One feature of the past few years is the rapid rise in government borrowing. – not just a rise in real debt but a rise in debt to GDP. This means debt burdens are a bigger % of National Output. It’s not the first time this has happened. A rise in debt to GDP typically occurs during periods of war and recession. However, the rise in debt seems to have affected countries in the Eurozone more than those outside.
A rise in government borrowing can create various problems.
- Rise in bond yields and general interest rates
- Potential for inflation, if governments fund deficits by printing money
- Likelyhood of higher taxes and spending cuts in future.
- See: Problems of government borrowing
Governments borrow by selling bonds on the bond market. Traditionally government debt is seen as secure, because governments rarely default. Therefore, governments can usually sell debt (government bonds) at a low interest rate. (For example, 10 year bond yield on UK bonds is currently 3.5%)
However, suppose that debt in the UK rose so rapidly that the ratio of debt to National output looked unmanageable. If markets felt the government were borrowing beyond their capacity to repay their debt, it would look very unattractive to hold UK bonds. At worst, the government may default and not pay you back. If markets feared government debt was unmanageable, fewer people would hold bonds, this would push up interest rates on debt, making it more expensive to borrow.
This market fear can spread contagiously. i.e. if some people start selling bonds, it may spread as no one wants to hold onto bonds.
When Does Debt Become Unmanageable?
This is the key question. Japan has a huge national deficit (close to 200% of GDP) and yet bond yields in Japan are barely above 1%. Yet, Spain with a national debt of 60% is causing markets to be worried. Over the next few years, the US has a similar borrowing requirement to Greece, and yet markets don’t seem worried about US debt.
A key issue is forecasts for growth and inflation. If a country faces years of negative growth and a period of deflation (falling prices). This means the debt to GDP ratio will rise rapidly. If a country has growth forecast, this will help to maintain a reasonable debt to GDP ratio.
A period of deflation increases the real value of debt making it more difficult to pay back.
More details – How much can governments borrow?
Why Euro Makes National Debt More of A Problem.
Markets have been worried mostly about countries in the Euro. Being in the Euro has certain disadvantages
- No Independent monetary policy. Countries which seek to cut spending to reduce the deficit, don’t have the ability
- to cut interest rates
- pursue quantitative easing
- devalue exchange rate
Therefore, economies is more liable to suffer from low growth and deflation. A country like the UK can cut spending to reduce deficit, but at least it can maintain a looser monetary policy and benefit from a weaker sterling. (will debt crisis spread to UK?)