Balanced Government Budgets

What is the government debt?

When a government spends more than it receives in revenues (from taxes, sale of government assets etc) the government is operating with a budget deficit (where Government spending (G) > Taxation (T)) in that year. In order to be able to spend more than it receives in revenue, the government must therefore borrow the difference in order to be able to spend.

The accumulation of this borrowing over time is called Government or National Debt. This sum represents the amount of money a government owes to its domestic and foreign creditors, such as commercial banks, IMF, World bank or individuals. Maintaining a sustainable level of debt is important to promote a stable macroeconomic environment and maintain long term growth. Governments can´t sustain high levels of borrowing in the long run, just as individuals can´t simply borrow unlimited amounts but instead borrow money at levels that is affordable for them to pay back. The same is true for Governments.

Measurement of Government Debt

The main method we use to measure and report government debt is to express the figure as a % of GDP. This method is useful as it shows the % of national income (GDP) is owed by the government to its creditors. The higher the debt to GDP ratio, the more unaffordable the debt.

During the start of the Covid Pandemic in 2020, governments around the world have increased their borrowing in order to offset the economic impacts of lockdowns and other impacts of the pandemic. Below is the list of the top 10 countries by their debt to GDP ratio from March 2020 (start of the pandemic) to the end of 2021.

March 2020 - Start of Covid Pandemic

End of 2021 - 18 months into the pandemic

Economic Cycles, Budget Deficits and Debt to GDP ratios

Each year the government runs a budget deficit (G>T), this adds to the overall Government or National Debt. This means that year on year, the cost of borrowing increases for governments, as their risk increases. Economic events such as recessions can also worsen governments levels of debt. For example, before 2008 global financial crisis, Spain had a debt to GDP ratio of around 39.5%. As Spain was heavily impacted by the 2008 financial crisis (due to its housing market crash) it´s debt to GDP ratio increased to over 100% by 2014. At the same time, unemployment reached around 26%. As a result, high levels of government spending and lower levels of taxation (due to the high unemployment rate) caused an unsustainable rise in the countries debt. This forced the government to take measures to reduce its debt, such as raising taxes and cutting government spending, and attempt to maintain stable level of debt. These policies did begin to reduce Spain's debt to GDP ratio, however the impacts of the Covid Pandemic has caused a slight increase again.

Costs of Government Debt

Credit Ratings

Credit rating refers to the measure of a borrower's ability to repay a loan. Countries/individuals with a more favourable credit rating are more likely to secure loans as they are considered to be more be able to repay their debts. The above are 4 global credit rating agencies, who give countries a credit rating, based on their criteria. Criteria may be determined by:

The borrowers previous credit record and ability to pay back. We can see Argentina has a rating considered Substantial Risk. One of the factors for this may be that Argentina defaulted on its debt (meaning it couldn´t pay it back) in May 2020.
The amount the borrower needs - the higher the amount, the more risk to the lender and so the higher the interest rate may be.

Those countries in the Prime description are more likely to access loans at a lower interest rate as there is less perceived risk. The lower the grade, the more risk associated and therefore the higher the interest rates will need to be on borrowing in order to secure a loan.

The current amount of loans - the more debt, the higher the risk of default or the need for debt restructuring.
The real GDP of the country - The larger the national income of a country, the more likely it is that governments will be able to repay their debt. For example, we can see above that Japan has a debt to GDP ratio of 257% of its GDP by the end of 2021. Whilst the rating does carry some risk, Japan is the 3rd largest economy in the world by GDP, therefore the value of its national income means it is still likely to be able to repay its debts.

A change in these criteria may cause a change in the rating of a country and therefore lead to higher borrowing costs for governments over the longer term.

The impacts on future taxation and government spending

Unsustainable levels of debt are likely to require an increase in the levels of taxation and reducing government spending (whether through government choice or through a process of debt restructuring by external organisations such as the IMF). This process of raising taxes and lowering government spending is called austerity measures. As a result, this process presents an opportunity cost for Governments. If governments need to reduce their spending in order to reduce unsustainable budget deficits and raise taxes, this can create trade offs for the government.

As we have seen previously, public goods need to be provided by the government due to the free markets inability to provide these goods. As well as this, we know the benefits of goods that provide positive externalities of consumption or production and the policies governments can use usually involve government spending in order to increase the production and consumption of these goods. However if the government is having to reduce its spending, it may have to reduce spending on these goods, thus the potential welfare gain from these goods may not be achieved.

Similarly, these goods can improve long term economic growth through improving the levels of human and physical capital. Reducing spending on these goods may affect long term growth as the quality or quantity of these goods decrease, potentially reducing the overall long term growth of an economy.

Finally, raising taxes may stall macroeconomic activity as consumer spending (C) may decrease as well as Investment (I) by firms on the factors of production. All of this can cause a decrease in the actual GDP of an economy and lower levels of actual growth. This could create problems with unemployment and therefore actually increase government expenditure on things such as transfer payments or unemployment benefits.

Above, Greece debt to GDP ratio.

Right, Greece Personal Income tax rates. Large increase in tax rates due to unsustainable debt in Greece from 2014.

So are all budget deficits and debt bad?

As we have seen, budget deficits can increase a countries national debt. However, this is not always a negative thing to support an economy when needed, for example during a recession. It is also not to say that governments should run a budget surplus (Taxation > Government Spending) as this could indicate taxation (a leakage to the circular flow of income) is too high and therefore people may not be incentivise to work more etc). However, a budget surplus may be beneficial if it can be used to reduce a countries debt.

Therefore, budget deficits and national debt are not always a negative, so long as the debt is sustainable in the long term.

Case Study: The Progressive Worsening of the UK Debt-to-GDP Ratio Since 2000

Introduction

The United Kingdom's debt-to-GDP ratio has experienced a significant upward trajectory since the early 2000s, influenced by various economic challenges and policy decisions. This case study examines the historical trends, underlying causes, and potential implications of the UK's increasing debt burden, incorporating specific financial figures to illustrate key contributing factors.

Historical Trends in the Debt-to-GDP Ratio

Early 2000s: In 2000, the UK's public sector net debt stood at approximately 29.6% of GDP. This relatively low level was a result of sustained economic growth and prudent fiscal policies during the late 1990s.
Pre-2008 Financial Crisis: By 2007, the debt-to-GDP ratio had modestly increased to 36.3%, primarily due to increased government spending on public services, including health and education.
Post-2008 Financial Crisis: The global financial crisis necessitated substantial government interventions, including bank bailouts and economic stimulus measures. Consequently, the debt-to-GDP ratio escalated sharply, reaching 47.9% in 2008 and 61.0% by 2009.
2010s Austerity Measures: In response to the rising debt, the government implemented austerity policies aimed at reducing public spending. Despite these measures, the debt-to-GDP ratio continued to climb, albeit at a slower pace, reaching 82.4% in 2017.
COVID-19 Pandemic (2020-2021): The pandemic led to unprecedented government borrowing to fund public health measures and economic support programs. This resulted in the debt-to-GDP ratio surpassing 100% in 2020, a level not seen since the early 1960s.
Recent Developments (2022-2024): As of September 2024, the debt-to-GDP ratio stands at 101.0%. Factors contributing to this include increased public spending, economic challenges such as the cost-of-living crisis, and rising interest rates.

Causes of the Worsening Debt-to-GDP Ratio

Economic Crises:

- 2008 Financial Crisis: The UK government injected approximately £137 billion to stabilize the banking sector, including significant investments in Royal Bank of Scotland (RBS) and Lloyds Banking Group. While a substantial portion has been recouped, losses remain, notably a £35.5 billion loss on the NatWest (formerly RBS) rescue.
- COVID-19 Pandemic: Government measures to combat the pandemic, such as the Coronavirus Job Retention Scheme and support for public services, resulted in spending between £310 billion and £410 billion, equating to about £4,600 to £6,100 per person in the UK.

Increased Public Spending:

- The government announced plans for around £640 billion of gross capital investment by 2024-25 for infrastructure projects, including roads, railways, and hospitals.

Stagnant Economic Growth:

- Periods of low economic growth have limited increases in GDP, making it challenging to reduce the debt-to-GDP ratio.

Tax Policies:

- Decisions to implement tax cuts without corresponding decreases in public spending have exacerbated budget deficits, contributing to the growing debt.

Demographic Changes:

- An aging population has increased pressure on public finances due to higher spending on pensions and healthcare.

Implications of a High Debt-to-GDP Ratio

Increased Debt Servicing Costs:

- Higher debt levels lead to greater interest payments, which can consume a significant portion of government revenues, limiting funds available for other public services.

Fiscal Constraints:

- Elevated debt may restrict the government's ability to implement fiscal policies aimed at stimulating economic growth or responding to future crises.

Potential for Higher Taxes or Reduced Spending:

- To manage debt levels, the government might need to increase taxes or cut public spending, which could impact economic growth and public welfare.

Investor Confidence:

- Persistently high debt levels can affect investor confidence, potentially leading to higher borrowing costs for the government.

Intergenerational Equity:

- Rising debt levels may place a financial burden on future generations, limiting their economic opportunities and fiscal flexibility.

Conclusion

The UK's debt-to-GDP ratio has progressively worsened since 2000, influenced by economic crises, increased public spending, and demographic shifts. Addressing this challenge requires a balanced approach that promotes economic growth, ensures sustainable public finances, and considers the long-term implications of fiscal policies.

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