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 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.