Public Debt and Its Pros and Cons
How to Tell When Its Too High
The public debt is defined as how much a country owes to lenders outside of itself. These can include individuals, businesses, and even other governments. The term "public debt" is used interchangeably with the term sovereign debt.
Public debt usually only refers to national debt. But some countries also include the debt owed by states, provinces, and municipalities. Therefore, be careful when comparing public debt between countries to make sure the definitions are the same.
Regardless of what it's called, public debt is the accumulation of annual budget deficits. It's the result of years of government leaders spending more than they take in via tax revenues. A nation’s deficit affects its debt and vice-versa.
U.S. Public Debt
The U.S. Treasury Department manages the national debt through its Bureau of the Public Debt. It measures debt owned by the public separately from intragovernmental debt. Public debt includes Treasury bills, notes, and bonds, which are bought by large investors. You can become an owner of the public debt by purchasing savings bonds and Treasury Inflation Protected Securities, also known as TIPS. Intragovernmental debt is the amount Treasury owes to some federal retirement trust funds, most importantly the Social Security Trust Fund.
On September 8, 2017, the U.S. debt surpassed $20 trillion. That makes the debt-to-GDP ratio around 104 percent. That's based on the most recent second quarter GDP of $19.2 trillion. But the public debt was a more moderate $14.6 trillion. That made the public debt-to-GDP ratio a safe 76 percent. According to the World Bank, the tipping point is 77 percent.
Perhaps that's why investors don't insist on higher interest rates. In fact, interest rates are still historically low. In order to understand why, one must be familiar with the U.S. Debt Crisis.
Public Debt Versus External Debt
Don't confuse public debt with external debt. That's the amount owed to foreign investors by both the government and the private sector. Public debt affects external debt, because if interest rates go up on the public debt, they will also rise for all private debt. That's one reason businesses pressure their governments to keep public debt within a reasonable range.
When Public Debt Is Good
In the short run, public debt is a good way for countries to get extra funds to invest in their economic growth. Public debt is a safe way for foreigners to invest in a country's growth by buying government bonds.
This is much safer than foreign direct investment. That's when foreigners purchase at least a 10 percent interest in the country's companies, businesses, or real estate. It's also less risky than investing in the country's public companies via its stock market. Public debt is attractive to risk-averse investors since it is backed by the government itself.
When used correctly, public debt improves the standard of living in a country. That's because it allows the government to build new roads and bridges, improve education and job training, and provide pensions. This spurs citizens to spend more now instead of saving for retirement. This spending by private citizens further boosts economic growth.
When Public Debt Is Bad
Governments tend to take on too much debt because the benefits make them popular with voters. Therefore, investors usually measure the level of risk by comparing debt to a country's total economic output, known as gross domestic product. The debt-to-GDP ratio gives an indication of how likely the country can pay off its debt. Investors usually don't become concerned until the debt-to-GDP ratio reaches a critical level.
When it appears the debt is approaching a critical level, investors usually start demanding a higher interest rate. They want more return for the higher risk. If the country keeps spending, then its bonds may receive a lower S&P rating. This indicates how likely it is the country will default on its debt.
As interest rates rise, it becomes more expensive for a country to refinance its existing debt. In time, more income has to go toward debt repayment, and less toward government services. Much like what occurred in Europe, a scenario like this could lead to a sovereign debt crisis.
In the long run, public debt that's too large can act like driving with the emergency brake on. Investors drive up interest rates in return for greater risk of default. That makes the components of economic expansion, such as housing, business growth, and auto loans, more expensive. To avoid this burden, governments must be careful to find that sweet spot of public debt. It must be large enough to drive economic growth but small enough to keep interest rates low.