What’s it: National debt is money owed by the government to its creditors. The government owes money to cover the budget deficit, where revenues are less than expenditures. And the higher the deficit, the bigger the debt. Sometimes, we call it government debt or sovereign debt.
Usually, the government will issue debt securities when borrowing, either in local or foreign currency. Creditors usually come from local and foreign institutions, such as pension funds, insurance, mutual funds, and banks. In addition, individuals can also participate in buying retail government bonds or savings bonds.
The national debt can have a positive or negative impact on the economy. Indeed debt can be dangerous if not controlled. If it piles up, a debt crisis could ensue – Sri Lanka is a recent one – which has the potential for huge economic and social costs.
But, if managed properly, debt can also be beneficial. For example, the government uses it to help the economy grow faster by financing productive investments. That allows the economy to grow in the long run and creates new tax revenue sources. Finally, tax revenues could grow higher to cover the debt.
Why does the national debt arise?
The national debt arises when the government runs a budget deficit. Government revenues are insufficient to cover expenditures. Unlike corporations, which can raise internal capital through retained earnings, governments cannot do so because they are not profit-oriented. Thus, the government must take on debt to cover the shortfall.
The bigger the deficit, the bigger the debt. So, we can say, the current debt balance represents the accumulated deficit from year to year after adjusting for items such as maturities and early redemptions.
The debt incurs interest expenses. And the larger the debt balance over time, the greater the interest expense. And, if government revenues cannot rise higher than debt, the deficit causes debt to pile up. As a result, the government must take on more debt to pay interest and other expenses.
How does the government borrow money?
The government usually takes loans by issuing debt securities. Based on the tenor (maturity period), we categorize them into three: bills, notes, and bonds. Bill is short-term, less than one year. Notes are for medium-term tenors, more than one year but less than 10 years. And bonds are for long-term tenors. The longer the maturity, the higher the interest paid because it is considered riskier.
Where are the debt securities issued? The government issue debt securities in local currency on the domestic capital market. Alternatively, governments issue them on foreign markets in a foreign currency – common to bonds -known as global bonds.
Meanwhile, creditors or debt securities holders come from the private sector or the public, both local and foreign. Common private investors are pension funds, insurance companies, and banks. Meanwhile, public investors can be central banks or governments from other countries.
In addition, individual investors can also participate, either directly or indirectly. For example, governments may issue retail bonds or savings bonds marketed to them. Or, they buy government bonds through mutual funds.
How is the national debt paid?
The government pays debts from the revenue it earns, mainly taxes. When taxes grow higher than government spending, the deficit decreases, and so does debt. And if tax revenues exceed expenditures, the budget leads to a surplus. And the government uses the surplus to pay off its debt, reducing future debt and interest burdens.
Tax revenue is usually positively related to the business cycle. For example, during an economic expansion, tax revenues increase. Conversely, during a recession, it goes down.
In other words, tax revenue positively correlates with economic growth. Higher economic growth creates prosperity during expansion. As a result, household income and business profits increased. So, the government can collect more taxes.
On the other hand, during a recession, economic growth is sluggish. Business activity declines, and the unemployment rate rises. As a result, the outlook for household income and business profits is deteriorating. Therefore, tax revenue decreases during this period.
In other cases, the government may have to finance debt with new debt because it is still running a budget deficit. In a low-interest environment, this option makes sense because new debt can have a lower cost. The government finances the old debt with new, cheaper debt. Thus, the future interest expense will be lower.
How do we measure the soundness of the national debt?
Among the indicators to measure the national debt soundness is the debt-to-GDP ratio (debt-to-GDP ratio). A low ratio is preferred because it indicates a higher ability to repay debt. When GDP increases (the economy grows), aggregate income and economic activity increase. Finally, it increases the tax base, such as household income, business profits, property, and consumption. That’s the reason why a lower ratio is better.
Another metric is sovereign rating. It is an independent assessment by a rating agency of a country’s creditworthiness. A higher rating is better because it indicates a better ability to pay and, therefore, a lower level of default risk.
What factors increase the national debt?
Several factors increase the national debt. The budget deficit is the main reason. The government has to borrow more when it runs a larger budget deficit. Finally, debt rises higher due to an increase in the deficit. Other factors are:
Interest rate. Higher interest rates increase the burden. This is because the government has to pay higher interest. Thus, future deficits and debt will increase if government income does not grow at a higher rate than interest increases.
Tax. The government pays debts through taxes as the main source. So, if taxes don’t grow, the deficit will get bigger, and so will debt.
Government discretion. The government deliberately increases the fiscal deficit to stimulate the economy during a recession. The government increases its spending, cuts taxes, or a combination of the two. Consequently, debt increases.
What is the positive side of the national debt?
As an investment instrument
Government bonds are a means for people to save. When we buy it, we are, in fact, lending our money to the government. As a return, we earn interest. Long story short, we can accumulate more wealth by buying government bonds.
And government bonds are safer investment instruments than stocks and corporate bonds. Buying them gives us predictable income; usually, we get it twice a year. In addition, we will get the principal at maturity.
Benchmark in capital market
The government bond market is also important for building a developed financial market. For example, its price becomes a benchmark when evaluating riskier fixed-income instruments such as corporate bonds. In simple terms, we add a premium to government bonds to determine the price of corporate bonds.
Thus, when the government bond market has developed, we can reliably assess the fair price of corporate bonds. Without it, we have no definite benchmark for their valuation.
Likewise with stocks. When using the discounted cash flow (DCF) model, we rely on government bond yields to calculate the discount rate, which represents the cost of capital when investing in a company’s stock. The model commonly used to calculate the discount rate is the capital asset pricing model (CAPM), which uses government bond yields to represent the risk-free rate.
Financing productive investments
The government is in debt because its revenue is insufficient to cover expenses. As long as the debt is used for the right purposes, it can benefit the economy. For example, the government uses it for productive investments such as building roads and improving education and job training. It increases capital accumulation and improves human capital. Physical capital such as roads and bridges encourage increased activity and reduce logistics costs. Meanwhile, education and training make the workforce more productive. Such investments increase the potential for economic growth in the long term.
Government fiscal policy
Debt is a consequence when the government carries out economic policies. For example, governments have to owe more when running higher budget deficits. And the deficit is needed when the government wants to stimulate the economy (known as expansionary fiscal policy).
The government increases the deficit by increasing spending, cutting taxes, or choosing both. Higher spending and lower taxes push aggregate demand up, stimulating the economy to grow. This policy is taken during a weak economy or recession. The government expects a higher deficit to bring the economy out of recession.
Government bonds also support economic growth through wealth securities. As explained earlier, they are a means for us to accumulate wealth.
And, our wealth affects our consumption and, ultimately, economic growth – known as the wealth effect. For example, when government bond prices rise, our wealth increases. We can set aside monthly income for spending more and less on savings without worrying about our wealth. As a result, consumption eventually increases and drives the economy to grow higher.
Better choice than printing money
The government can finance the deficit with taxes or print money. The first alternative is more desirable than the second alternative. Printing money harms the economy. That destabilizes the economy as inflation can spike.
When the government prints money, the money supply soars. Thus, more money chases fewer goods, causing prices to soar.
If inflation is out of control, it leads to hyperinflation. This situation is dangerous because the prices of goods and services rise rapidly in an instant. Finally, it worsens confidence in the domestic currency. People no longer believe in money because the domestic purchasing power falls instantly.
What is the negative side of the national debt?
Accumulated debt can be harmful to the economy. The budget burden is increasing, leading to fiscal unsustainability. The negative consequences of high national debt are:
The accumulated debt reduces the government’s ability to pay it off. As a result, the default risk increases, causing creditor confidence to fall. And the situation could lead to a debt crisis, which has huge economic and social costs. The debt crises in Sri Lanka and Europe are examples.
As mentioned earlier, significant debt increases the default. As a result, lenders demand higher interest to compensate for the higher risk. And it is difficult for governments to negotiate low-interest rates when debt is high. Without high interest, creditors are not willing to lend money.
The effect can rub off on the economy as a whole. Because it is used as a benchmark, the price of riskier financial instruments such as corporate bonds also rises. As a result, interest rates are high in the economy.
Crowding out effect
High debt leads to high-interest rates, leading to a decline in private investment. Businesses see the cost of investing to be more expensive, perhaps more than the profit can be made. As a result, their investment is unfeasible due to the high cost of capital. The situation demotivates them to invest.
A decline in private investment may have a more significant impact on economic growth than one driven by a budget deficit. The government is in debt for running a budget deficit to stimulate the economy. However, what the government is trying to do may be in vain because, at the same time, private investment falls due to high-interest rates.
Lower public investment
The interest expense grows when debt increases. As a result, the government will spend more of its budget to pay interest.
The government must include interest payments into the budget before deciding on other expenditures to prevent default. As interest expense increases, it can reduce public investment.
Painful austerity policy
The government takes austerity measures to prevent defaults. For example, the government may raise taxes or lower government spending. Or they combine the two if they need to reduce debt significantly.
Such austerity policies can be painful for the economy. The public must pay the rising tax burden. In addition, public services decline because the government reduces spending.