Readers Question: Does Government debt matter? Do high fiscal deficits threaten economic stability?
Many worry that high levels of government debt could cause economic instability. In certain occasions, countries with high debt have seen investors lose confidence, leading to higher bond yields and putting pressure on the government to slash spending, for example several countries in the Eurozone (2010-12). In rare cases, governments with high debt have responded by printing money – causing inflation to spiral out of control, for example, Germany in the 1920s. Another potential problem is when government debt is financed by overseas borrowing. If overseas investors lose confidence and sell their debt it can cause a loss of foreign exchange and a destabilising devaluation.
However, in many cases, high levels of government debt do not cause instability – but can actually prevent a deeper recession. The main argument for government borrowing is that in a recession, government borrowing and government spending can help prevent a collapse in demand and economic growth. In a recession, generally people save more and so wish to buy government debt. This means governments can often borrow cheaply to finance public sector works.
In the 1950s, national debt in the UK reached 200% of GDP, but it did not compromise economic growth or inflation. The UK was able to reduce this debt burden over several decades of economic growth.
Does debt matter?
- It depends how it is financed – e.g. does it rely on overseas borrowing which can be more risky?
- What are the prospects for economic growth? – With economic growth, the debt to GDP ratio is likely to fall. If you are stuck in recession, the debt to GDP ratio will likely rise.
- Are domestic investors willing to buy government bonds? Japan has very large public sector debt, but it has large pool of domestic savings so the government has been able to borrow cheaply.
- Is the debt cyclical or structural? Debt is a bigger problem if the government is borrowing heavily during a period of growth and there is a structural deficit.
More detail on question
Economic stability would involve.
- Low inflation
- Positive, sustainable economic growth (e.g. close to long run trend rate of growth)
- Stable bond yields (i.e. avoid rapidly rising bond yields which could create difficulty in dealing with debt.)
- Stable exchange rates
High fiscal deficits mean the government is forced to borrow a large sum – Annual government spending is greater than tax revenues.
For example, in 2011/12 the UK government will have to borrow an estimated £125bn (just under 8% of GDP). Anything over 3% of GDP could be classed as a high fiscal deficit.