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Government debt, the money borrowed by a country to finance its operations, is a ubiquitous concept in today’s world. It’s a topic that sparks debate among economists, investors, and everyday citizens alike. But how exactly does government debt work? What are its potential benefits and drawbacks? And how does it impact the overall health of an economy? Let’s delve deeper and explore the complexities of government debt, unpacking its role in shaping our economic landscape.
Understanding government debt and How it works
Government debt, also known as public debt or national debt, is the amount of money borrowed by the government. According to the International Institute of Finance (IIF), public debt will reach USD70 trillion in 2019, up from USD65.7 trillion in 2018.
Debt arises when the government runs a fiscal deficit, which is when spending exceeds tax revenue. To cover the shortfall, the government must owe, primarily by issuing government bonds and bills.
Accordingly, the outstanding existing debt represents a net accumulation of national budget deficits in previous years. When running a massive deficit for many years, national debt accumulates.
The government borrows from the private sector, both external and internal. Domestic debt holders usually are banks, pension funds, insurance companies, and central banks. Meanwhile, foreign holders can be governments, central banks, or investors from other countries.
The government pays debt from tax revenue. Usually, tax revenue positively correlates with economic growth (measured from real GDP growth). The higher the economic growth, the greater the tax potential that the government collects.
Because of this relationship, the soundness of government debt is usually measured by the ratio of debt to GDP. A high ratio is not good because it can burden the economy in the long run.
Global debt landscape: Which country has the most debt?
The three countries with the most significant debt are the United States, Japan, and China. The United States government debt reached USD27.98 trillion, or around 133.92% of its GDP. Meanwhile, the government debt of Japan and China each reached USD12.82 trillion (254.13% of GDP) and USD9,86 trillion (66.33% of GDP), respectively.
| Country | Nominal (USD Bn)* | % Of GDP |
| United States | 27,980.91 | 133.92 |
| Japan | 12,821.12 | 254.13 |
| China | 9,861.70 | 66.33 |
| France | 3,020.15 | 115.08 |
| Italy | 2,936.95 | 155.81 |
| United Kingdom | 2,830.80 | 104.47 |
| Germany | 2,654.01 | 69.06 |
| India | 2,383.79 | 89.61 |
| Canada | 1,931.09 | 117.46 |
| Spain | 1,535.53 | 119.92 |
| Brazil | 1,429.45 | 98.94 |
| Korea | 784.33 | 47.88 |
| Australia | 779.36 | 57.33 |
| Mexico | 655.40 | 61.03 |
Government debt: A haven for investors
For investors seeking stability, government debt can be a compelling proposition. Here’s why:
Lower risk: Government bonds are widely considered less risky than corporate bonds. This is due to governments’ inherent power to levy taxes on their citizens.
This ability to generate revenue provides investors with a strong assurance of repayment, making government bonds a more stable investment option.
In contrast, corporate bonds are directly tied to the financial health of the issuing company. If a company encounters financial difficulties, it may struggle to repay its debts, potentially leading to losses for bondholders.
Benchmarking tool: Government bonds play a critical role beyond just providing investment opportunities. They act as a benchmark for valuing corporate bonds of similar maturities. Investors use the interest rates offered on government bonds as a reference point to assess the relative risk of corporate bonds.
Essentially, a higher interest rate offered on a corporate bond compared to a government bond of similar maturity indicates that the corporate bond carries a greater risk of default. This comparison allows investors to make informed decisions about the appropriate level of return they should expect for taking on additional risk with corporate bonds.
Good debt vs. Bad Debt
Government debt can be a double-edged sword. While it offers potential benefits for economic growth, excessive borrowing can also pose significant risks. Let’s explore both sides of the coin:
Benefits of government debt
For investors, government debt securities such as bonds and bills are considered less risky than corporate debt. For this reason, they often use government bonds as a benchmark in valuing corporate bond prices.
Debt becomes a better alternative than printing money when governments run a budget deficit. Excessive money printing by governments can lead to hyperinflation, a situation where rapid price increases erode the value of currency. In such scenarios, debt can act as a less risky alternative. By borrowing funds instead of printing money, governments can finance spending needs without fueling inflation.
Government debt can be a tool to finance crucial long-term investments. Funds from borrowing can be used to develop infrastructure projects like roads, bridges, and public transportation systems. These improvements create jobs during construction and lay the groundwork for a more efficient and productive economy in the long run. Additionally, debt can be used to fund education initiatives and research and development programs, fostering innovation and a skilled workforce—both essential for sustained economic growth.
Government debt may be necessary to stimulate economic growth. During economic downturns, governments may resort to deficit spending, which involves borrowing to increase spending or lower taxes. This approach aims to boost aggregate demand within the economy. By putting more money in people’s pockets and encouraging business investment, deficit spending can help stimulate economic activity and pull economies out of recessions.
Drawbacks of high debt
Debt can also have a severe impact. High debt can cause a crowding-out effect, namely the fall of private investment due to high government debt. Substantial debt means a high demand for money. As a result, the price of money (interest rates) becomes expensive, leading to a higher interest rate. An increase in interest rates makes investment costs more expensive, decreasing investment in the business sector.
Furthermore, high levels of debt can lead to high tax rates. Governments may raise taxes to generate revenue for debt repayment. However, high taxes can disincentivize businesses and individuals from economic activity, potentially slowing economic growth.
If investors lose confidence in a government’s ability to manage its debt, they may be less willing to purchase government bonds. This can force central banks to print money to finance the deficit, potentially reigniting the threat of inflation.
