Government Debt

Issues in Public (or Government) Debt

Receipts, expenditures, and balances are economic flows. They are generated in each period.

Government assets and liabilities are instead stocks that are transmitted from period to period: their value at the beginning of each year equals that at the end of the previous year, as for private assets and liabilities or a capital stock.

Take for example, the public, or government debt—the total financial liabilities of the government—on January 1 equals that on December 31 of the previous year.

From one year-end to the next, a deficit increases the debt, while a surplus can be used to pay it down or to buy financial assets.

Public debt accumulation arises because deficits must be financed through borrowing on the bond market or through loans from the international organizations.

In a simplified setting where the government finances itself by issuing a single type of bond, the relationship between the public deficit and the public debt is:

Debt at end of period (t) = Debt at end of period (t – 1) + Financial deficit of period (t)

Formally, if D represents the deficit and B (for Bonds) the debt:

Bt = Bt–1 + Dt

Debt therefore increases as long as there are deficits. In this typical stock-flow relationship, debt is measured in nominal terms (disregarding changes in its market valuation) and it is assumed that the government does not sell assets to finance its deficit nor borrow to invest in financial assets.

From an accounting standpoint, however, these dimensions should be taken into account. In particular, gross debt should be distinguished from the debt net of government assets, which is called net debt: for example, the 234% of GDP gross debt government figure for Japan in 2015 is misleading because it neglects the fact that a large part of this debt is held by government agencies; debt net of financial assets is a still high but less frightening 126% of GDP. However, the concept of gross debt is generally used because government assets can be illiquid.

The previous equation can be rewritten, distinguishing the primary deficit and the interest on debt outstanding:

Debt at end of period (t) = Debt at end of period (t – 1)
+ Interest payment on debt at end of period (t – 1)
+ Primary deficit of period (t)

Formally, if P is the primary balance (the opposite to the primary deficit) and i the interest on public bonds,

Bt = (1 +i) Bt –1Pt

Debt increases if interest payments on the outstanding stock exceed the primary balance. This is why the latter is a key target variable for overindebted countries.

Debt here represents the liabilities of the government or the public sector. Like for the deficits, alternative perimeters can be considered, from the narrow confines of the central government’s budgetary functions to the much more broadly encompassing public sector, which includes government agencies, social insurance institutions, local governments, and public entities benefitting from government guarantees.

Differences in perimeter matter: in Canada for example, public debt at end 20110 varied from 39% to 67% of GDP depending on the definition chosen.

The old maturing debt securities need to be replaced throughout the year by new ones at prevailing interest rates, while additional debt is issued to finance the deficit.

Total securities issuance over the year (i.e., the sum of maturing debts and deficit) is called gross financial need.

The larger these are, the more difficult it is to tap into the market. If a country loses market access and is forced to rely on official assistance from the IMF Opens in new window and/or the European Stability Mechanism (ESM) Opens in new window, the volume of assistance is determined by these needs, which explains the central role of this concept for the design of assistance programs (IMF, 2013):

Gross financing needs of (t) = Maturing debt of period (t) + Deficit of period (t)

Public debt (also called sovereign debt when the borrower is the central government) should not be confused with external debt, which represents the liabilities of all domestic agents—public as well as private—vis-à-vis the rest of the world.

Of course, both concepts have a common component: government borrowing often results in the accumulation of liabilities vis-à-vis the rest of the world. But some countries, like Italy, exhibit both high levels of public debt and low levels of external debt.

In practice, there are several ways to finance a deficit and therefore several types of financial liabilities.

The bulk of them consist in debt securities (long-term bonds and short-term bills) that give the creditors the right to payments in capital and interest, as specified by the associated debt contract (see the Market for Government Debt Opens in new window).

But governments can also receive loans from banks or international organizations such as the IMF. Or they can incur debt in a hidden form: in situations of stress, they often delay payments to suppliers or even to public employees and pensioners. According to IMF research on a sample of 61 countries, bonds amount to 68% of total debt of the median country, whereas loans represent 22.5% and payable 8.4% (Dippelsman, Dziobek, and Gutierrez Mangas, 2012).

An alternative to open indebtedness is for the government to finance itself through the national central bank (which amounts to creating money). The counterpart to this monetization of the deficit is an increase in the money supply. This practice originates in the capacity (called seigniorage) of kings to finance expenses by printing money, and it used to be common, particularly to finance wars.

Deficit monetization amounts to letting the requirements of the public Treasury, rather than the economy’s needs, determine the pace of money creation; when sustained, it has proved to be a powerful source of inflation. Hyperinflation episodes are systematically connected to it.