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The Dartmouth
May 27, 2024 | Latest Issue
The Dartmouth

Anand: The Case for Reducing Government Debt

In the face of rising interest rates, a sharp reduction in government debt is imperative.

In recent years, debt has become a key global strategy to address economic crises, from the Great Recession to COVID-19. However, rapidly rising interest rates across the world threaten to bankrupt indebted countries. In order to avoid the growing risks of debt, governments must take action now.

For the past three decades, low interest rates have prevailed across both the developed and developing world. Interest rates on government bonds — a proxy for the interest rate on government-issued debt — have fallen in the U.S., Germany, U.K., Canada and Japan since the 1990s, with the federal funds rate — a crucial benchmark interest rate for the U.S. and much of the developed world — declining from 8% in 1990 to near-zero levels. Similarly, average mortgage rates in the U.S. have also been declining, with a decline from a high of 18% in 1980 to below 6% prior to 2022. 

Just as low interest rates encourage us to take on debt to purchase houses and cars, they enable governments to take on high levels of debt with minimal cost. This debt has been used to cover the expenses of growing militaries, infrastructure projects and a variety of other beneficial public investments across the world — the expenses for which were much larger than government revenues. Who bought this debt? For the U.S., it was foreign governments and investors, U.S. citizens and government-affiliates, like the Federal Reserve or Social Security.

In this low-interest environment, highly indebted countries such as the U.S. or Japan were simply able to issue new debt to cover the repayment of old debt. In other words, these countries have been able to consistently rollover their debt with little to no negative repercussions. In fact, although the U.S. debt-to-GDP ratio has risen dramatically over the past decade (from 96% in 2011 to 137% in 2021), interest expenses on debt have only increased from $454 billion in 2011 to $575 billion in 2021, a relatively small increase given the large expansion of debt. If global interest rates remained low in the future, indebted countries around the world would face few challenges in servicing their growing debt burdens.

Any increase in global interest rates, however, will make existing debt much more costly for the world. The Committee for a Responsible Federal Budget estimates that a 1% increase in the interest rate would increase U.S. interest expenditures by roughly $225 billion. For developing countries, a rising interest rate could lead to widespread economic instability and defaults on debt. Poorer countries such as Argentina and Pakistan are already suffering from higher commodity and oil prices caused by the Russian invasion of Ukraine; higher interest rates on their debt to foreign investors would add fuel to the fire.

There are signs that interest rates are beginning to rise from their ultra-low levels. As countries across the world seek to tame inflation caused by supply chain disruptions, COVID and excessive stimulus, central banks from Canada to Australia are raising benchmark interest rates aggressively. Adjusted for inflation, the interest rate on 30-year U.S. treasury securities — another proxy for the interest rate on government-issued debt — have climbed from negative levels to around 1.6%. The 30-year U.S. mortgage rate has risen above 6% after a decades-long decline.

Other than central bank rate hikes, there are other factors that threaten to push up interest rates. As China builds out a solid government safety net, its citizens may see a lesser need to save, depressing the global availability of capital and boosting interest rates. Furthermore, if people begin to expect inflation to persist far into the future, investors may begin to demand higher rates on government debt to compensate for the value of their future interest payments being eroded by rising prices.

Even if interest rates do not rise, increased government debt still has negative effects on the global economy. When the government takes on high levels of debt, they compete with businesses who also want to borrow capital. In other words, government debt can crowd out and stifle private investment, leading to slower economic growth. Separately, government debt can also cover the expenses of inefficient projects or excess spending that generate inflation, not unlike the excessive COVID stimulus spending in the U.S.

Moreover, high levels of debt prevent countries from having effective responses to future crises. Investors are less likely to lend money to already indebted countries in a crisis, as the risk of default is much higher than that of a country with relatively low debt. This is especially true for developing countries, which are often seen as lacking financial credibility. Investors favor putting money into the debt of wealthy countries such as the U.S., which are generally perceived as safer investments.

Thus, given that higher interest rates are likely to persist, governments around the world should be focused on slowly reducing their debt by decreasing expenditures. Following the massive increases in government spending and debt during the 2008 financial crisis and COVID pandemic, running budget surpluses should be prioritized. In the case of rising interest rates or another economic crisis, lower debt levels will be crucial to securing economic stability and prosperity.