How bad is an increase in debt/GDP really?

As government debt exploded in 2020 to fight the economic fallout from the pandemic, investors are once again getting worried about rising debt/GDP ratios and what that means for a government’s interest cost and, ultimately, our taxes. Well, if you live in a major industrialised economy, like the United States, the UK, or most of the Eurozone, the answer is simple: not much.

First, let’s look at the distribution of sovereign credit ratings for advanced economies (AE) and emerging economies (EMDE) as a function of gross debt/GDP ratios below. What you should notice is that for advanced economies the relationship between credit rating and debt/GDP is almost flat. There are several countries with gross debt/GDP above 200% and still a pretty solid investment grade rating of A or better. For an emerging market, that is unheard of. If an emerging economy has debt/GDP ratios of 100% or more it is typically placed in the junk categories.

Credit ratings as a function of gross debt/GDP

Source: IMF.

An advanced economy with a lower investment grade rating (e.g. Spain, Italy, Portugal) that sees its debt/GDP ratio increase by 10 percentage points has a c. 5% higher probability of being downgraded a notch or two. A study by the IMF reports that on average, a 10 percentage point increase in debt/GDP equates to a downgrade by half a notch. Meanwhile, countries with high investment-grade ratings like the United States, the UK, Germany, or France can increase their debt/GDP ratios by 10 percentage points and on average experience a 3% higher probability of a downgrade or an average downgrade by one-quarter notch. In other words, increasing debt/GDP ratios by 10 to 20 percentage points, as we are doing in 2020 and 2021 is not going to make any difference to our sovereign credit ratings and our long-term funding costs.

Of course, bond yields may go up while credit ratings stay the same as many Eurozone countries have experienced in the Eurozone debt crisis, but with the introduction of Eurobonds this summer, the Eurozone has now a reliable mechanism to avoid a repeat of the Eurozone debt crisis. And if a country has its own currency like the UK or the United States, then the impact of an increase in debt/GDP ratios on interest costs are miniscule anyway. Yes, if a country increases its debt levels it will in the first instance experience higher rates both for the safe short-term rate of interest and the long-term rate of interest. 

However, Olivier Blanchard has rightly pointed out the flaws in this argument in his 2019 speech to the American Economic Association (a non-technical version is available here and should be mandatory reading for everybody who is concerned about high debt levels):

• In the long run, there is little evidence that higher debt ratios lead to higher long-term rates. Just look at the last 30 years when debt/GDP ratios in the United States, the UK, etc. increased at the fastest pace since the end of the Second World War yet long-term interest rates have declined to the lowest levels ever.

• If you want to go to the extremes, then look at Japan, a country with a debt/GDP-ratio of more than 200% a credit rating just one notch below the rating of the UK, and a 10-year government bond yield of zero.

• As central banks continue to engage in QE, they will keep long-term interest rates very low and act as a buyer of long-term government debt at low rates in order not to reduce economic growth.

In short, there is little to no evidence that higher debt levels in advanced economies lead to a sustained increase in the cost of debt and zero evidence that it leads to higher taxes.

Instead, as Blanchard argues, advocates against debt financing often think that all debt is created equal. But there are good and bad deficits. Deficits are good if they are used for investments like infrastructure that enable economic growth. And deficits are bad when they are created due to tax cuts or to fund overly generous social safety nets. In these cases, the money spent by the government does not create additional economic growth in the future and the money is essentially lost.

Thus, instead of being constantly worried about rising government debt, let’s focus on how the money is spent. If it is spent wisely to foster economic growth, there is no problem. And if you don’t like how your current government spends the money or think they are spending it unwisely, you can always lobby against these policies and vote them out of office at the next opportunity.