Public debt

2 Concepts and distinctions

Debt vs deficit

government debt

The total amount of money owed by the government at a specific point in time.

stock

A quantity measured at a point in time. Its units do not depend on time. See also: flow.

flow

A quantity measured per unit of time, such as annual income or hourly wage.

government budget deficit

When the government budget balance is negative.

gross domestic product (GDP)

A measure of the market value of the output of final goods and services in the economy in a given period. Output of intermediate goods that are inputs to final production is excluded to prevent double counting.

insolvent

When the value of an entity’s assets is less than the value of its liabilities.

Debts and deficits are not the same. Government debt is a stock that measures the total amount of money owed by the government at a point in time. For example, the debt of France at the end of 2020 was €2.65 trillion. The budget deficit is a flow. It measures the difference between government expenditure and revenues over a period of time; when expenditure exceeds revenues, it is a deficit and in the opposite case, it is a surplus. (For more details on the government’s finances, see Section 14.8 of The Economy 1.0.) For example, the budget deficit of the French government during 2020 was €212 billion. These two variables are related, because the difference between the stock at the end of this year and the stock at the end of last year should equal the deficit during the year.

Debt-to-GDP ratio

In analyzing public debt, it is useful to scale that debt by GDP. To learn more about how GDP is calculated, see Unit 13 of The Economy 1.0. The same nominal amount of debt will be less burdensome for a larger economy, and economies grow over time. Whereas U.S. public debt stood at $233 billion in 1949, it was $5.6 trillion in 1999. At first glance, this 25-fold increase might look worrisome. But it appears very different when one observes that U.S. GDP grew from $270 billion to nearly $10 trillion, a 37-fold increase, over the period. The debt-to-GDP ratio fell from 86% to 56%. The debt-to-GDP ratio is also convenient for international comparisons. For instance, a debt of $88 billion (170% of GDP) brought the Lebanese government to the brink of insolvency in 2020. But $88 billion of debt would have been mere rounding error for a country like Germany, with a GDP of nearly $4 trillion.

Some authors suggest adjusting interest payments for the erosion of debt by inflation, replacing
[(Debt + (Interest rate × Debt)) ÷ GDP]
by
[(Debt + ((Interest rate − inflation rate) × Debt)) ÷ GDP],
where Debt is nominal public debt.

The debt-to-GDP ratio is the most widely used metric of public debt, because it is useful for analyzing the factors influencing the evolution of the debt burden over time (as we show starting in Section 5). But it is not the only possible way of scaling the debt. Alternatively, one can compare interest payments with GDP. This measure focuses on the current financing situation. It has the advantage that we are comparing a flow (interest payments this year) with another flow (GDP this year). Its corresponding disadvantage is that interest payments and GDP this year tell us nothing about the likely future evolution of the debt burden going forward.

In addition, it is important to note that the share of taxes in GDP varies substantially across countries. According to the International Monetary Fund (IMF), in 2021, tax revenues were 14% of GDP in Uganda, for example, but 52% in France. (The average for high-income economies was 42%, while the average for emerging and developing economies was 27%.) Typically, government revenues are dominated by tax receipts. However, some governments such as those of Norway and Saudi Arabia also derive large revenues from the extraction and sale of natural resources. If debt is serviced from government revenues, then these large differences suggest that the typical high-income economy can sustain a higher debt-to-GDP ratio than the typical emerging economy. For some purposes, therefore, debt relative to government revenues can be a more useful metric.

Different ways to classify debt

For a brief explanation of the diabolic loop, see Section 6.1 of ‘A crash course on the euro crisis’ by Markus K. Brunnermeier and Ricardo Reis.

debt securities

Another, equivalent way to refer to bonds. See also: bonds.

For some purposes it is important to disaggregate public debt according to who holds it. Debt securities issued by the government can be purchased by individual investors, mutual funds, pension funds and banks. Accumulation of large amounts of government bonds by banks in particular can create macroeconomic risks, since any problems of servicing the government’s debt will then become problems for the banks and, equally, any problems for the banks that force them to liquidate their holdings of government bonds can become problems for the government. In Europe, where these linkages were prominent starting in 2008, they became known as ‘the diabolic loop’.

inflation

An increase in the general price level in the economy. Usually measured over a year.

For other purposes it is important to distinguish whether debt is denominated in domestic or foreign currency, whether its term to maturity is long or short, and whether the interest rate is indexed to inflation. (For more about inflation, see Section 15.1 of The Economy 1.0.) When debt is denominated and issued in a foreign currency, as foreign investors have historically required of most governments, changes in the exchange rate can have implications for its sustainability. When debt is short in term, there will be little scope for using inflation to reduce its real value, since as soon as their debt securities mature, investors will be able to demand a higher interest rate in compensation for inflation, limiting any erosion in the real value of their investments. Thus, the maturity of the debt may influence a government’s policy choices. When the interest rate is indexed to inflation, there will be absolutely no scope for inflating away the debt. But there can be unanticipated consequences for debt-servicing costs. If the government, unlike investors, is confident that there will be no inflation, indexed debt can be cheaper than debt with a fixed interest rate. However, if inflation turns out to be higher than expected by investors, indexed debt will end up being more expensive for the government.

A further complication is the existence of different levels of government. One could focus on debt issued by the central government alone, or on general government debt, including that of state and municipal governments. The difference between central and general government debt can be substantial in federal countries. In 2020, when the central government debt of Switzerland was 21% of GDP, general government debt was 42% of GDP (the average debt of cantons, the 26 states of the Swiss Confederacy, was 12% of GDP and municipal debt 9% of GDP). Although statistics on general government debt are more encompassing, some countries do not keep good track of local government debt. Hence general government debt statistics are not always comparable across countries.

Gross debt vs net debt

To obtain a measure of net debt, one might subtract the government’s assets from the gross debt. Large differences between gross and net debt can arise when government agencies hold a large fraction of the government’s debt. For instance, about one-quarter of U.S. federal government debt is held in the Social Security Trust Fund, which funds future payments to retirees. In this case, one agency of government (the Treasury) is making payments to another agency of government (the Trust Fund). Therefore, U.S. statistical sources normally report ‘debt held by the public’, which nets out these cross-holdings.

From Figure 1, we can see that the difference between net and gross debt is large in Japan, where the government owns land and other assets valued at about 100% of GDP. At the other extreme, there are countries where the government holds few assets and for which gross and net debt are almost identical, as is the case of Barbados and Nigeria, for example.

liquidity

Ease of buying or selling a financial asset at a predictable price.

But calculating net debt can be problematic, since some government assets are not traded, and so can be difficult to value. In terms of liquidity, government assets may not easily be sold if the government needs to raise cash in a debt crisis when it needs to buy back debt. This renders gross debt a better measure of vulnerability.

Further, standard public debt measures do not include payments to future pensioners for which trust fund resources have not yet been put aside, or other implicit liabilities of the public sector (for example, the need in the future to inject resources into loss-making state-owned enterprises). These unfunded liabilities can be important, but measuring them is not easy, conceptually or practically.

In recent years, central banks have bought considerable amounts of public debt. The Bank of Japan holds 43% of Japanese government debt, and the U.S. Federal Reserve System holds 22% of U.S. federal government debt. If we remove these amounts from the net debt figure in Figure 1, Japan’s debt-to-GDP ratio would fall to 50% of GDP, and the U.S. debt ratio to 75%. It is tempting to make this adjustment, since the central bank is an arm of the public sector. The Federal Reserve System, like the Social Security Trust Fund, is part of the U.S. public sector. However, to purchase public debt, the Federal Reserve must issue liabilities of corresponding value. These take the form of reserves held by member banks at the central bank, on which the Federal Reserve pays interest. Because those reserves are not counted as public debt, it is conventional not to net out government securities held by the central bank.