What is government debt – and how is it paid back?

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Simon Read, Senior Writer, Formative Content

• Governments around the world borrowed heavily to meet the costs of tackling COVID-19.
• Countries can borrow from international organizations or by selling bonds to investors and pension funds.
• Government debt is used to pay for public services instead of meeting the whole cost through taxation.
• Some analysts fear the amount of debt owed by developing economies will be unsustainable.

Soaring government debt is a pandemic legacy we are going to be living with for years to come. Countries borrowed heavily as they struggled to keep their economies afloat while tackling COVID-19.

It is a financial hangover which has put government borrowing – also known as national or sovereign debt – firmly in the spotlight. Global government debt will reach $88 trillion by the end of 2022, according to a forecast from credit ratings agency Fitch.

How does government debt work?

The numbers are staggering, but government borrowing is different from the debts we run up as individuals. That’s because countries can raise taxes and issue their own currency, giving them ways to pay back loans.

Borrowing allows governments to spend more on public services and projects than they raise in taxes. They often borrow to bridge that gap between their income and spending because tax rises are politically difficult, leaving citizens with less money and threatening economic growth, as the BBC reports.

Countries borrow from each other or from global organizations like the World Bank and the International Monetary Fund (IMF).

Pension funds buy government debt

But governments also raise money by selling bonds, often to institutional investors or pension funds. An investor buying a bond is lending the government money for an agreed term, and many bonds pay out interest at regular intervals – known as coupon payments.

When the agreed term of a bond ends – known as its maturity date – the government pays back the original sum of money. Some bonds are very short term, others last for decades.

Buying government debt is normally a safe investment – if you are lending to a rich and stable country.

As Investopedia explains, the US is usually seen as the lowest risk because it is the world’s largest economy and has never defaulted on its sovereign debt.

US economic power

The US dollar is also the world’s main reserve currency – meaning it is the currency most likely to be held by central banks and frequently used for international trade.

That economic muscle means investors can be confident US Treasury bonds will be honoured, allowing the federal government to borrow relatively cheaply.

Lending to poorer or more volatile countries is a higher risk because of the threat of economic or political turbulence.

More than half of governments have defaulted

Coups, financial crises or sanctions can result in a regime which is unwilling or unable to pay its debts. Those risks make it more expensive for weak or unstable governments to borrow.

More than half the world’s governments have defaulted since 1960, according to a database run by the Bank of Canada and the Bank of England.

So investors have to take the risk of default seriously. If an individual or a company doesn’t pay back a loan, creditors can take legal action and go after the defaulter’s assets.

That is far less likely to work if you are chasing money you are owed by a nation state.

Government debt in relation to economic output

Economists are divided over how much borrowing countries can afford. Traditionally, they become alarmed if a state’s debt is high in relation to its gross domestic product (GDP).

But many countries borrowed far more than they planned in the pandemic. The European Union, for example, relaxed rules which limit debt to 60% of economic output.

Some analysts think poorer countries will struggle to repay money they borrowed to meet the vast costs of dealing with COVID-19 and the economic disruption caused by Russia’s invasion of Ukraine.

Future generations pay back costs of today’s spending

“Over the next 12 months, as many as a dozen developing economies could prove unable to service their debt,” says Marcello Estevão, Global Director, Macroeconomics, Trade and Investment at the World Bank, “the largest spate of debt crises in developing countries in a generation.”

Even in wealthy countries, the current levels of government debt are potentially unfair on future generations whose taxes will be used to pay back money borrowed to pay for today’s public spending.

That will be more manageable if economies grow, but there is a danger some governments will find paying the interest on their debts cuts into the money they have available to invest in projects which could have helped with development.

High government debt isn’t the only concern. The amount of money owed by private businesses and individuals is also surging in some countries, pushing global debt to new heights. That has prompted the IMF to warn that governments need to act together to tackle spiralling borrowing and safeguard security and prosperity across the world.