The National Debt: Fiscal Sustainability and Fiscal Rules
The budget deficit is a flow: the amount by which government spending exceeds tax revenue in a single year, which must be financed by borrowing (issuing government bonds, known as gilts in the UK).
Before you start
Make sure you're comfortable with these topics first:
Method
- Distinguish the deficit, a flow measured over one year, from the debt, a stock representing the accumulated total owed.
- Distinguish a cyclical deficit, caused by the automatic stabilisers during a downturn and expected to shrink automatically as the economy recovers, from a structural deficit, which persists even at full employment (trend) output and requires a deliberate policy change to close.
- Explain how the debt-to-GDP ratio changes over time: it tends to rise when the deficit as a share of GDP exceeds the rate of nominal GDP growth, and tends to fall when nominal GDP growth exceeds the deficit ratio, or when the government runs a surplus.
- Explain the purpose of a fiscal rule, e.g. a target for debt to be falling as a share of GDP within a rolling period, or for day-to-day (current) spending to be covered by tax revenue, borrowing only to fund investment.
- Explain the risks of a high or rising debt-to-GDP ratio: higher debt interest payments create an opportunity cost by crowding out other government spending, and if investors doubt the government's ability to repay, they may demand a higher interest rate (yield) on new borrowing, reducing the government's fiscal space to respond to future shocks.
- Evaluate by considering what the borrowing was used for (investment that raises future growth and tax revenue versus current spending that does not), who holds the debt (domestic versus foreign holders), the relationship between the interest rate paid on debt and the economy's growth rate (if growth exceeds the interest rate, the debt-to-GDP ratio can fall even while the government continues to borrow), and the economic and political costs of the spending cuts or tax rises needed to meet a strict fiscal rule.
Worked example
At the start of the year, a country's national debt is 2,600 billion pounds and its GDP is 2,700 billion pounds. During the year, the government runs a budget deficit of 100 billion pounds, adding this to the national debt, and nominal GDP grows to 2,800 billion pounds. Calculate the debt-to-GDP ratio at the start and end of the year, and state what happened to it.
- Calculate the debt-to-GDP ratio at the start of the year: 2,600 / 2,700 x 100 = 96.3% (to one decimal place).
- Calculate the new level of debt at the end of the year: 2,600 + 100 = 2,700 billion pounds.
- Calculate the debt-to-GDP ratio at the end of the year: 2,700 / 2,800 x 100 = 96.4% (to one decimal place).
- Compare the two ratios: 96.3% at the start and 96.4% at the end.
- Conclude: the debt-to-GDP ratio was almost unchanged, rising only slightly, because nominal GDP growth (from 2,700 to 2,800 billion pounds) was almost large enough to offset the extra borrowing, illustrating that a growing economy can absorb continued borrowing without a rapidly rising debt ratio.
Practice questions
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Q1Define the national debt.Show answer
Answer: The total accumulated amount a government owes, built up from the sum of past budget deficits minus any surpluses.
Q2Define a budget deficit.Show answer
Answer: The amount by which government spending exceeds tax revenue in a given year, which must be financed by borrowing.
Q3Distinguish a cyclical deficit from a structural deficit.Show answer
Answer: A cyclical deficit arises temporarily from the automatic stabilisers during a downturn and tends to correct itself as the economy recovers; a structural deficit persists even at full employment output and needs deliberate policy action to close.
Q4A government's debt is 1,800 billion pounds and GDP is 2,000 billion pounds. Calculate the debt-to-GDP ratio.Show answer
Answer: 1,800 / 2,000 x 100 = 90%.
Q5What is a fiscal rule?Show answer
Answer: A self-imposed target that constrains government borrowing or debt, such as a commitment to reduce debt as a share of GDP within a set period.
Q6Explain in one sentence why higher debt interest payments have an opportunity cost.Show answer
Answer: Money spent servicing existing debt cannot be spent on public services such as health and education, or used to cut taxes.
Q7Give one reason why a rising national debt might not be a serious problem if the economy is growing quickly.Show answer
Answer: If GDP growth is faster than the interest rate paid on the debt, the debt-to-GDP ratio can fall even while the government continues to borrow.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain the difference between the budget deficit and the national debt, using a numerical example.
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Evaluate the view that a rising national debt is always a serious problem for a government.
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