Sustainable Levels of Government Debt (DP IB Economics)

An Introduction to Sustainable Government Debt

• Governments borrow money in order to run their economies

  • This borrowing is used for both current and capital expenditure 

• Sustainable levels of government debt refers to a situation where the government's borrowing and debt levels are  manageable and they are able to manage repayments without placing their economy at risk

• It is considered a macroeconomic objective because the level of government debt can have wide-ranging impacts on the economy as a whole 

Reasons why Sustainable Government Debt is Important

Measuring Government Debt

• Government debt is commonly measured as a percentage of GDP (Gross Domestic Product) to assess the relative size of the debt in relation to the country's overall economic output

• This ratio, known as the debt-to-GDP ratio, provides an indication of the sustainability and affordability of the government's debt burden 

• The debt-to-GDP ratio is expressed as a percentage and is calculated using the formula

• Suppose a country has a total government debt of $1 trillion, and its GDP is $20 trillion. The debt-to-GDP ratio would be

• A higher percentage indicates a larger debt burden relative to the size of the economy, which could raise concerns about debt sustainability
  

• A lower ratio suggests a more manageable debt level 

Levels of government debt as a percentage of GDP in 2022 with Japan being the highest at 256%

(Source: OECD)

The Relationship Between Government Debt & a Budget Deficit

• Government debt refers to the total amount of money that a government owes to creditors, including domestic and foreign entities 

• A budget deficit occurs when a government's total expenditures exceed its total revenues within a specific fiscal year

  • It represents the shortfall between the government's spending and its income from sources such as taxes and other revenue streams 
    

• Budget deficits contribute to the accumulation of government debt

  • When a government runs a budget deficit, it needs to borrow money to cover the shortfall

  • As the government issues bonds or takes loans to finance its deficit, this borrowing adds to the outstanding government debt 
    

• Budget surpluses can help reduce government debt

  • In a surplus situation, the government's total revenues exceed its total expenditures

  • This surplus can be used to repay outstanding debt, thereby reducing the overall debt burden 

• Persistent or large budget deficits can lead to a significant increase in government debt over time 
  

• A budget deficit is not the sole determinant of debt accumulation

  • Other factors such as interest payments on existing debt, economic conditions, fiscal policies, and debt management practices also play a role in determining the overall trajectory of government debt 
    

• High levels of government debt may mean that financial markets view offering any new loans to a government as risky

  • If that is the case, then the interest rate for these loans would be higher, effectively costing taxpayers more to repay

The Impact of High National Debt

• Having a high national debt can have several impacts on an economy which vary depending on the specific circumstances and factors at play 

• Following the Financial Crisis of 2008, Greece nearly defaulted on its loans

  • Debt to GDP peaked at 181%

  • Borrowing costs peaked at 7.1%

  • Greece embarked on years of austerity in order to repay its debt
     

The relationship for Greece between their debt, borrowing interest rates and real GDP growth

(Source: Peterson Institute for International Economics) 

• Government's will seek to limit the impact of rising debt by managing their debt as carefully as possible - and in a way that financial markets consider to be wise

  • The UK Prime Minister Liz Truss and her Finance Minister (Kwasi Kwarteng) made policy changes in October 2022 which nearly crashed the British economy as financial markets considered their plans to create a crisis in UK Government debt management
      

The Impact of high debt on an Economy