How To Reduce National Debt

Readers Question: How does a country reduce it’s national debt if it’s running a national deficit?

I read that a deficit is the amount of money a government has to borrow to make up the shortfall in what it takes in. So if a government is always having to borrow then does it’s national debt keep rising?

I read that all countries in the EU should aim for 3% of GDP (annual budget deficit) or lower but then that means they would still have a rising national debt? Surely countries should be aiming for a surplus so they can use the money to pay off the debt or have I got all that wrong?
You are correct that governments borrowing occurs when governments spend more than they receive in taxes. National debt is the total amount of accumulated borrowing. For example,  in the UK the Public sector net debt is the total amount of outstanding debt. In the UK the national debt is currently £890bn or 61% of total GDP.

To reduce the outstanding level of debt (£890bn) it would be be necessary to run budget surpluses. (which the UK briefly had at the start of the 2000s)

However, economists put more emphasis on national debt as a % of GDP.

For example, during the first world war US national debt rose from about $1 billion in 1916 to $25 billion in 1920. As a % of GDP that was quite significant (about 30% of GDP). Clearly though $25 billion in todays economy would be very insignificant. US national debt is currently over $10,000 billion (about 70% of GDP).
debt

Debt to GDP ratio – has risen since 2001 to over 60% of GDP. But, in 1950, Debt to GDP was much higher.

Importance of Debt to GDP

  • Suppose countries run a budget deficit equal to 3% of GDP. This means national debt will be rising.
  • However, suppose that a typical European country grows at 3% a year. This means national debt is rising at the same rate as GDP. Therefore, the debt to GDP ratio will remain the same.
  • If debt to GDP ratio stays the same, then ceteris paribus, the cost of servicing the debt (interest rate cost) will stay the same as a % of GDP. Though the interest rate cost will rise, the government will be getting higher tax revenues (e.g. income tax. Therefore, if debt to GDP remains the same, the % of resources devoted to servicing the debt will remain the same. (e.g. UK was paying about £35bn a year or 2% of GDP on interest rate payments). Though this will be increasing because of our rising debt to GDP ratio.
  • A stable debt to GDP ratio is also likely to reassure markets that the government can maintain debt repayments.

Example, suppose you take out a mortgage. Your mortgage payments may be fixed at £900 a month. As a % of income, this could be 40% of your income when you start the mortgage. However, if you income grows (due to inflation and real wage growth), it becomes easier to pay your mortgage over time. At the end of your mortgage period, mortgage payments are often a small % of your income.

If your income grows, you could take out a bigger mortgage and devote same % of income to paying your mortgage payments.

Growth Faster than borrowing.

Suppose that a government borrowed 1% of GDP, but, growth was 2.5% (this is average rate of growth in the UK). This means that GDP is rising faster the increase in national debt. Therefore, although debt is rising, as a % of GDP it is falling.

This means that, assuming constant interest rates, the cost of paying interest on government debt is growing at a smaller rate than economic growth. The cost of servicing debt will fall as a % of GDP. Therefore, it is possible to cut taxes marginally as a result.

How Not To Reduce National Debt

The problem facing European countries is that debt / GDP ratios are rising. For example, even though Greece is trying to implement severe spending cuts, this is unlikely to reduce debt to GDP. One problem Greece faces is the prospect of several years of negative or stagnant growth.

If your economy is in recession, and your borrowing is 0 – national debt as a % of GDP is still going to be rising. So National debt could become more of a problem – even if you balance the budget.

This is complicated by the fact that if you try to reduce government borrowing by spending cuts, it can lead to lower aggregate demand and lower economic growth.

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10 Responses to How To Reduce National Debt

  1. Ralph Musgrave June 27, 2010 at 12:55 pm #

    The above claim that when government spending exceeds income the result is necessarily a rise in the national debt is totally untrue. The offending sentence was: “You are correct that governments borrowing occurs when governments spend more than they receive in taxes..”

    As Abba Lerner, an economist much admired by Keynes, pointed out, if government spending exceeds income, government can perfectly well just print money to make up the difference. (I’m using the word government in the sense “government and central bank combined”).

    Milton Friedman also set out a monetary system in a paper in the American Economic Review which involved no national debt, and where government just printed extra money when spending exceeded income. Friedman’s proposals were essentially the same as Lerner’s See: http://www.jstor.org/pss/1810624

    Unbeknown to 95% of economists, it would be perfectly feasible to exploit Lerner and Friedman’s ideas to bring about a quick reduction in the national debt starting tomorrow. Here’s a quick guide. (I’m offering a £500 prize to the first person to spot an obvious and serious flaw, by the way.)

    1. Print money and buy the debt back – or to be more realistic, cease rolling the debt over and/or cease issuing it in the first place, and make up for lost government revenues with printed money.

    2. The above would almost certainly be too stimulatory and hence too inflationary. So mix the above inflationary debt reduction method with a deflationary method: raise taxes and/or cut government spending and use the money that yields to buy back the debt.

    3.The above two “levers” provide a means to effect any speed of debt reduction desired and any stance on the reflation – deflation scale while doing so. For example, for a faster rate of debt reduction, apply more of both levers. Or for a more deflationary stance, apply more of the deflationary lever relative to the inflationary one.

    Q.E.D. (Quite Easily Done).

  2. Danny Richard June 27, 2010 at 4:55 pm #

    I’m in agreement with Mr Musgrave. Cut government spending whilst outright printing money to replace rolling over debt.

    Our money supply has got too heavily weighted toward debt money, the only way possible to reduce debt without a deflationary depression is to increase the amount of “equity” money, which is base M0.

    happy to hear other comments.

  3. Ellie Velinska June 28, 2010 at 4:25 am #

    For the £500 prize.

    What money can’t buy can be bought with more money.

    You give the government the power to buy anything: give away a gift, a welfare check, a hospital bill, a bribe…

    Corruption for the easy money will eat the system.

    Government will have the money to pick winners and losers: give money to some – refuse money to others.

    Government already has too much power. Money can build and money can destroy. Freedom is priceless.

    The economy will stop growing – the intensives for creating something new will go away – after all there will be easy money for everybody according to his needs.

  4. Ralph Musgrave June 28, 2010 at 2:23 pm #

    Ellie: you make an essentially political (right wing) point namely that the more power government has the more corrupt it becomes. There is a lot of truth in the old saying that “power corrupts”. But where does that point lead us? Do we have no government at all?

    Also in that money and power are synonymous, and to the extent that we DONT take money (i.e. taxes) off the private sector and give it to government, we are just leaving power in the hands of the private sector. And presumably the extent to which the latter is corrupted by its power is not vastly different to the extent to which government is corrupted. Indeed this is fundamental argument between right and left: what is the best or least damaging split of GDP as between public and private sectors.

    Finally I totally fail to see why my proposal leads to there being “easy money for everybody according to his needs”. My proposal is, to over simplify, just to reduce government borrowing to near zero, but leave everything else much the same. The total government take of GDP remains the same (unless some left of centre political party is elected, in which case governenment’s share probably rises).

    The major change is that Gilts are replaced with monetary base. And if anyone suggests that will be inflationary, I’ll tear their argument to shreds. Just watch.

  5. Ellie Velinska June 28, 2010 at 6:12 pm #

    PS It is probably a cultural issue, but I find it insensitive to offer money reward when you believe it is impossible for the reward to be earned.

    It is difficult time. Many folks are close to broke.

    I have the same problem with the Cobden Center. What makes you offer a reward you have no intention to give away?

  6. Ellie Velinska June 28, 2010 at 6:21 pm #

    I wrote another comment which is probably being moderated. If it does not appear in few hours I’ll try to write it again.

  7. Ralph Musgrave June 29, 2010 at 12:35 pm #

    Ellie: what is this “reward” and who is being offered to for free? I don’t get it.

  8. Ellie Velinska June 29, 2010 at 3:55 pm #

    It looks like my comment is lost – so I will try again.

    Ralph Musgrave,

    I agree that your proposal is not inflationary. I have no problem with that.
    ——-
    you say:

    Finally I totally fail to see why my proposal leads to there being “easy money for everybody according to his needs”

    I say:

    I view the government spending as: money that are spent to cover specific needs in the country.

    For example: There is need for security – the Gov spends money on law enforcement and military.

    The more progressive the government – the more needs it covers.

    For example: It is OK to pay for basic education, but do we really need to subsidize the PhD graduate students?

    Some believe: yes. Where does it end? To everybody according to his/her needs.

    If you let the government to print money to cover the deficit – it is easy way to cover the needs – instead of taxing and spending cuts (the hardest).

    I bet the Gov will tend to go the easy way – and print more than it will tax and cut spending.

    Unless they are required by law to do the other measures too – the gov will just go printing.

    What is disturbing in your model is that printing, taxing and austerity – all leave the Government with more and more money to redistribute.

    I think they already have too much power.

    The debt is like an alarm light that makes the government gone wild to adjust. I think it is healthy.

  9. Ralph Musgrave June 29, 2010 at 5:12 pm #

    Ellie: In saying you think government has too much power (your last sentence) you are still confusing politics with economics. Government power (assuming that by that you mean the proportion of GDP that government takes) is a purely political point. It is decided at election time. If the electorate decides that government takes 60% of GDP and the private sector 40%, you might not like that, but if you believe in democracy you have to accept it.

    On a purely economic point, you seem to worry that under my proposal government will go for the easy option: printing money. To be more specific, you say “I bet the Gov will tend to go the easy way – and print more than it will tax and cut spending.”. My answers are thus . (By the way I use the word “government” in the sense “government and central bank combined”).

    Governments that issue their own currencies (e.g. U.K., U.S. , Japan, etc) ALWAYS HAVE steadily increased their money supplies and ALWLAYS HAVE faced the temptation of printing excessive amounts of money.

    E.g.the U.S. monetary base doubled between 1985 and 1995. But there was no rampant inflation in the U.S. in 1995,6,7 or 8. See http://research.stlouisfed.org/fred2/series/BASE

    I.e. with some obvious exceptions ( Mugabwe, Germany in the 1920s, Argentina (from time to time)) governments normally manage to resist the temptation to go mad with the money printing presses.

  10. Ellie Velinska June 29, 2010 at 6:05 pm #

    Ralph, you say:
    If the electorate decides that government takes 60% of GDP and the private sector 40%, you might not like that, but if you believe in democracy you have to accept it.

    I agree.

    Governments that issue their own currencies (e.g. U.K., U.S. , Japan, etc) ALWAYS HAVE steadily increased their money supplies and ALWLAYS HAVE faced the temptation of printing excessive amounts of money.

    I agree.

    I believe your plan will insentivize the government to move in direction of USSR (politically) and Zimbabwe (economically).

    Your plan is great on theory – practically though it is very unlikely for the politicians to cut any program from a budget if they can just print the money.

    For example, President Obama proposed total of 10 lousy billion dollars in spending cuts in his 2011 budget. None of them will really happen. The cutting of the NASA Moon program made so much fuss, that Obama promised a new program to get the US on asteroids and beyond.

    Another example: the Obama health care was supposed to cut the reimbursement for doctors by 20% to pay for new entitlements. Congress is refusing to enact this “doctor fix” for years.

    Practically spending cuts just don’t pass through – politicians have no guts for those.