Size of a National Debt Relative to GDP

The national debt is the total amount of money owed by the central government. It is important for a country to grow its economy and, at the same time, reduce its national debt. Many believe that government debt can cause great political instability. To some degree, this could be true because it may cause:

• a loss of confidence by investors;
• reduced government spending; and
• the printing of currency, leading to inflation.

However, this is usually not the case. High national debt does not necessarily cause instability. In fact, on the contrary, it may even prevent deeper economic depressions. Some economists argue that during a recession, government borrowing and spending can help prevent a collapse in demand and growth.

In a recession, individuals tend to save more and they can therefore buy government debt denominated in their own currency. This allows the government to borrow at low prices to finance public sector expenditures.

National debt matters depending on the following factors:

1. the way it has been financed. For instance, depending on overseas borrowing can be risky because of currency rate risk;
2. higher economic growth enables a country to be able to repay its debt. If a country is stuck in a recession, the debt will increase relative to the GDP;
3. domestic investors are willing to buy government bonds. When a country has a large pool of domestic savings, its government will borrow cheaply; and
4. there is a structural deficit, and the government is borrowing heavily in a period of growth.

For a stable economy, the government needs a low and stable inflation rate and a sustainable economic debt.

Crowding Out

During recessions, the private sector borrows less but saves more. A more critical situation occurs when both the private sector and government debt grow simultaneously, as this will eventually result in crowding out. Crowding out can lead to a substantial rise in interest rates, which discourages businesses from making capital investments.

Asset Bubbles

A persistent lack of capital caused by consumption demand and speculative asset prices creates bubbles. The most likely outcome will be short-term economic growth and a long-term decline in growth, as seen from the housing bubble that took place before the 2007-2008 housing market collapse and subsequent recession.

Question

Which one of the following is most likely a disadvantage of national debt?

A. A country acquires additional funds for growth

B. National debt improves the standard of living

C. National debt can cause inflation

Solution

The correct answer is C.

When the government borrows too much, it causes problems by raising interests rates and consequently inflation.

Options A and B are potential advantages of national debt.

Reading 16 LOS 16q:

Describe the arguments about whether the size of a national debt relative to GDP matters