Government Debt: Meaning, How It Works, Good, Bad

Government debt, public debt, or national debt represent 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.

How does government debt work?

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, existing debt outstanding represents a net accumulation of national budget deficits in previous years. When running a massive deficit and 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. When the ratio is high, it is not good because it can burden the economy in the long run.

Which country has the most debt?

The three countries with the most significant debt are the United States, Japan, and China. United States government debt reaches USD27.98 trillion at 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).

Goods 

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. Printing money will only lead to hyperinflation, which endangers the economy and drops confidence in the domestic currency.

Debt is also useful if the government uses it to increase the productive capacity of the economy. Infrastructure development, education improvement, research capacity building, and public development all have a positive contribution to the economy in the long run.

Deficits and debt are also alternatives to reduce the unemployment rate, for example, during a recession. By increasing spending or lowering taxes (run a fiscal deficit), the government can stimulate aggregate demand. When successful, it contributes to driving economic activity.

Bads

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 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. The government increases tax rates because it needs more money to repay debt. When tax rates are high, it disincentivizes business and entrepreneurial activities.

Also, when investors lose confidence in the government, they may not demand government bonds. As a result, the central bank has to print money to finance the deficit, leading to hyperinflation.