a. Readers Question: Why is debt related to GDP?
Debt to GDP shows how significant the debt is relative to tax revenues. For example the total debt of the Irish government is quite low by UK standards, but as a % of the economy it is high.
For example, if total government debt stayed exactly the same, but GDP fell. It would make it more difficult to finance the debt payments. If GDP fell, tax revenues would fall. Therefore, the government may have to increase tax rates to finance the debt interest payments – even though the total level of debt is the same.
On the other hand if the economy was growing, it would be easier to pay the debt interest payments. For simplicity assume the total debt stays the same, but real GDP increases significantly. With rising GDP, the government would automatically get more income tax, VAT and corporation tax. Therefore, it would be easier to meet the debt interest payments. With higher GDP, the government can devote a small share of tax revenues to debt interest payments.
In 1950, UK total debt was £640bn (at 2005 prices). But this was 250% of GDP. In 2009, UK government debt is approx £558bn at 2005 prices – but just 44% of GDP (2009) ( – a much smaller % of GDP) . (In 2011 it was 58% of GDP)
A big problem facing countries like Greece, Ireland and Spain is high borrowing combined with falling GDP. This creates a rapidly rising debt to GDP ratio and therefore markets fear the governments are quickly losing ability to keep on top of debt interest payments.
Readers question – how can debt rise, but debt to GDP fall – an example showing importance of debt to GDP ratios