Impact of National Debt on Economic Growth

Readers Question: What is the Impact of persistent national Debt on UK economic growth?

There are many issues here. Firstly, UK national debt is the total amount of debt the government owe the private sector. It means the government is running an annual budget deficit.

Firstly, a budget deficit implies government spending is greater than tax. This represents an injection into the economy and therefore should increase Aggregate Demand. In a recession, government borrowing can play a role in increasing in offsetting private sector saving and helping to increase growth.

However, if there is persistent borrowing, then crowding out is more likely to occur. Crowding out occurs when higher government borrowing leads to lower private sector investment and spending. The argument is that the government borrow by selling bonds to the private sector. If the private sector buy government bonds then they have to less to spend in the private sector. In a recession, crowding out is unlikely to occur because there are unemployed resources, but, if the economy is at full capacity, then crowding out is more likely to occur.

Higher Interest Rates.

It is argued persistently high levels of government borrowing may lead to higher interest rates. This is because higher interest rates will be required to attract people to buy government debt. However, this does not necessarily have to occur. There is persistent government borrowing in Japan (approaching 200% of GDP) but, interest rates are still very low. It depends on many factors we haven’t time to consider in this answer. However, if government borrowing pushed up interest rates, then growth would be adversely affected.

Higher Taxes and lower spending

The scale of UK government borrowing means that to reduce the debt burden, the government will have to increase taxes and / or cut spending over the next 3-4 years. These higher taxes and lower spending will have the affect of reducing UK economic growth and could even damage any economic recovery.

However, if fiscal policy is tight and reducing inflationary pressure in the economy, it can enable interest rates to stay lower and this expansionary monetary policy may offset the deflationary fiscal policy.

Why is Government borrowing?

If government is borrowing to invest in public services like transport and education. It is possible, the government will increase productive capacity and enable a higher rate of economic growth. however, if the government borrowing is to finance transfer payments e.g. pensions and health care to an ageing population then there will be no boost to productive capacity from government borrowing.

It is certainly an interesting question given the scale of UK government borrowing over the medium long term. Many economists feel the very high levels of borrowing will provide a constraint to future growth because of the forecast tax rises which will be necessary to reduce the debt burden to more manageable levels in the future.

5 Responses to Impact of National Debt on Economic Growth

  1. Adit M. June 11, 2009 at 3:56 am #

    This article is very relevant to the macroeconomics I studied in my AP Economics class. This has a lot of information on aggregate demand and the impact of national debt and the policies that can be put to use. You have explained the implications of government borrowing very well. I have a clear insight into the concept of government borrowing and its impact on the economy.

    This article talks about how government spending can increase aggregate demand, and is very interesting. This article also talks about contractionary fiscal policy and how it can reduce inflation. Expansionary monetary policy can help to counteract the fiscal policy.

    Thanks,
    Adit M.

  2. Ralph Musgrave July 28, 2010 at 1:50 pm #

    “If government is borrowing to invest in public services like transport and education, it is possible, the government will increase productive capacity and enable a higher rate of economic growth.”

    There is a flaw in this argument, as follows. Government spending on capital projects is much the same from year to year. Thus government might just as well pay for such projects out of income. And even if it doesn’t, it will still effectively pay for them out of income because every year it will have to repay capital sums borrowed years ago, and pay interest on sums not yet repaid.

    Indeed, I argue in this paper that ALL government borrowing is a farce – it’s pointless:

    http://mpra.ub.uni-muenchen.de/23785/

  3. J Welsh. January 20, 2011 at 12:23 am #

    This article is misleading, actually. It claims to be talking about National Debt, but what it’s really talking about is Public Debt.
    Public Debt is basically debt incurred by the Government that the citizens of the country are responsible for, which is all of it. A government has no money of its own, just its people’s.
    Private Debt is the amount of money owed foreign investors by private citizens, basically like if GM takes out a loan from Chinese investors.
    National Debt is the sum of both types of debt.

    To some degree the logic in this article still holds true – that borrowing money for pleasure items (consumption) rather than for investing will lead to economic downfall in the future. But, please remember that this is an article about Public Debt when you read it, not about National Debt.

  4. malimi mabondo February 12, 2012 at 10:59 am #

    excellency article, i like it; i have improve my understanding capacity on this issue

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