Deficits and debt
When governments spend more than they collect, they borrow. Deficits and debt are central to debates about fiscal policy.
Deficits and surpluses
A budget deficit occurs when government spending exceeds revenue in a year; a surplus when revenue exceeds spending. The primary deficit excludes interest payments on existing debt, showing whether current policy is adding to debt.
Government debt
Government debt is the total accumulated borrowing from past deficits minus surpluses. It is usually measured as a percentage of GDP, since a larger economy can support more debt. Governments borrow by selling bonds to investors, banks, pension funds, foreign governments, and sometimes central banks.
Debt levels
Debt ratios vary widely. After the pandemic, many advanced economies had gross government debt around or above 100% of GDP; Japan's has been above 200%. Debt rose sharply in the world wars, fell in the following decades, and rose again after the 2008 crisis and the 2020 pandemic.
The cyclically adjusted deficit
Deficits naturally rise in recessions because of automatic stabilisers. The cyclically adjusted (structural) deficit estimates what the deficit would be at full employment, separating deliberate policy from the effects of the business cycle.
Debt dynamics
Whether debt is sustainable depends on the interest rate (r), the growth rate of the economy (g), and the primary balance. If \(r < g\), the debt ratio can fall over time even with small primary deficits; if \(r > g\), primary surpluses are needed to keep the ratio stable. Rising interest rates since 2022 have made this calculation tighter for many governments.
Concerns about debt
High debt can mean large interest payments that crowd out other spending, may push up interest rates and reduce private investment (crowding out), and can limit room for future emergencies. If investors lose confidence, borrowing costs can spike, as in the euro area crisis of 2010-2012 for Greece and others.
Arguments for borrowing
Borrowing can be sensible to smooth spending over the business cycle, to respond to emergencies, and to fund investments, such as infrastructure and education, that raise future output. Countries that borrow in their own currency and have credible institutions usually find it easier to sustain debt.
Worked example
A country has debt of 90% of GDP, nominal growth of 4%, and pays 3% interest on its debt. With r < g, a primary balance of zero would gradually lower the debt ratio: debt grows 3% a year from interest while GDP grows 4%. If interest rose to 6%, the same policy would push the ratio up.
Key takeaways
A deficit is spending above revenue in a year; debt is accumulated borrowing. Debt is measured as a share of GDP, financed by selling bonds. Many advanced economies have debt near or above 100% of GDP. Sustainability depends on interest rates, growth, and the primary balance. High debt can crowd out spending and risk crises, but borrowing for investment or emergencies can be justified.
Flashcard
Spending exceeds revenue in a year
Check your understanding
What is the difference between a budget deficit and government debt?