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Many countries keep a national debt over 50% of their GDP every year, including first world countries. They owe each other and also to banks, companies and households.

As I understand, it wouldn't make sense for an individual or company to make new loans every year to pay old ones. That would constantly leak their wealth to interest.

When countries do it, doesn't it result in moving wealth from the general population (tax payers) to the wealthiest (companies/households with the most money available to invest)?

What are the legitimate reasons for countries to do that?

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    I actually like this question a lot, because there's both a political and an economic answer to it. +1 – Avi Sep 9 '15 at 0:57
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    For a company there is an optimum amound of debt it should have at any moment given the interest rate and the company's income. It is wrong to say that it is always better to take no loans. – Anixx Sep 11 '15 at 16:42
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This question can be answered in two ways. The first way is to examine politically why countries often run large deficits. A nation's debt grows when its revenues are less than its expenditures; to be able to fill the gap, it has to borrow the money. It can reduce the amount it borrows in one of two ways. The country can either raise revenues or decrease its expenditures.

Both of these options can be met with political opposition. At least in the short term, it's usually not pleasant for people who have to pay more taxes, or who were receiving benefits and then lost them. As those are the means by which you can avoid a budget deficit, countries may be politically locked into taking on more debt.

However, there are also valid economic reasons why a country might want to run a deficit. Specifically, if the cost of borrowing is lower than the amount of money the country can make by investing, then a country can use that debt to finance growth.

Let's say, for example, that a country wants to fund a large infrastructure project, but doesn't have a way to feasibly raise the money internally. The IMF estimates that recent fiscal multipliers for government spending have been about 1.6, meaning that every dollar the government spends increases the size of the country's economy by $1.60.

An increase in GDP means an increase in revenue, as a lot of that economic activity will probably be taxed. This means that, if the country can borrow at a low enough rate, it may end up profiting off of having borrowed money (and, as a bonus, will have new and well-maintained infrastructure).

Of course, for most countries, that can only continue in moderation. If a country borrows more than it can reasonably pay back, then interest on its debt might rise. If it does, then that country would have to see a lot more growth from its expenditures to make borrowing profitable, and that could be more than it can actually achieve.

But in the case of the United States, interest rates are below inflation, meaning that borrowing money is of no cost; because of this, it's very easy to increase revenues with debt-financed stimulus. So, aside from austerity measures being politically unpopular, countries can have rational economic motives for borrowing money when they believe that they will be able to use that money to increase the size of their economy faster than they are acquiring debt.

  • The first thing you mention (to be locked into taking debt), I believe it to happen but as a result of badly planned actions that led into being locked that way. So mustn't be the main reason for most countries. – Vituel Sep 9 '15 at 14:42
  • The second (to grow and profit more than the borrowing price) is what I suspected to be the main reason. Now I'm curious to find the numbers that support this, something like revenue increase vs debt interest along the years. – Vituel Sep 9 '15 at 14:42
  • The third one is quite interesting. I wouldn't have believed it (negative real interest rates) to happen because it sounds like the investors are losing money, but the Wikipedia link explains it. And this can explain the whole debit by itself in the case of the US. – Vituel Sep 9 '15 at 14:43
  • @Vituel it's possible that a program can be funded more easily when it began than it is now (see: Social Security), so it's not necessarily bad decision making. I gave you an IMF link that recent fiscal multipliers have been 1.6, but if you want, I can provide you more links on the subject of debt-financed stimulative spending. – Avi Sep 9 '15 at 22:51
  • Nice answer very clearly stated! – Joze Sep 10 '15 at 9:11
8

You write “As I understand, it wouldn't make sense for an individual or company to make new loans every year to pay old ones” but that's incomplete in many ways.

It's indeed a bad idea for an individual to make new loans to pay old ones. That's because they have a finite lifetime, limited use for the money (mostly, individuals build up debt to move consumption in time or simply because they can't meet obligations but they will have to get money through other means to repay it) and because they would quickly have deteriorating credit and pay a lot of interests.

Companies by contrast certainly can do that profitably, as long as they can find investments that are more profitable than the cost of the debt. And, as long as there is a healthy financial market and the debt remains manageable, there are actually accounting reasons why it's a bad idea for a company to be entirely debt-free.

States are in an even better position to borrow money. They exist essentially indefinitely and provide very strong guarantees because their future income stream (i.e. taxes) is even less likely to disappear than a company's. That's why many (but by no means all) states can currently finance themselves at very low interest rates, which incidentally shows that a debt of 50 or even 100% or more of GDP isn't actually that “large” compared to a state's future ability to pay.

(Note that public debt is conventionally expressed as a percentage of GDP because the absolute value would just reflect the size of the country but there is nothing “magical” about 100% or any other threshold, it's just a way to scale the number. Some states have or had at some point in history much larger debts than that.)

Importantly, a state, especially in a large and moderately open country (but not in a tiny wide open economy like say Luxembourg), is also in a very different position than an individual or a company because it can actually influence the whole economy. When an individual spends less, there is no reason why it would impact their income and they simply end up with more money, which can be used to reduce debt.

Not so with a state. When it spends less, it means that it pays less money in wages, subsidies, etc. and a state is big enough that it could depress an entire economy and ultimately damage the state's own revenue (i.e. taxes). Conversely, it means that if the economy is depressed, spending more can jumpstart activity and result in increased tax revenues which both reduces the deficit and makes the total debt lower relative to a growing economy. The feedback effect is so strong that you can't think correctly about public debt through analogies with personal debt.

This is important because it means that in some conditions (I am certainly not suggesting states can always borrow and spend arbitrary amounts of money), building more debt and spending the money can profit everybody and the state itself, even if it's used for something that sounds completely unproductive (Keynes' proverbial burying of old notes to let people dig them up again). It's not even necessary for the debt to fund things that will increase productivity and ultimately create wealth in their own right like infrastructure projects.

Finally, debt issued by the state has some useful functions in the financial sector. Banks and other investors currently have a lot of money which they don't know how to use and there are technical reasons why it can be useful to offer them something to do with it. That's another, even less intuitive reason for states to borrow money.

Of course, that does not mean that deficit spending or, conversely, attempts at reducing the debt through reduced spending are motivated by a clear understanding of all this. Ulterior motives and political expediency obviously play a big role and not only on the spending side of the equation.


Also, technically, countries issue new debt because they need the money to meet obligations (pay something or roll over some old debt). Of course, they often need to borrow money because the budget is not balanced but that's not something you can control that easily.

That's an important distinction because states cannot directly act on the budget or simply decide that they don't want more debt. What they can do is make decisions on spending and taxes but the resulting budget outlook also depends on interest rates and economic growth (and the state's own ability to carry out its decisions, which is not always trivial). An extreme example of that would be Greece in recent years. It performed massive cuts with an explicit goal of balancing the budget and reducing debt but it ended up needing even more money.

  • I like how you corrected me very didactically, specially that it may be even a bad idea for a company to be debt-free (when they're missing an opportunity to grow, and that's faster than the interest). – Vituel Sep 9 '15 at 16:41
  • Now it would be nice if we found evidence that governments are actually doing that. Something like comparing revenue increases with the interest paid over the years. But I'm not sure it's that easy. Given a low increase we might claim the loan was good because it saved them from a decrease. Or conversely, that an increase wasn't caused by the loan, it would have happened anyway. – Vituel Sep 9 '15 at 16:42
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    @Vituel Well, they do, to some extent, it's what studies about the multiplier are about for example, and governments increasingly have experts groups making projections based on that. But like I said, it does not mean policy is always driven by these considerations. They can also do the right thing for the wrong reasons or have no idea what they are doing ;) – Relaxed Sep 9 '15 at 16:56
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In addition to the excellent answer by Relaxed, I would like to point out that in some countries, particularly, the US, all issued paper and metal money are accounted for as loans from the central bank to the government. So the more money the state had printed, the more "debt" it has before its own central bank.

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Your question presupposes there are indeed "reasons" for the way a country behaves. While that may be true in some realms, I certainly have never seen any evidence that this is true in terms of economics. Nation state behavior is better thought of as the fault line where competing interests meet. No one plans on running a particular economic model, it's the compromise that remains when opposing sides duke it out to exhaustion.

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    Your answer appears to be very shallow. It could be improved a lot by explaining what these competing interests are and why the result is usually a deficit spending. – Philipp Sep 9 '15 at 14:10
  • If you say so. The question says "purpose for a country to maintain a large public debt" then links that with the modifier "reasons". This implies that large public debt is part of an intentional scheme. i.e. a roads bill has a "purpose" of creating roads, and building roads is the "reason" a bill to build a highway is created in a democracy. High debt isn't a result of intentional action, and therefore there is absolutely no REASON for a high debt, it is the result of on unintended consequence, and therefore has no PURPOSE. Better to ask the MECHANISM than creates the debt. – Jim Maguire Sep 15 '15 at 1:53

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