National debt refers to the total of all debts owed by the government of a country. It mostly comes from bonds and other debt securities, but can also be from direct borrowing from international institutions such as the World Bank.
Classifications of National Debt
National debt can be classified in various ways, such as listed below:
National debt can be issued by different levels of government from federal to municipal. The risk profile of the debt depends on the issuer. Municipal and provincial debt is deemed riskier than federal debt.
Just like other kinds of debt, national debt also has different term lengths. Most national debt have a long maturity, and typically the yield on 10-year federal government bonds is considered the prevailing risk-free rate.
3. Method of Repayment
The method of payment refers to the source from which repayment is derived. Typically, taxes are used to repay government debt, but repayments can be derived from a specific source, such as tolls, if the debt is used for the construction of a highway.
National debt can be held either by citizens or foreigners. The debt held by citizens is in the local currency, while the debt held by foreigners is typically in the foreign currency. This adds an element of foreign currency risk hence, the risk of default is much lower for the debt held by citizens.
Debt vs. Deficit
National debt should not be confused with deficits. A deficit is created, when in a year, the expenditure of the government exceeds its revenues. To fund the deficit, the government may issue debt, sell assets, or raise taxes. Hence, the deficit is not equal to debt, but it will add to the national debt if financed by debt.
Instruments and Mechanics of National Debt
National debt is issued mainly through two instruments:
Government bonds are issued in the local currency by the central bank of the country. The government borrows money from the central bank, and then the central bank auctions these bonds to the public via selected financial institutions. These bonds are tradeable and have a liquid market. Common examples of government bonds are the U.S. Treasury Bills, British Gilts, German Bunds, Japanese Government Bonds (JGBs), etc.
Governments can also raise funds via loans from commercial banks. These are syndicated loans extended to national governments. Unlike bonds, they are not tradeable, but there might be derivative instruments – like credit default swaps – linked to the performance of these loans.
There are clear procedures laid down for the settlement of government debt. The Bank for International Statements (BIS) is the international body that makes the rules and administers the settlement of national debt. In the case of a default, the rules are not clearly defined. They are dealt with using laws of default pertaining to specific countries.
Typically, national debt is restructured, and some restrictions are placed on government expenditures. The main reason behind restructuring is that the government must continue to function even if it cannot service its debt.
Economic Policy Consequences
The use of national debt comes with consequences for economic policymaking. Two arguments define the impact of national debt on the economy and whether it should be used:
1. Ricardian Equivalence
Ricardian equivalence refers to the equivalence in the use of debt or taxes to meet the financing needs of the government. The argument is as follows – if the people know that using debt today will translate to more taxes in the future, then there is no difference in using debt or taxes.
The policy assumes that the use of debt is the same as taxes. The problem here is that the degree to which people realized this fact is unknown and hence, the equivalence cannot be used to decide the mix between debt and taxes.
2. Crowding Out Effect
The crowding out effect is the impact of increased government spending using debt. The argument is as follows – when the government issues more debt, it uses monetary resources that could’ve been used for private investment.
The practice increases the interest rate for other borrowers, and hence, reduces the investment done by the private sector. It runs counter to the idea that government spending can be used to stimulate and grow the economy. Therefore, there is a possibility that the use of debt can harm the economy.
National Debt Measures and Statistics
There are various measures of national debt that are reported by organizations like the International Monetary Finance (IMF) and the Federal Reserve. Some examples of the measures used for national debt are:
Central Government Debt: The stock of debt issued by the central government of a country. It is reported either as an absolute amount or as a percentage of GDP.
General Government Debt: The stock of debt issued by all levels of government in a country, which includes provincial and municipal debt.
Non-Financial Public Sector Debt: The amount of debt that non-financial public sector corporations hold. The debt is often guaranteed or considered to be guaranteed by the government.
Financial Public Sector Debt: The amount of debt issued by government-owned financial institutions like public sector banks.
The following map is based on IMF data on public debt held by various counties as a percentage of GDP: