies such as Moody's or Standard and Poor's, evaluating the risk a government poses to lenders when issuing bonds.
How credit ratings work:
- Ratings range from top grades like Moody's "Aaa" (safest, lowest risk) to low grades like "C" (high default risk with poor recovery chances).
- As the debt-to-GDP ratio rises, downgrades become more likely, forcing governments to offer higher interest rates (a risk premium) to attract buyers.
- This can create a vicious cycle of escalating debt and default risks.
The diagram below shows that cycle. A rising debt-to-GDP ratio makes a credit rating downgrade more likely, and the downgrade means investors demand higher interest rates (risk premium) before they will keep lending. Those rates mean higher debt servicing costs, and the extra borrowing needed to cover them pushes the debt-to-GDP ratio higher still, so the country can end up trapped in a debt crisis.
Austerity policies
Austerity involves cutting government spending and raising taxes to shrink budget deficits and achieve a primary budget surplus.
A primary budget surplus occurs when tax revenues exceed government spending, excluding debt servicing costs. While aimed at reducing absolute debt, these policies often slow economic activity, potentially raising the debt-to-GDP ratio temporarily even as debt falls.
Factors affecting debt sustainability
Debt sustainability refers to a government's ability to manage and repay debt without defaulting. Several elements influence whether debt remains sustainable.
Key factors in debt sustainability
| Factor | Debt is more sustainable when | Debt is less sustainable when |
|---|---|---|
| Interest rates vs economic growth | The growth rate exceeds the interest rate, so income and repayment ability rise faster than debt obligations | The interest rate exceeds the growth rate, so debt costs outpace the economy |
| Primary budget balance | The government runs a consistent primary surplus | Debt is rising and the primary balance does not improve |
| Use of borrowed funds | The borrowed money pays for productive investment, such as infrastructure, that raises future growth | The borrowed money pays for current consumption, which adds nothing to the stock of capital |
| Ownership of debt | Most of the debt is held by domestic investors, who may be more patient | Much of the debt is held by foreign investors |
| Currency denomination | The debt is denominated in the domestic currency | The debt is denominated in a foreign currency, so exchange rate movements change the cost of repaying it |
| Economic stability | Strong institutions and a credible policy record let a country carry a high ratio without a crisis: in 2025 Italy carried debt of 137% of GDP and Greece 146% | There is no single safe threshold, and a lower ratio can still cost more to service: Hungary, at 75% of GDP, spent a larger share of its budget on interest than either of them |