Why Governments Are In Debt And Why It Matters
According to the World Debt Clock, the world is $78 trillion in debt at the time of writing; this is almost 90% of the world's Gross Domestic Product (GDP). But who do we owe this money to? How can the entire world be in debt? To answer these questions, we need to explore the definition, causes, and effects of national debt.
Background
National debt, or sovereign debt, is the cumulative sum of the debt owed by a government to its creditors. Generally, national debt can be classified into two major groups: public debt and intragovernmental debt. Public debt is national debt held by members of the public, or to put it in another way, money that the general public lends to national governments. The government could borrow money by issuing government bonds, such as U.S. Treasury Bills, for the general public to purchase. The proceeds of this sale fund government expenditure – thus, the government borrows money. It is important to note that "public" incorporates all parties other than the domestic government, including citizens, foreign investors, and foreign governments. On the other hand, intragovernmental debt is debt that a government owes itself. This happens when the government borrows money from one or more of its departments. If some government departments have surplus revenue, the government may "borrow" these funds for other purposes and return the money to the department after some time. For instance, the U.S. Government borrows money from the Social Security retirement account consistently to pay for its budget deficits.
Although the absolute amount of national debt is a useful figure, other measures provide a more holistic view of a country's national debt level. A few examples include the debt level as a percentage of GDP and debt per capita. These measures are considered more suitable for international comparisons because they more accurately capture the extent of financial burden on the economy. National debt is also not to be confused with budget deficit. A budget deficit means that a government's expenditure is higher than its revenue in a fiscal year. The accumulation of budget deficits through several fiscal years will lead to an amount of money that is owed by the government to other entities; this amount of money is the national debt. Budget deficits and national debts also affect a country's credit rating. Credit rating is an assessment of a borrower's creditworthiness - its ability to pay back debts, and the probability of it defaulting on its debts. A good credit rating (Aaa by Moody's, AAA by S&P and Fitch) will ensure governments have easy access to international capital markets and enable them to borrow money at a low cost.
Foreign Entities
Credit ratings and access to international capital markets point to a crucial, yet often misunderstood, aspect of national debt – external debt. As its name suggests, external debt is debt owed by governments to foreign lenders. On the surface, external debt seems perfectly logical: governments should be able to borrow money from international markets. However, on second thought, why would the lending party lend capital to foreign governments when they could expect higher returns elsewhere, such as the stock market, or easily lend money to their own governments? For foreign private investors, buying foreign government bonds may well be a calculation of risk and return. Based on a country's credit rating and interest rate, foreign private investors can gauge if their investment will maximize returns. A country with a low credit rating will most likely offer a high interest rate on its bonds to attract capital – high reward – but will also be more likely to default on its debt – high risk. In times of financial uncertainty, investors prefer highly rated government bonds such as U.S. Treasury Bills, which have never defaulted. Treasuries are considered so safe that they are deemed "risk-free," whereas 10-year Treasury bonds are used as benchmarks for interest rates on lending products.
The other party to external debt is foreign governments. The motivations behind foreign government purchases of sovereign debt are not as black and white as foreign private investors. This is not to say that foreign governments cannot purchase sovereign debt for the same reasons as individual investors. In fact, many central banks hold foreign exchange reserves in the form of government bonds, treasury bills, and other government securities because of their low risk, high liquidity, and stability. However, scholars and pundits have accredited foreign ownership of national debt to a more shrewd economic maneuver – currency manipulation. China and Japan, the two largest foreign holders of U.S. debt, have been accused of purchasing Treasuries to keep the U.S. Dollar (USD) strong to protect their export-orientated economies. For a start, foreign entities purchase government bonds with the local currency, in this case, bonds denominated in USD. Foreign entities have to exchange their currencies to USD in the foreign exchange market (FOREX) if they are to purchase U.S. Treasuries. This drives the demand for USD in the FOREX, keeping the price of USD high. In contrast, these governments will be selling their currencies, increasing the supply and lowering their currencies' price. Thus, foreign governments are effectively reducing the price of their exports, allowing them to grow their economies.
Nevertheless, developing countries without good credit ratings – lower than investment-grade (junk/speculative) – may find it difficult to borrow from international capital markets. These countries could still raise funds in two methods: to borrow from domestic entities (citizens, government departments, domestic institutional investors, etc.) or to borrow money from international organizations such as the International Monetary Fund (IMF) and the World Bank. Between these methods, many developing countries prefer to lend from international organizations as funds from domestic investors may be limited. This is because developing economies usually do not have a robust financial system that could support complex financial products and attract large amounts of capital. Therefore, developing countries look to the IMF and the World Bank for loans, as they offer lax repayment schedules and low interest to help these countries economically.
Economic Theories
That being said, most countries - developed and developing alike - table budget deficits and issue debt annually, resulting in an ever-increasing national debt with no end in sight. This phenomenon can largely be attributed to two distinct schools of economics that are predominant in the 20th and 21st century: Demand-side "Keynesian" economics and supply-side "trickle-down" economics. Keynesian economics is named after the British economist John Maynard Keynes, who proposed that government intervention in the economy is required to stimulate demand and growth, which will, in turn, optimize economic performance. Keynes argued that government spending in the economy is necessary to prevent, or at the very least to minimize the damage caused by, economic downturns. Keynesian economics's central idea is counter-cyclical spending: the government should increase spending during periods of depressed economic activity to boost aggregate demand in the economy and reduce spending when the economy is booming to prevent overheating. Deficit spending is encouraged to shore up deficient investment and consumer demand; the increased spending will be amplified through the multiplier effect and bring the economy back from a recession. Even the champion of the free market economy, the United States, embraced this economic thinking during times of market stress. For instance, the U.S. Government, with The American Recovery and Reinvestment Act of 2009, spent $840 billion in the aftermath of the 2008 Financial Crisis to extend unemployment benefits and fund public work projects. The sheer scale of this program meant that the Federal Government funded it not through government revenues, but by issuing debt, which added $830 billion to the national debt.
Conversely, supply-side economics promotes free market competition without government intervention in the economy. Proponents of this theory suggest that lower income tax rates, relaxed business regulations, favorable corporation taxes, and cheaper credit will spur economic activity as they will induce an increase in all components of the aggregate demand. The lower tax rates mean that the wealthy will have more surplus capital. As a result, more money will remain in the private sector to be invested in the economy. The resulting increase in investment should lead to lower unemployment rates and higher economic growth. As firms employ more workers, consumer demand in the economy rises, which allows firms to increase production and raise wages, and the process repeats all over again. Therefore, wealth will "trickle-down" from the upper class to the lower class. Lower interest rates also mean that consumers and firms can borrow money from banks at a low cost, boosting spending in the economy and growing it at a higher rate. In addition to that, the deregulation of the economy encourages free market competition and innovation, which could encourage lower prices for consumers. The theory also states that the increased economic activity will increase government revenue by so much that it will pay for the original tax cuts. Perhaps the most prominent example of supply-side economics is Reaganomics, a series of tax cuts, deregulation, and reduced government spending during the 1980s "stagflation" – high inflation with low economic growth. As a result, total Federal receipts increased from $599 billion to $991 billion, and the GDP grew by 3.51% annually between 1981 and 1989. However, supply-side economics also unexpectedly resulted in widening income inequality, stemming from unequal income growth between the rich and the poor. The resulting economic inequality has been found to further worsen the government's debt level as provisions of basic government services have to be scaled up to cater for a larger share of the population. Thus, increased government expenditure meant that the higher government revenue is far from sufficient to match government expenditure, swelling the national debt from $738 billion to $2.1 trillion during this period.
Although demand and supply side economics increase the national debt, deficit spending during times of economic uncertainty can stabilize and bring an economy out of recession. Deficit spending is intended to be a temporary, stop-gap measure to fix the economy. Once it has successfully brought the economy out of a recession, the national debt is supposed to be repaid slowly. But this is not the case. National debt has become the rule rather than the exception. Due to the pervasiveness of negative financial balances in countries worldwide, the consequences of this policy must be fully understood.
Consequences
Some economists propose that government debt is one of the many causes behind the modern business cycle. As deficit spending is meant to boost aggregate demand, it is most efficient when employed during a trough in the business cycle. If governments still use expansionary fiscal policy when the business cycle is at its peak (also known as a "boom"), it may result in the economy overheating. In simple terms, overheating is when an economy is growing at an unsustainable rate, leading to aggregate demand outstripping aggregate supply. As a result, high inflation, and the higher interest rate that follows, will eventually cause consumer demand and investment to drop, possibly resulting in a recession. Overheating of the economy due to excessive government debt may happen as there is a time lag between policy implementation and its effect on the real economy. This lag also means that the overheating can only be clearly noticed when it is too late to salvage the deficit spending. After all, government policies must go through thorough analysis and consultation with advisors before implementation. By the time the economy overheats and goes into a bust, the government can only issue more sovereign debt to try to stop a recession. Therefore, a government may always find it necessary to borrow money to overcome economic crises one after the other.
In addition to that, a country's economy may struggle to grow if its debt to GDP ratio is excessively high. A debt to GDP ratio higher than 100% means that the country has outstanding debt that is over the value of its annual domestic economic production. In other words, the country's debt is so high that it would take it more than a year for it to produce that level of economic value. Excessive sovereign debt will result in unsustainable interest payments as the country struggles to repay its promised coupon to investors. Thus, funds are diverted from domestic spending, which could increase economic growth, to repay debt. A country with a high debt to GDP ratio is also more likely to default on its debt obligations. Therefore, investors will demand higher interest rates to compensate for the risk taken in lending money to that country. A higher interest rate signifies higher subsequent debt repayment, further burdening the already indebted economy. The endless cycle will cause economic growth to grind to a halt as higher interest rates discourage consumer spending and investments. Japan is the perfect example of a country struggling with excessive sovereign debt. Its debt to GDP ratio has been above the 100% mark since the mid-1990s, peaking at a staggering 238.2% - the highest in the world - in 2018. Due to its struggling economy, Japan is forced to introduce quantitative easing (Q.E.) while keeping interest rates low to increase liquidity, and issue debt to encourage aggregate demand, causing national debt to skyrocket. Japan's over-leveraged economic structure led to negligible economic growth, popularly known as The Lost Decade (1991-2003), with its GDP hovering around the $5 trillion mark since the mid-1990s.
Overcoming debt
Due to its potency in damaging a country's long-run economy, sovereign debt has been placed under more stringent scrutiny by politicians, economists, and the members of the public. One question dominates the discourse surrounding public debt: how can a country reduce it? For starters, a government could behave as an individual in debt would: cutting expenditure. Since sovereign debt is mainly used for government spending, the simple solution is for governments to reduce their role in the economy and reduce government expenditure on public works, education, healthcare, and so on. However, this policy is extremely unpopular as the poorer members of society rely on government support to maintain their livelihoods. For instance, government handouts during the COVID-19 health crisis - up to $1,200 per month - protect millions of Americans from starvation and homelessness. Furthermore, government spending on infrastructure and social services is crucial as they form the safety net for a large proportion of the population and is the bedrock of a strong economy. If government spending is reduced, there is also a question of which expenditure should be reduced. In recent history, austerity measures in the United Kingdom and Greece were met with fierce opposition. Reduced welfare spending, local government spending, and an increased value-added tax in the United Kingdom resulted in decreasing disposable income and increasing economic inequality. Similar measures worsened unemployment and economic growth in Greece.
On the other hand, governments could seek to increase their revenue by raising taxes. With more revenue, the government should be able to repay its debt more quickly, right? A rise in taxation would dampen consumer demand in the economy because higher taxes will result in higher prices, reducing consumers' disposable income. Therefore, for the same amount of income, consumers can effectively purchase fewer goods. Higher taxation would also disproportionately affect the less fortunate members of our society as a specific tax - such as taxes on petrol or sugar - extract relatively more from the poor than from the rich. Firms would be reluctant to embark on new investments given low consumer demand and pessimism about an economy's future. Besides, higher corporation taxes, as suggested by many politicians recently, might not be a viable solution to reduce sovereign debt. This is because higher corporation taxes could reduce company profits and may increase production costs (if taxes are levied on machinery or other production-related items). With depressed consumer sentiment in the market, investors would be less likely to buy company stocks or bonds. This will present liquidity problems, affecting the general stock market, and later, the economy. It could be observed that higher taxation might not be the solution after all, especially if it weakens aggregate demand and pushes the economy into recession.
Countries can also engage in interest rate manipulation to reduce their debt obligations or to raise revenue. Governments can issue two types of debt: floating-rate or fixed-rate government bonds. Floating rate government bonds are debt issued with variable interest payments. The coupon of these bonds depends on the prevailing interest rate. Thus, a government could artificially set a low interest rate before interest payments to reduce its outstanding debt obligations. Conversely, if the government issues fixed-rate bonds, the interest payment to investors is fixed during the bond issue. The only method employable by this government to repay its debt is to raise revenue. To a certain extent, this can also be done with low interest rates. The mechanisms behind this policy are similar to that of supply-side "trickle-down" economics. Higher consumer demand and increased investment by firms would increase government revenue, theoretically allowing governments to repay their debts. Nonetheless, low/zero interest rate policies by some governments have proved ineffective in solving this challenge. Japan, the United States, and the European Union (E.U.) all carried out quantitative easing and expanded money supply with hopes to boost consumer demand in the market. The United States and E.U. implemented low interest rates as part of their expansionary monetary policies in the aftermath of the 2008/2009 Financial Crisis. The E.U. reduced its effective interest rate to 0% while the U.S. reduced its interest rate to a historic low of 0.25%. Japan went one step further to set its interest rate below 0% - negative interest rate policy. This means that commercial banks have to pay to deposit money at the central bank, making it more costly for commercial banks to not lend money to consumers. Consumers also have to pay interest on their deposits in commercial banks. This nuclear option is meant to stimulate aggregate demand in the economy as it would be more expensive not to spend money in a negative interest rate economy. These policies put these economics in a problematic position because any rise in the interest rate would depress the already fragile economy, effectively locking these economies in a low interest environment.
In the worst-case scenario, a government defaults if it cannot meet its debt obligations. This phenomenon is also known as a sovereign debt crisis. Sovereign debt crises are fatal not only to the domestic economy but also costly to the global economy. The Greek Sovereign Debt Crisis in 2010 demonstrates the dangers of government defaults. This crisis began when Greece's budget deficit exceeded 15% of its GDP in 2009, causing widespread fears of default and prompting investors to demand higher interest payments. The extremely high interest rates - 35% on 10-Year Greek bonds in 2012 - led to a collapse in the Greek bond market. As a member of the European Union, Greece's fall would threaten the structural integrity of the European economy. Therefore, the E.U. and private investors loaned Greece an unprecedented $300 billion, the most extensive sovereign financial rescue package in history. Greece had to practice strict austerity measures as part of the loan agreement, resulting in a 25% unemployment spike, a decrease in GDP per capita by 24%, a 5-year recession, and an increase in the poverty rate to 36% at the height of the crisis. Despite austerity measures, Greece defaulted on its $1.7 billion IMF payment in 2015, creating an economic straitjacket and further restricting its fiscal independence as it is stuck between a recession and high debt repayments. Greece still struggles to repay the rescue package and relieve its stricken economy today.
Takeaway
Amidst discourses on the viability of sovereign debt, it is undeniable that government debt plays an ever increasing role in financing government operations from employee salary to infrastructural projects. Virtually no government could carry out daily operations without incurring additional debt. It is crucial for policymakers and economists to balance short-term benefits and long-term risks, given the challenges presented by outstanding government debt. If economic history is to teach us anything at all, it is that immediate lending for the simplest of government operations is not a sustainable economic policy; an overburdened economy cannot survive, let alone thrive. However, the dominance of demand and supply-side economic policy worldwide equates to an ever inflating world debt for the foreseeable future. Although it may sound counterintuitive, governments are in debt because they must be in debt. Otherwise, they would be too weak, too fragile, and too poor to function.
Written By Amos Tong, Undergraduate Economics Student
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