Government Debt: Burden or Boon?

October 9, 2021

Editor(s): Daniel Li

Writer(s): Vickram Mehtaanii, Yasindu Athauda, Julia Hu

Increasing levels of government debt worldwide are not necessarily detrimental to countries, so long as debt keeps funding their GDP growth. However, it is worth noting that a study, “Growth in a Time of Debt ”, concluded that across both advanced and emerging economies, high debt-to-GDP levels (~90% or greater) lead to notably less growth (Rugy & Salmon, 2020). The study is considered to be the foundation on the subject of debt and growth, and became widely cited and influential among academics and politicians. The authors, economists Carmen Reinhart and Kenneth Rogoff, compiled data from 1949-2009 from the International Monetary Fund (IMF), the World Bank, and the Organisation for Economic Co-operation and Development (OECD) for 44 countries to determine the effects of government debt on GDP.

One of the ideas behind the negative relationship between high debt levels and growth of an economy is the crowding out of public investment (Rugy & Salmon, 2020). As the government increases its borrowings, the interest payments also increase, which lead to it consuming a larger portion of the federal budget. As a result, less funds are available for public investment projects such as research & development, infrastructure, and education. The Congressional Budget Office (CBO) of the US projects that by 2049, national debt interest payments would be the third-biggest item on the federal budget, making up 6% of GDP, behind only Social Security and Medicare. Simultaneously, Americans are finding it harder to purchase a home, finance a car, and pay for college, decreasing the social mobility of the US. Hence, the growth potential of the economy takes a major hit due to the combination of crowding out of public investment and decreasing social mobility (Rugy & Salmon, 2020).

What do current debt levels look like?

Australia’s debt levels have increased significantly during the COVID-19 pandemic, however, the debt levels are still low compared to most developed countries (Chang, 2021). Even before the COVID-19 pandemic began, Australia’s debt levels were similar to the UK and New Zealand, and below the US, Canada, and France (Australian Parliament House, 2021). For instance, in the US, the net debt-to-GDP ratio has been rising at an unprecedented pace and currently sits at 127%. The net debt of the US is also expected to rise to 277% of GDP by 2029, surpassing Japan’s current 272% net debt-to-GDP ratio (Ticha, 2021). On the other hand, Australia’s 2021 Budget projected the net debt to be $729 billion – or 34.2% of GDP – at 30 June, 2022 and peak at $981 billion – or 40.9% of GDP – in 2024-25 (Mizen & O’Mallon, 2021). The net debt is also predicted to fall to 37% of GDP by 30 June, 2032 (Chang, 2021).

In the past two months itself, COVID-19 restrictions and lockdowns have dealt a $17 billion hit to the Australian economy and there are no signs of stopping (Ticha, 2021). Rough estimates show that Sydney’s lockdowns have cost approximately $1 billion every week, whereas numerous lockdowns in Victoria have set them back at least $5 billion. The current state debt constitutes 23% of total government debt and is expected to be 29% by 2024, however, it is worth highlighting that the long-term average of state debt is only 13% of the total government debt (Ticha, 2021). It is understandable that different states have different debt levels, particularly during times like the COVID-19 pandemic. Still, in order to justify such high levels of state debt, it is important to compare the debt levels of each state against the impact of the pandemic in their respective state. For example, the net debt for NSW is projected to be $63.3 billion in 2021-22, whereas Victoria’s net debt is projected to be $102.1 billion (Ticha, 2021). This is partly due to NSW having the highest GDP of all states but more so because Victoria’s economy has been affected the most by the ongoing pandemic. While Commonwealth debt and state debt are similar, the Commonwealth government benefits from lower interest rates in comparison to the interest rates states borrow at, thanks to a stronger and better credit rating.

Although the national debt levels have been steadily rising throughout the last several years, it rapidly spiralled upwards during the COVID-19 Pandemic. To mitigate the effects of the downturn and boost economic activity many governments across the world ramped up government spending which in turn increased debt levels to record high figures.

Keynesian economic theory has long supported these measures, arguing that recessions require expansionary fiscal policies with lower taxes and increased government spending. Of course, this would mean a rise in national burrowing, but Keynesian economists suggest that the benefits of quick recovery outweigh the negative implications of borrowing. For instance, many economists agree that the European nations’ shift towards austerity in the years after the GFC significantly weakened the Eurozone’s recovery. In fact, a study by IIF suggests that fiscal tightening led to Europe’s trend growth becoming just half of that of the US since 2008, in stark contrast to the period before the recession when trend growth for both the economies were roughly the same (Edwards, 2018).

Moreover, many deficit doves contend that increased public debt is not a source of worry if it funds sustained GDP growth. For instance, if the debt is used to finance a large-scale investment in infrastructure development, education or healthcare it is likely to raise capital and labor productivity and thus foster economic growth. Indeed, Germany, which has long adopted a debt-brake policy to limit deficit spending, also suffers from a backlog in public investment and lags behind many other developed nations in Infrastructure quality and capital investment.

The Modern Monetary Theory provides another interesting outlook on public debt, suggesting that a nation can borrow from itself as long as it has the ability to create its own currency. It argues that because a government can print more of its currency to pay back the debt, it can never default and thus, a nation can borrow indefinitely to fund government programs. (Wolf, 2021). Further, advocates of MMT argue that increased spending is unlikely to create high inflation unless that economy is operating with capacity constraints. However, it should be noted that the MMT is still not a part of mainstream Economics and thus policy makers need to be careful in its use. 

Furthermore, there is a prevailing misconception that as a country’s debt to GDP ratio rises, a country is closing in on insolvency. For instance, the general public view tends to be that when a country exceeds the 100% debt to GDP threshold it is virtually becoming a bankrupt nation. However, this is simply not true; if the country is able to make its interest payments without refinancing and significant damage to its economic growth. Japan serves to be a good example for this; even though the country’s debt to GDP ratio has reached an extremely high level of 256.49% (Statista, 2021), it is not facing a significant risk of default. One of the main reasons for this is that the majority of the government’s bonds are held by Japanese citizens, yielding extremely low interest rates.

So what impact could high government debt have?

However, the spiralling debt levels should raise concerns for governments across the world. For instance, a study conducted by the World Bank revealed that a country’s economic productivity and growth can be hampered if the public debt to GDP ratio exceeds 77%. Beyond this point, an increase of one percentage point in public debt is followed with an average decline of 0.017% from the annual real economic growth rate. The issue is even more pertinent in emerging markets, as the research found that the aforementioned threshold reduces to a debt to GDP ratio of 64%; exceeding this level 1% increase in the debt to GDP ratio could lead to a 0.02% reduction in real economic growth. (Grennes et al., 2013)

One of the many reasons that high borrowing leads to lower productivity and growth is the issue of crowding out. The classic example of crowding out is the effect on investment spending with the rise in government borrowing. An increase in government borrowing will raise the demand for debt causing a rise in interest rates. As the cost of borrowing increases, the opportunity cost of private sector investments rises leading to a reduction in investment expenditure. Thus, there could be a reduction in economic activity hindering the nation’s economic growth.

Yet, inhibiting development is not the only cause of concern for many developing economies who are facing increased government borrowing. Over the recent years, many economists and politicians have coined the phrase ‘debt-trap diplomacy’ to highlight a situation where a country or an institution with considerable economic power would provide excessive debt to another nation to gain influence over the debtor nation. Many of these contracts would be drawn in favor of the lending party and in a scenario where a poorer debtor nation is unable to make the payment, the lender will have considerable leverage to exert economic and political influence over the particular country.

Finally, it is important to remember that political parties will have different outlooks on national debt. Heavy borrowing in certain periods could lead to substantial opposition by parties who support austerity measures. Subsequently, in situations where borrowing might be crucial, these parties may oppose borrowing as debt is already at an extremely high level. This is likely to be problematic especially if a government doesn’t hold a strong majority in the decision making bodies, as seen recently in the US where the lack of support for raising the debt ceiling by the Republicans and a few Senate Democrats left the country in the risk of default. (Rappeport and Weisman, 2021)

As countries continue to deal with the fallout of the COVID-19 pandemic, it is clear that the implications of long-term levels of high government borrowing remain uncertain. While the public may view debt with distrust and concern, the use of government borrowing to fuel economic growth among developed nations seems to have yielded positive results. Indeed, with perspectives such as the Modern Monetary Theory gaining popularity, it appears that it is only time before increasing levels of government debt is viewed with less scrutiny as long as it can generate GDP growth.

Of course, detractors of these arguments point to the issue of crowding out, and the asymmetric effects of high government debt on developing nations. By potentially hampering economic growth and initiating a financial crisis, debt can become an incredibly dangerous tool. Likewise, the risk of default for even developed countries remains prevalent, as seen through the case of Greece’s debt crisis and the USA’s current debate on national debt.

If anything, it is clear that the increasing levels of global government debt will remain a contentious issue. And as such, the discourse around the role, future, and impact of government borrowing will only continue to evolve, creating room for new theories and perspectives to solidify. 

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