Using a data set on government debt that was previously unavailable, the article analyzes
who bears the burden of government debt. The database includes 12 countries with both
debt and GDP data on the countries stretching back over a century. The paper shows
that in addition to the level of the Debt/GDP ratio, anticipated future changes in this
ratio, as well as the interest cost of covering the debt are important variables affecting
the economy. Most nations have seen their government debt/GDP ratio exceed 100%
in the past, but not all have sparked a financial crisis. The impact of the government
debt/GDP ratio also depends upon the causes, whether the increase is short-term due
to war or economy fluctuations, or secular due to unfunded increases in government
spending. Reducing the Debt/GDP ratio is a political decision. The government must
decide to reduce it by reducing compensation to government employees, recipients of
government funding, through higher taxes, or an outright or inflationary default.
The current economic recession has led to
unprecedented peacetime deficits and increases in
government debt in developed countries. For only
the second time in the history of the United States,
government debt will soon exceed GDP. The long-run
costs and the impact of this growing debt remains
highly uncertain and is the chief topic of political
debate in the current US elections. While the White
House says these deficits are necessary despite the
costs, others say the debts impose costs on future
generations. Tea Party supporters say government
expenditure must be cut.
Unfortunately, very little is known about the historical
levels of government debt for different countries of the
world outside of the United States and how different
countries have dealt with large levels of government
debt in the past. Global Financial Data has collected
historical government debt and GDP data for the
major world economies going back to the 1800s. This
paper is based upon the findings of this research.
The government runs a deficit because it is unable or
unwilling to collect a sufficient amount of taxes within
any given year to cover its expenditures. For most
of its history, the United States balanced its budget
except in war time. After the war, the government
ran surpluses to pay down the debt accumulated
during the war or ran deficits less than the growth in
nominal GDP. A long-term graph of US debt shows rises in the Debt/GDP ratio during the War
of 1812, Civil War, World War I, and World War II.
The true cost to the economy of government is
the expenditures it makes, not the taxes it collects.
Government can either collect taxes today or issue
promises (currency or bonds) to pay for its purchases
in the future. When the government increases the
money supply, it can cause inflation, and if it issues
bonds, it can “crowd out” the private sector.
Running deficits implies less spending in the future
since the government must pay interest or retire
bonds. In some cases, short-run deficits can be
justified. Just as consumers or businesses may wish
to smooth out the cost of consumption over time,
so can the government. If the government is building
infrastructure which has long-term benefits, it may
borrow money today to be paid off in the future.
Similarly, the government may run a cyclical deficit
during a recession which it can pay off when the
Structural deficits are another matter. A structural
deficit that is used to pay for services or transfer
income, unlike capital investment, does not add to
the net wealth of society, and implies higher taxes
or lower government services in the future to offset
the accumulated structural deficits. As Robert Barro
has shown, these types of structural deficits can have
multipliers less than one because of their impact on
incentives and the economic misallocations they
create. Unfortunately, a portion of the current deficit
the US is running is structural in nature.
A structural deficit implies structural adjustments
in the future; however, it may be difficult to generate
the future surpluses needed to pay off this debt for
demographic reasons. An aging population implies
both a higher recipient to taxpayer ratio and higher
healthcare costs for the elderly. Calculations of
the implied cost of the entitlement programs the government has promised in the future, such as Social
Security, Medicare, Medicaid and other programs,
predict large increases in these costs in the future
without large reductions in the promised benefits.
Any attempt to run surpluses to pay back the debt
will require large increases in taxes.
Paying off the debt is largely a political choice. Who
bears the cost of paying off the debt? Is it government
workers through lower pay and lower benefits? Is
it individuals who see a reduction in government
services or entitlements, either directly through cuts
or indirectly through slower growth in benefits?
Is it taxpayers who pay higher taxes and fees? Are
the additional taxes born by the rich or the poor or
both? Is it bondholders who get paid back in inflated
currency or don’t get paid back at all?
Government debt as a share of GDP can be reduced
or eliminated in a number of ways.
Just as the purpose of running a deficit is to hide the
cost of government services and expenditures through
indirect taxation (inflation tax) or delaying the costs
(issuing bonds), so the goal of the government in
paying down the debt will be to make the cost as
indirect as possible, or to impose the costs on those
without political power.
The rest of this paper will look at the experience of
twelve major economies to see how they have created
and paid off deficits in the past. Each country’s
experience could be the subject of a book, so only
the barest of outlines is possible. Nevertheless, these
brief histories and their subsequent graphs will give
an idea of the choices the major developed countries
now face. We will look at both the debt/GDP ratio and
Interest Share of GDP which equals the benchmark
bond interest rate times the debt/GDP ratio.
Historically, there have been several factors which
have caused increases in the debt/GDP ratio. One is
war. Globally, the primary examples are World War
I and World War II. The two wars were “paid for”
Most governments used inflation to reduce the cost
of debt accumulated during World War I and in
Germany even used “inflationary default” as a way
of eliminating the debt, wiping out bondholders
completely. In the United States during World War
II, government controlled prices and interest rates
which produced a higher return of principal in real
terms, but lower interest rates to investors. The debt
was paid off by allowing economic growth to shrink
the deficits. On the other hand, inflation in Italy and
France wiped out their debt after World War II while
Germany used a Currency Reform to eliminate its
Major recessions and depressions also increased
government debt, the Great Depression of the
1930s and the current Great Recession being prime
examples. Governments tend to grow their way out
of the deficits generated by recessions. Wars and
Recessions provide quick increases in government
debt which can be reversed over time.
The final source of government deficits is the attempt
to increase government benefits and entitlements
faster than people are willing to pay for them. These
deficits are secular in nature and generally require
a restructuring of government expenditures and
obligations to stop the accumulation of debt. Because
of their structural nature, an outright or inflationary
default is unlikely to work. Those who fear the current
deficits will lead to inflation miss this point. Because
of the politics involved in making these structural
adjustments, reversing structural deficits is the most
difficult of all.
Lenders are willing to tolerate deficits due to War and
Recessions because they are temporary events that can
be followed by surpluses after the cessation of war or
a return to growth. Deficits that occur due to secular
increases in government services that cannot be
immediately reversed will inevitably lead to a financial
crisis that ends in the repeal of these services.
The current growth in government debt is both
structural and cyclical. Many people feel that once
the government debt/GDP ratio exceeds 100%, a
financial vurred. Unfortunately, history shows that
governments have to be forced into a crisis to solve
these problems, rather than addressing them before
the crisis occurs.
Australia saw its Debt/GDP ratio rise steadily from 1850
to 1900 when it established itself as a Commonwealth.
By 1900, the Debt/GDP ratio was over 100%. It rose
above 100% again during World War I and peaked at
almost 200% of GDP during the Great Depression.
Significantly, the World War II Debt/GDP peak was
below the Great Depression peak, though still over 180% of GDP. Since World War II, Australia has
grown out of its Debt, which now represents less than
10% of GDP placing it in one of the most fiscally sound
positions of any developed country.
Australia was able to increase its Debt/GDP ratio
through 1900 because it was a growing colony. It
could borrow money in London with little problem.
As it grew, Australia moved its debt burden from
international to domestic borrowers and has now
almost completely eliminated the foreign debt
portion of its government debt. Australia borrowed
as it developed its economy, and has grown out of its
debt successfully with few periods of high inflation.
Returns to fixed income investors in Australia have
been high as a result.
Unlike Australia, Canada kept its government debt
relatively low until World War I, at which point
it rose to 70% of GDP. The debt rose to over 80%
of GDP during the 1930s and peaked at over 150%
during World War II. The debt declined steadily
until the 1970s. Canada reached a debt crisis in the
1990s when secular increases in government services
and entitlements pushed debt to over 70% of GDP
and the interest cost to over 6% of GDP. Even during
World War II when debt exceeded 150% of GDP, the
“interest cost” of the debt was only 4% of GDP.
The increase in government debt was clearly unsustainable.
The Canadian government was forced to cut
back on its spending to eliminate its deficits. Consequently,
because Canada put its government finances
in order in the 1990s, it has suffered less during the
current Recession than other developed countries.
France saw rising deficits during the 19th century
until it reached 100% of GDP by 1900. Most of
this increase occurred after 1870 when Germany
imposed a costly indemnity on France as a result of
the Franco-Prussian War. Consequently, when World
War I began, France’s Debt/GDP ratio exceeded 80%
(vs. 3% in the US). Despite inflation during World
War I, France’s Debt/GDP ratio rose to over 200% by
the early 1920s. Because of this debt, it is no wonder
France wanted to impose a large indemnity on
Germany when Germany lost World War I.
By the beginning of World War II, France’s Debt/
GDP ratio was down to 100% but shot over 200%
during World War II. With no prospect of an
indemnity from Germany after World War II, France
inflated its way out of its debt imposing heavy losses
on bondholders, but to the benefit of taxpayers. This
laid the foundations for France’s rapid growth after
World War II. Despite the fact that France’s Debt/
GDP ratio has grown since the 1970s, it has not
reached crisis levels due to high tax rates.
What is important to see about France is that after
almost three decades (1915-1945) of having taxpayers
bear a high debt cost, the government finally punished
bondholders through an “inflationary default”.
Today, this would be more difficult to do because
debt is issued in Euros rather than Francs or another
local currency, and, as we have seen with Greece, the
Euro countries will help countries that could default
on their debt because of the costs of the default
contagion effect. Nevertheless, there is no guarantee
that a country such as Greece couldn’t remove the
Euro strait jacket, abandon the Euro, convert its debt
into Drachmas and inflate its way out. This possibility
is what keeps Greek debt at its current high yields.
The graphs for Germany are deceiving because there
are key periods, during World War I and World War
II, when data on Germany’s debts are unavailable.
Germany inflated its way out of its debts from
World War I through hyperinflation, wiping out
bondholders. In 1948, Germany used a currency
conversion from Military Marks to Deutschemarks
to effectively reduce its debt obligations by 90%.
In part, because Germany twice destroyed the assets
of bondholders, it has been more fiscally responsible
then other countries since World War II. Although
its Debt/GDP ratio has been rising since the 1970s,
it remains lower than most other countries. Holders
of Confederate and German bonds know that if you
lend to the losing side of a war, bondholders can be
Although Italy has had a long history of running deficits, its Debt/GDP ratio has rarely exceeded 100% of GDP by a large margin. Like France, Italy inflated its way out of its debts after World War II, imposing large losses on bondholders. Unlike France, it consistently ran budget deficits after World War II and used inflation as a way of minimizing the true cost. In the 1990s it reformed its finances to stop the Debt/GDP ratio from growing more and upon joining the Euro benefitted from lower interest rates cutting the Interest Coverage Cost of its debt to more realistic levels. Significantly, despite its high Debt/GDP ratio, the yield on its government bonds has not risen as steeply as those of Ireland, Portugal, Greece and Spain.
The lesson for Italy is that persistently high deficits impose persistently high costs on investors even if the debt never hits ruinous levels. Because Italy has persistently refused to balance its budgets, it has provided the worst returns of any G-7 country to both equity and fixed income investors. This is because Italy has had consistently high inflation, yielding low or negative interest rates at the expense of bondholders.