A Darker Side to Government Debt

Government debt is created when a country’s government spending exceeds its revenue in a budget deficit. In order to fund this excess spending, governments borrow money from foreign governments, (mainly private) banks and investors. While it can be argued that borrowing boosts long-term economic growth prospects, how significant are the impacts of government debt on each country’s economy? And, ultimately, is borrowing worth it?

First of all, let’s understand how and why government debt is created, before delving into its impacts. In 2022, the US government spent $6.27 trillion, roughly 25% of its total GDP, with 13% of this spending on National Defence. To put that into context, US military spending exceeds that of the nine next highest spenders combined. As a result of this mass spending exceeding the value of its revenue, the federal debt of the US now amounts to 123% of its total GDP, a figure which has been growing since the American Revolutionary War of 1783. Figure 1 shows that the US’ debt, proportional to its GDP, has increased since 1966, with some notable spikes such as during the 2008 financial crisis and at the beginning of the COVID-19 pandemic in 2020. The reason government debt spiked in these years across the world is because of a combination of increased spending by the government e.g. furlough schemes where the government provided grants to employers so that workers could be paid during the pandemic, and also a decrease in tax revenue due to indirect taxes falling as a result of less consumption (less VAT) and also less profits for firms (less corporate tax). And so, government borrowing had to increase in order to sustain the economy through spending on education healthcare, social security and other aspects of the economy, thus leading to these spikes in debt. Therefore, events such as these have shown over the course of history that government borrowing and debt is essential- but how significant is a large amount of borrowing on the economy?

Now, onto the downsides. There are clearly many problems with a budget deficit being sustained in the long term, the largest of which being that it hinders economic growth. This can be shown by comparing the national debt of a country over time against its real GDP growth, e.g. for the US. By comparing Figure 2 to Figure 1, we can see that when the GDP has taken a dip in a given year, in that same year the level of national debt has had a sharp increase. This is as a result of measures such as a decrease in taxation being put in place. These fiscal policies are funded by borrowing, and they tend to cause an increase in the effective demand of consumers and so consumption increases. This in turn leads to the rate of inflation increasing. When the effects of inflation begin to show (usually 12-18 months after the policy is put in place) governments then increase interest rates so that consumers are more inclined to save their money. This was evident in the UK as in December 2021, when the restrictions put in by the pandemic loosened to a large extent, the interest rate was 0.5% – significantly smaller than the 3.5% interest rate put in place 12 months later. An increase in interest rates makes it harder for businesses to invest and expand because it becomes more expensive to take out loans, and so productivity growth declines, as does overall economic growth.

Importantly, the fact that governments borrow money from abroad is also a significant weakness of borrowing, with 30% of US debt held abroad. This is because it means that economic growth within the US also contributes to the economic growth of countries abroad since debt has to be repaid with interest to foreign investors. Since foreign investment profits are taxed and collected by their own governments, this is a weakness as it means that economic growth in one country leads to economic growth in another too, so it is harder to grow at a faster rate than other countries.

Now, it can be argued that in emergencies borrowing is needed in order to allow markets to continue to function, such as in 2008 or during COVID. However, the larger the existing debt in a country, the less fiscal space the government has to increase short-term borrowing. Fiscal space is defined as the room for a government to make significant changes to their fiscal policy in order to react to a major event. This means that less fiscal space is dangerous for countries as it means that over time, it will be harder for a government to protect markets in during significant event which has a large impact on their economy. Therefore, in order to increase a country’s fiscal space, during more economically stable time periods, governments should borrow less, proving it to be a weakness.

One more modern economic theory is known as ‘The Fiscal Theory of the Price Level’, which economist John H. Cochrane wrote a book about earlier this year. He states that the main determinant of the price level of goods and services in an economy, rather than interest rates, is actually the level of government debt in that economy. Explaining that while price levels increase when people don’t expect the government to repay its debt, in a recession, inflation rates decrease because governments promise to partially repay their debts. This leads to prices adjusting so that the value of the government’s debt = the value of tax revenue / government expenditure, so that the government budget is sustainable and solvent. Through this, we can say that increased debt leads to people having less belief that the government will repay their debt, leading to higher rates of inflation. Therefore, yet another theorised disadvantage of a sustained budget deficit is that it may be the source of high rates of inflation of prices for consumers.

So what should our opinions be about government debt? While it may be essential to borrow money in some, rare emergencies, it seems as though long term budget deficits and growing debt has severe impacts on the economy. Some economists do follow a Modern Monetary Theory, whereby they believe that governments have no need to borrow since they can print money, meaning government policies theoretically wouldn’t be effected by any threat of national debt. However, this theory seems to only be valid in a time when the gold standard still existed. Nowadays, the governments of most countries cannot just print money, with the UK as an example having an independent Bank of England. Thus, it is impossible to say that the long term prospects of borrowing money for investment are more substantial than the downsides of it. And so, while it may be essential in times of economic crisis, in the long-term, the gradual increase of government debt as a result of sustained budget deficits is not worth it.