Q&A – Government debt and deficit

At a time when the health of the global financial system has started to improve, a new threat to global financial stability is emerging from the sharp increases in government debts and deficits, especially in developed countries.

Cutting budget deficits is an urgent need for many governments, but exiting from high public debts will be a more difficult task, one which requires fundamental long-term changes.

  • Government debt and deficit: what are they?
  • How did countries accumulate large debts and deficits?
  • Why should debt and deficit matter?
  • How to cut budget deficits and exit high public debt?
  • What is the future outlook?

Government debt and deficit: what are they?

A deficit occurs when the money the government spends (called expenditure) exceeds the money it takes in (called revenues) each year; this deficit is usually referred to as government budget deficit. Revenues include the money the government takes in from income tax, excise duties, and social insurance contribution, as well as other non-tax revenues such as foreign aid. Expenditures include all government spending ranging from public services, social security and welfare to national defence, education and interest payments on government debt.

When the government is running a deficit, it has to borrow the money needed to finance its expenditure plans each financial year. It borrows by issuing securities such as long-term government bonds and short-term notes and bills to the public, or by borrowing directly from the capital markets. Government debt, also known as public debt or national debt, is the total amount of all government borrowing which has not been repaid.

Debt and deficit are usually viewed as a percentage of GDP. Because the ratios of public debt and deficit to GDP measure a country’s debt and deficit in relation to the size of its economy, they indicate the country’s ability to pay back its public debt and serve as a barometer of a government’s financial health. Economists say that budget deficits above the level of 3.0% of GDP are generally unsustainable while the EU limit for public debt is 60% of GDP.

How did countries accumulate large debts and deficits?

In the wake of the global financial crisis, which started in the USA and spilled over to the rest of the world in the summer of 2008, many governments especially in developed countries raised spending, cut taxes, and provided unprecedented help to the financial, housing and automotive industries in order to support the economy. However, amid a difficult economic climate, government tax revenues have been reduced.

The combination of higher government expenditure and lower tax revenues has led to soaring public debts in many countries, especially in the developed world:

  • The average public debt-to-GDP ratio of the G20 economies, which stood at 62.4% in 2007 prior to the global financial crisis, is estimated to have risen to 82.1% in 2009 and is expected to hit 86.6% in 2014;
  • In Japan, years of economic stagnation have increased the country’s public debt ratio from 50.7% of GDP in 1990 to 183.8% in 2009, the highest ratio of all developed economies. In March 2010, the Japanese parliament passed a record ¥92.3 trillion (US$1.0 trillion) budget for the 2010/11 financial year, as the government plans to launch fresh stimulus measures to boost economic recovery in 2010. The government will issue an all-time record ¥44.3 trillion of new bonds to help fund a revenue shortfall, which will see Japan’s public debt reaching 200% of GDP – or being twice as much as the economy – in 2010;
  • In the eurozone, where countries are abided by the European Union’s Maastricht Treaty rules which set a 60.0% of GDP limit on public debt and a 3.0% of GDP limit on government budget deficits, the global financial crisis has exposed the high levels of public debt in the PIIGS economies of Portugal, Ireland, Italy, Greece and Spain. In particular, Italy and Greece are the two countries with the highest public debt-to-GDP ratio, at 115.2% and 113.3% respectively in 2009;
  • In 2010, after years of profligacy (hosting an expensive Olympic Games in 2004 and failing to rein in its spiral public debt), financial misreporting (to comply to the Maastricht criteria), and poor tax collection, Greece plunged into a public debt crisis when the markets lost trust in the government’s plan to cut its deficit and believed that Greece could default on its debts.

Why should debt and deficit matter?

Insufficient government efforts to consolidate finances leading to public debt rising disproportionately high in relation to the size of the economy will have a profound negative impact on the economy:

  • The credit rating – an assessment of a country’s ability to repay its debts – will be downgraded, which will immediately make the issue of new government debt to the financial markets more expensive and difficult. In April 2010, Standard & Poor’s downgraded Greece’s credit rating to junk status, effectively lifting Greece’s borrowing costs to a level that made it unsustainable for the country to borrow from the financial markets, pushing it into a bailout by the EU and the IMF;
  • Investor confidence will also weaken as unmanageable debts and deficits reflect a mismanagement of the economy. This will lead to lower levels of investment, with negative knock-on effects on the labour market and economic growth. As of 2010, major developed economies such as France, the UK, the USA, and Japan are all at risk of a downgrade in their credit ratings because investors are yet to be convinced about government deficit cutting plans in these countries. China, on the other hand, saw major credit rating agencies (including Fitch, Moody’s and Standard & Poor) upgrading its credit ratings in late 2009 on expectations that the country’s economic recovery is taking stronger hold with only modest effects on the government’s finances;
  • Public debt crisis from countries such as Greece can have significant cross-border spill-overs. Banks in heavily indebted countries will have trouble obtaining enough money to support adequate lending to local businesses, which can have damaging impacts on the economy. Likewise, banks outside the indebted country could suffer heavy losses on their loans to the indebted country. This, in turn, will push up the costs of borrowing in other countries;
  • Large public debts require large interest payments. This means funds intended for social programmes and public services will be spent instead on debt servicing. Given the global economic recovery is still fragile and a large part of the financial system continues to rely on government rescue funds (e.g. purchasing bad assets from, and injecting capital into, troubled institutions), reduced government expenditure as a result of soaring interest repayments can undermine efforts to spur economic recovery;
  • For consumers, as the government draws much of its revenues from the population, government debt is an indirect debt of the consumer who is also a taxpayer. Additionally, when investor confidence in the economy weakens and government expenditure on social security and welfare reduces, the consumer will be directly impacted with lower job rates, lower earnings, and higher taxes. As a consequence, household spending will be reduced.

How to cut budget deficits?

As the global economic conditions improve, governments are expected to start introducing fiscal adjustment measures in order to reduce budget deficits, bring public debts down to manageable levels, and regain investor confidence:

  • In May 2010, the IMF issued a warning to developed economies that they face an urgent need to cut their budget deficits to ensure that the sharp increase in deficits and debts resulting from the 2008-09 global financial crisis does not pose a new threat, which is growing sovereign risk, to the global financial system;
  • In the eurozone, many countries have introduced or are in the process of introducing a range of austerity measures. In Portugal, measures including pay cuts for public sector staff and tax increases are expected to save €2.0 billion in 2010 in order to cut the deficit to 7.3% of GDP in 2010 and 4.6% in 2011, from 9.4% in 2009. In Spain, spending cuts totalling €15.0 billion in 2010 and 2011 will be introduced to bring the deficit to 9.3% of GDP in 2010 and 6.0% in 2011, compared with 11.2% in 2009. Meanwhile, Greece plans to narrow its budget deficit from 13.6% of GDP in 2009 to 8.1% in 2010 and 7.6% in 2011 through tax hikes, pension freezes until 2012 and a public sector pay freeze until 2014;
  • In the USA, the budget deficit is forecast at US$1.6 trillion, or 10.6% of GDP, in 2010, up from 9.9% of GDP in 2009. However, the government aims to reduce the deficit to 8.3% of GDP in 2011 and further to 3.0% of GDP by 2019, through a range of measures including tax hikes on affluent families, scrapping subsidies to energy companies and curbing federal projects. The success of these measures however is dependent on Congress approval and on whether the economy recovers strongly enough to sharply lift tax revenues. However, even if budget deficit cuts go to plan, the US public debt is still forecast to rise above 71.0% of GDP by 2013 (up from 54.8% in 2009), and reach nearly 80% by 2020 – levels that could damage investor confidence.

What is the future outlook?

  • According to the IMF, developed economies will continue to run sizable deficits over the medium term, leading the average public debt-to-GDP ratio to reach 110% of GDP by 2015, up from 73% of GDP in 2007 before the global financial crisis;
  • On the contrary, in emerging economies, public debt levels are expected to decline slightly, after the initial rise in 2008/2009 as a consequence of fiscal stimulus measures during the economic downturn. Falling public debt levels in emerging economies reflect lower interest spending than in developed economies and a stronger projected economic recovery;
  • On the global financial market, the IMF projected that credit recovery is to be “slow, shallow and uneven,” as heavy government borrowing soaks up available funds and banks continue their reluctance to lend to repair their balance sheets;
  • Cutting spending is only a short-term measure to demonstrate to investors that the government can manage its deficit. In order to exit from high public debt, many economies, especially those in the developed world where population ageing is also raising public expenditure, will have to undergo more fundamental, long-term changes such as ending the welfare state, abandoning some of the labour laws that make hiring and firing difficult in order to encourage productivity increase, and pushing back the retirement age.
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