NATIONAL DEBT

National Debt

National Debt

What Is the “National Debt”?

National government financial debt is created when the expenditures in a fiscal year exceed tax and fee revenue. The national government finances the excess of expenditure over revenue by borrowing. For example, the U.K. government auctions off U.K. Treasury bills, notes, and bonds (U.K. bonds, hereafter). The U.K. Treasury defines the Gross Debt to be the value of all national government bonds outstanding. However, the media and the public often refer to this same concept as the National Debt. Gross Debt and National Debt are synonyms. The remainder of this chapter uses the former term. (Barro, 1989, pp. 940-971)

A government's ability to sell bonds depends on creditors' faith that the bonds will be repaid and on the creditors' financial capacity to buy the bonds. Creditors' faith depends on the economy's ability to generate future tax revenue, which depends on the economic growth rate. Creditors' financial capacity depends on their incomes and saving. Because saving cannot grow faster than the economy in the long run, creditors' financial capacity to buy bonds is limited by the economy's long-run growth rate. Therefore, if Gross Debt grows faster than the economy in the long run, the economy's ability to generate tax revenue to service debt, and creditor's capacity to buy new debt, falls short of the government's liabilities. If the public understands that the Gross Debt continually grows faster than the economy, creditors will demand abnormally high interest rates to compensate for the risk of not being repaid. Or creditors may simply refuse to purchase additional government debt.

In this case, the government faces a “debt crisis,” and the government's choices become severely constrained: (a) taxes must increase or expenditure must be cut, or both, or (b) government must default on its liabilities and convince creditors to reschedule debt payments. If these options are not available, the only recourse is for the government to repudiate the debt. In this case, government simply declares its intention to not repay the debt.

Interest rates tend to increase greatly in debt crises, and living standards tend to decline. If the government responds to a debt crisis by raising taxes and reducing spending, this exacerbates the decline. Fortunately for the United States, its national government has never experienced a debt crisis. (Bernheim, 1997, pp. 263-304)

Countries that default on debt often have attempted to maintain financial viability by rescheduling debt payments. In this case, the government usually ends up paying much higher interest rates to compensate for the increase in risk perceived by creditors. Even though interest rates increase, the exchange value of the country's currency tends to decline greatly, as creditors shift funds to safer environments. A large decline in the currency reduces the standard of living because imports become more expensive.

Debt Repudiation

Debt repudiation is the most drastic response to a fiscal crisis. One form of debt repudiation occurs when a government renounces its debt obligations. In 1917, Russia announced that it would not repay debt incurred by the ...