How Much Can the Government Borrow?

With public sector debt increasing around the world (list of National Debt by country), I often think - how much can governments get away with borrowing? This is an important question. If the governments try to borrow more than markets will lend them, there will be serious economic problems such as inflation, high interest rates and a decline in credit worthiness of the government.

Record Levels of Government Debt

At times Government Debt has been very high:
  • US 117% of GDP in 1945 (gross federal debt (1)
  • During WWII UK national debt increased from £7.1 billion to £21 billion (over roughly 150% of GDP )
  • Japan 195% of GDP currently
  • Zimbabwe 218% of GDP 2007 est.

Governments can Finance Their Debt in Two Main Ways

  1. Selling Bonds to the Private sector - either domestic or foreign
  2. Central Bank Finance Shortfall in revenue by increasing the money - printing money is a loose analogy.

Factors Which Influence How Much a Government Can Borrow

  • Domestic Savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan had very high levels of public sector debt, but, with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings.
  • Relative Interest rates. If government bonds pay a high interest rate, then ceteris paribus, it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low interest rates because government bonds are seen as more attractive than other investments. (e.g. demand for US treasuries is quite high at moment because they are seen as a safe investment, and this is a bigger selling point than the paltry 2% interest rate.
  • Confidence and Security. Usually, governments are seen as a safe investment. Many governments have never defaulted on debt payments so people are willing to buy bonds because at least they are safe. However, if investors feel a government is too stretched and could default, then it will be more difficult to borrow. Therefore, some countries like Argentina with bad credit histories would find it more difficult to borrow more.
  • Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt (Japan, China, UK). This foreign demand makes it easier for government to borrow. However, if investors feared a country could experience inflation and a rapid devaluation, foreigners would not want to hold securities in that country.
  • Inflation. Financing the debt by increasing the money supply is risky because of the inflationary effect. Inflation reduces the real value of the government debt, but, that means people will be less willing to hold government bonds. Inflation will require higher interest rates to attract people to keep bonds. In theory, the government can print money to reduce the real value of debt; but existing savers will lose out. If the government creates inflation, it will be more difficult to attract savings in the future.
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Perma Link | By: T Pettinger | Wednesday, January 7, 2009
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2 Comments:

Blogger clive said...

Hi
How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency? Surely joining the € and effectively fixing the exchange forever seem to make more sense now than ever before. The argument about interest rates do not, seem as valid as before, now we know the banks have their own inter bank rates, also the “toilet paper currency as the Tories once described the € seem to have back fired. Which is the toilet paper currency now? This debate will not go away Britain is coming to the cross roads, and as I see it what point is there in being part of Europe if its citizens can not afford even to holiday there? That alone do business which is not on an even playing field?

Regards

Clive Cargill

January 8, 2009 9:23 AM  
Blogger clive said...

Hi
How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency? Surely joining the € and effectively fixing the exchange forever seem to make more sense now than ever before. The argument about interest rates do not, seem as valid as before, now we know the banks have their own inter bank rates, also the “toilet paper currency as the Tories once described the € seem to have back fired. Which is the toilet paper currency now? This debate will not go away Britain is coming to the cross roads, and as I see it what point is there in being part of Europe if its citizens can not afford even to holiday there? That alone do business which is not on an even playing field?

Regards

Clive Cargill

January 8, 2009 9:24 AM  

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