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Public debt of many developed countries is high above 100% of GDP, and in a few years this value will become the global average. NES Professor Valery Charnavoki answers the questions whether we should worry about the state of public finances, how long a country can live with such a debt burden, and how we can distinguish between a stable and unstable level of public debt.
The last two decades saw a rapid growth of budget deficits and public debt worldwide. According to the IMF, total public debt of all countries exceeded $100 trillion in 2024, and it is expected to reach a record 100% of global GDP by 2030. At the same time, the major share of it comes from just two countries, the United States and China.
The US government debt is generally a popular topic both in America and abroad. There are many online counters (the first two search results are the US Debt Clock and the USA Debt Clock). During his second presidential campaign Donald Trump promised to eliminate the national debt, possibly with the help of cryptocurrencies, and after winning the election, he talked about a potential economic 'catastrophe' because of the debt.
The strong increase in government debt was largely due to large-scale programs to support and stimulate the economy during the global financial crisis of 2008 and the covid pandemic of 2020. After emerging from the pandemic, the level of public debt in most countries began to stabilize. However, in the United States, China, and some European countries such as France and Italy, budget deficits remain high, and national debt continues to grow, raising concerns about the sustainability of public finances in the long term.
There are many reasons for concern. Low population growth, increased life expectancy, and rising inequality are putting additional strain on healthcare, pension, and social security systems, taking away more and more of the governments’ financial resources. According to the Congressional Budget Office, in 2023, social, pension and healthcare programs accounted for 70% of US federal budget expenditures (excluding interest payments on government debt), and in 30 years this share will reach 75%.
The growing public debt and the increase in government bond rates put additional pressure on the budget. Interest payments on the US national debt have exceeded $1 trillion per year. Geopolitical risks and related defense and security costs, programs for the development and support of priority industry sectors (for example, basic infrastructure, green energy, chip manufacturing) further exacerbate the problem of budget deficits. The European Union, for example, is currently discussing an increase in defense spending worth EUR 800 billion.
Tax increases could help solve the problem of budget deficits and public debt. But governments avoid this in every possible way, trying to maintain their electoral support. As a result, many countries face an impossible fiscal policy trilemma, Vitor Gaspar, the director of the IMF’s Fiscal Affairs Department, notes. As they manage their finances, countries face three key policy pressures. To begin with, governments are under intense pressure to increase spending on defense, climate change, and much more. At the same time, they face strong public resistance to higher taxes. Finally, higher levels of public debt and higher deficits are threatening to put the public finances and financial stability of many countries at risk. It is virtually impossible to pursue all three choices at the same time. But they are under pressure to cut deficits and debt so they have to sacrifice something in the end.
A high and, more importantly, unstable level of public debt (we will define it below – editor) can create significant issues for the economy long before the insolvency of the government becomes obvious, and the risk of default or high inflation is imminent.
First, the growth of government debt threatens financial stability and increases the risks of a full-scale financial crisis. This was the case of Russia in 1998, when a default on government bonds triggered a financial and banking crisis that led to the closure of half of the top-10 banks. Today, the banking system and government debt are closely interrelated (see sovereign-bank nexus). Both commercial and central banks hold huge amounts of government bonds, which are generally considered risk-free and highly liquid assets. Even small doubts of investors about their reliability can create problems with liquidity and solvency for financial institutions. And in the case of a systemic banking crisis, heavy debt restricts the government's ability to provide guarantees and support the largest banks, which further increases the risks of crisis development.
Secondly, the high and unstable level of government debt may cause investors to fear that the government will try to solve the problem with increased inflation, the central bank will lose its independence and monetary policy will switch to fiscal dominance. These will raise inflation expectations. Central banks will either have to accept accelerating inflation, thereby reinforcing initial concerns, or respond by raising interest rates, which will slow down economic growth and increase the government debt service spending, further aggravating the debt problems.
Higher risk of inflation or default contributes to an increase in interest rates, which slows down private investment and economic growth, as well as increases the cost of servicing government debt. This will take up an increasing part of budget revenues, which could otherwise be allocated to more productive expenditures that support long-term economic growth, for example, to infrastructure or human capital financing.
How can we understand that a country's public debt is on an unstable path and may lead to defaults or high inflation in the future? Can Japan's current gross national debt of 250% of GDP, or the United States' 120%, be considered sustainable? And why do many developing countries often default on much lower debt, like Ecuador did in 2020 having a public debt of less than 65% of GDP? The matter is not just in the amount of debt.
Not all debts are the same. In many developing countries, a significant part of government debt is made up by foreign currency liabilities and with relatively short duration. Public debt of these countries often rises sharply following the devaluation of their currencies, complicating its refinancing and servicing even with its relatively low volume. In such countries, currency crises and sovereign defaults often go hand in hand, and their governments are forced to pursue pro-cyclical fiscal policies, drastically cutting spending or increasing taxes during economic crises.
Developed countries that are not members of monetary unions do not have this problem. They have large and liquid capital markets, their government debt is denominated in national currency, and its maturity is spread over decades. Servicing and refinancing such debt is usually not a major problem, as investor confidence and demand for safe assets are high, and interest rates are low. Therefore, developed countries have a much larger capacity to finance significant budget deficits during periods of serious economic crises, as was the case in 2008 and 2020.
Nevertheless, even developed countries can have problems because of high debt. Martin Larch, Head of Secretariat at the European Fiscal Board, uses the example of the EU to demonstrate how using public debt to solve current problems at the expense of future generations is already creating problems for the current generation.
The governments of developed countries, like everyone else, are bound by an intertemporal budget constraint: the current amount of public debt must be secured by current or future primary (i.e., net of interest payments) budget surpluses. At the same time, future surpluses are discounted based on the nominal interest rate on the debt: the further these surpluses are postponed into the future, the more they should be, because the debt accumulated during this time requires more and more interest payments.
If we recalculate this budget constraint for the level of public debt to nominal GDP ratio, then discounting future surpluses (as a share of GDP) will be based on the difference between the nominal rate and the growth rate of nominal GDP. Simply put, it is easier to maintain a stable level of public debt (relative to GDP), at which no major tax increases or spending cuts will be required in the future, given higher inflation or real economic growth rates and lower nominal interest rates on debt (for example, as a result of financial repression).
The traditional approach to assessing the sustainability of public finances is based on comparing the nominal interest rate on government debt (r) and the growth rate of nominal GDP (g). If the government debt rate is higher than GDP growth rate (r>g), then inflation and real economic growth will not be enough to offset rising interest payments. In this case, in order to maintain the same level of public debt as a share of GDP, the government will need to maintain a stable primary budget surplus. If nominal GDP growth rate is higher than government debt interest rate (r<g), then with a zero primary deficit, government debt as a share of GDP will decrease, because its increase due to interest payments is more than offset by inflation and real economic growth. In this case, the government even has the option of ‘enjoy now, pay later’, i.e. to constantly maintain a limited budget deficit without increasing the national debt in relation to GDP.
Olivier Blanchard noted that the abovementioned condition worked for the United States throughout the post-war period up to the 1980s. Rapid economic growth and inflation in the 1960s and 1970s, as well as the use of financial repression measures to curb nominal debt rates, significantly reduced the US public debt to GDP ratio. The situation was similar in many other advanced economies. The real interest rates were negative (i.e. nominal interest rates, including on government debt, being lower than inflation) there half of the time between 1945 and 1980, as it was shown by Carmen M. Reinhart, former Chief Economist of the World Bank, and M. Belen Sbrancia from the IMF in their research The Liquidation of Government Debt. The United States and Great Britain, for example, managed to reduce public debt by 2-3.5% of GDP per year.
The nominal growth of the US economy again went above nominal interest rates on government debt in the 2000s, especially after the financial crisis of 2008, when central banks of developed countries began to pursue a policy of zero interest rates. However, the public debt to GDP ratio continued to grow: at that time, the US budget deficits significantly exceeded the ratios needed for a safe ‘enjoy now, pay later’ option.
The traditional approach to sustainable public finances is linked to a number of issues. First of all, it is based on the assumption that investors view the government debt of developed countries as a risk-free asset. However, as shown, in particular, by Weicheng Lian, Andrea F Presbitero and Ursula Wiriadinata from the IMF, in countries with higher public debt to GDP ratios, the difference in nominal interest rates and nominal GDP growth rates is higher on average, and cases when this difference becomes negative are much less common. This may indicate that investors are beginning to demand a higher premium for the risk of default or inflation, and the ‘enjoy now, pay later’ option becomes much less possible.
In addition, this approach does not take into account the uncertainties associated with future fiscal policy, interest rates, inflation, and economic growth. Henning Bohn has shown in a series of papers that the sustainability of the national debt largely depends on fiscal policy after it dramatically raises due to shocks (wars, economic crises). If the budget balance then turns to surplus, it is easier to keep the public debt on a stable path. But if the government continues easing policies after the crises, then the debt level can easily go into the danger zone. Enrique Mendoza and co-authors from the IMF have demonstrated that countries with very high public debt have fewer chances to return to budget surplus after crisis events, and when a certain threshold is exceeded (according to their calculations, it is around 180-200% of GDP), a debt crisis becomes inevitable.
However, there are exceptions to this rule. The case may be significantly different for countries stuck in a liquidity trap, e.g. Japan: even with interest rates close to zero, it has very slow GDP growth and deflation. For these countries, there are more chances for the ‘enjoy now, pay later’ option, and an increase in budget deficit can be a boon even with an ultra-high level of public debt. Debt growth stimulates economic growth and inflation, leading to a decline in the public debt to GDP ratio, despite the increase in its nominal volume. For example, Atif Mian, Ludwig Straub and Amir Sufi have argued that for Japan, with its gross public debt of 250% of GDP, the chances for ‘enjoy now, pay later’ are significantly higher than for the United States, which has a much lower public debt (120% of GDP). For the US, a sustained primary budget deficit above 2% of GDP is a serious problem.
To sum up, high levels of public debt and persistent budget deficits pose a threat to the economy. However, when assessing the threshold beyond which a debt crisis becomes imminent, one should take into account specific features of a particular country.
