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Interest Rates and Government Debt

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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Some linkages and consequences

In a much-cited address in August 1984 at the 40th Congress of the International Institute of Public Finance, Jacques de Larosière, then Managing Director of the IMF, expressed his concern about the “explosion of public debt” that was affecting developing and developed countries alike. He outlined various consequences of excessive indebtedness and called on governments to pursue structural reforms in their public finances to contain such an “explosion” and put their fiscal houses in order.

Given the high and growing public debts in most industrial countries in recent years, the renewal of such concerns is not unjustified. There has been much controversy, in particular, as to whether an enlarged public debt could raise interest rates. While earlier studies have examined the effects of fiscal deficits and debt on real interest rates for individual countries, there is a growing consensus that, in view of the increasing integration of financial markets, which allows fiscal deficits of one country to be financed by savings of other countries, a better understanding might be obtained by taking a global, rather than a national, perspective. Thus, each country’s deficit has its impact on interest rates in the world capital market.

For a detailed version, see “Interest Rates and Government Debt: Are the Linkages Global Rather than National?” by Vito Tanzi and Mark Lutz, IMF Working Paper (WP/91/6), available from the authors.

This article surveys various issues associated with the growth of public debt among the Organization for Economic Co-operation and Development (OECD) countries. It highlights the links between increases in the ratio of government debt to GDP and increases in real interest rates, between increases in interest payments and reductions in capital spending, and between increases in interest payments and increases in taxation.

Reasons for concern

Debt financing substitutes for taxation. It thus allows governments to maintain or increase, at least temporarily, public spending without the need to legislate tax increases. In other words, it has the political advantage of generating an immediate benefit (the public expenditure) without an immediate cost (the raising of tax rates). Given that governments are likely to have short horizons and, thus, to discount future costs at high rates—especially when there is a high probability that these costs will be faced by another set of policymakers, or even by another party—the temptation to finance spending through debt is naturally strong.

If the additional spending is temporary, an argument can be made that debt financing will help smooth the required changes in tax rates over time. Since sudden and temporary changes in tax rates generate distortions and, thus, welfare losses, with adverse effects on growth, the use of debt finance will increase the efficiency of the economy. This would be the case especially when the increase in spending is caused by wars, depressions, or large public investments concentrated in a relatively short time. In the latter case, if the investment is productive, the debt would pay for itself by raising the level of economic activity and, therefore, the tax base.

If the increase in public spending is not temporary and is financed by debt, the share of public debt in national income may grow. As a consequence, the cost of servicing the debt will also grow, especially if interest rates are high. Thus, ironically, the debt that may have been used to keep tax rates down may eventually force these rates up, since the country will in time need to generate a “primary surplus” (the difference between revenues and non-interest expenditures) to service the debt. In cases where public spending is difficult to cut, that primary surplus must be generated mostly through higher taxes. Over the 1975–87 period, for example, in spite of the increase in the share of public debt into GDP, the share of total taxes in GDP grew substantially in most OECD countries, largely to finance higher government interest payments.

The growth of the ratio of debt to GDP is influenced by the rate of growth of the economy, the interest rate on the debt, and the size of the primary surplus. Thus, a high growth rate and a low rate of interest will be major contributors to restraining the growth of public debt in GDP. The current fiscal stance, as assessed through the primary surplus or deficit, also plays an important role. In fact, since countries generally cannot, over the longer-term horizon, significantly influence the rates of interest and the growth of the economy, the policy variable available to them is the primary surplus. If non-interest spending cannot be reduced, then the tax rate becomes the basic policy instrument.

In the absence of comparable real effective (i.e., inflation and growth-adjusted) interest rates on the debt, comparisons of debt ratios over time or across countries are not particularly meaningful. In recent years, because of large capital movements, interest rates have tended to converge across countries. This implies that global factors, as distinguished from purely domestic factors, have played a growing role in influencing domestic interest rates. However, even if real world interest rates tend to be influenced by the size of the global debt, and if countries with higher than average debt tend to pay some differential over the international interest rates, then cross-sectional comparisons still need to be qualified.

Public debt in OECD countries

The ratio of general government gross debt to GDP has been rising in most OECD countries, reaching very high levels by 1987 in many of them. Between 1975 and 1987, the ratio rose from 61.1 percent to 132.4 percent in Belgium; from 11.9 percent to 57.2 percent in Denmark; from 64.3 percent to 128.7 percent in Ireland; from 60.4 percent to 92.7 percent in Italy; and from 22.4 percent to 76 percent in Japan. Chart 1 shows the behavior of gross debt as a share of GDP for the United States, Japan, and Germany combined (G-3), as well as for the G-3 plus France, Italy, the United Kingdom, and Canada (G-7). In addition, 13 OECD countries for which the statistical information was available were aggregated to provide the G-13 group. In each of these groups the weight of a country was based on its gross domestic product, and the conversion into dollars, on average official exchange rates.

Chart 1General government gross debt, 1970–87

(Percentage of gross domestic product)

Chart 2 shows the behavior of real long-term government bond rates, reflecting the average for the same groups of countries. A comparison of Charts 1 and 2 reveals some common trends: Until 1974, the ratio of debt to GDP was falling and so was the real bond rate. Between 1975 and 1980, there was some increase in the debt ratio, as well as in the real bond rate. From 1980 to 1985 the share of debt in GDP rose very fast, tracking closely with the real bond rate. After 1985, however, the trends seem to diverge, with the debt ratio continuing its upward trend, though at a slower pace, while the real bond rate declined somewhat.

Chart 2Real long-term government bond rate, 1970–87

(Percentage points)

Source: IMF Working Paper91/6.

Government debt and interest rates

We can no longer assume that the fiscal deficits of any country will necessarily be financed by the financial resources of that country alone, or that there must be a strong correlation between the total domestic demand for savings (including investment and fiscal deficits) and the total domestic supply. For the world as a whole, the demand for financial savings must be equal to the supply of financial savings. International interest rates must play a major role in bringing about this equilibrium. This means that the impact of fiscal policy on interest rates is more meaningful in a global context. This, of course, does not mean that the fiscal policy of a specific country will not have any effect on the real interest rate of that country. Rather, each country’s financial policy, apart from its impact on the world interest rate, influences the difference between its interest rate and the average international interest rate.

How can we capture the global link between world real interest rates and levels of global government debt? The global real interest rate can be modeled as being determined by the process equilibrating saving, both public and private, and investment. The demand for capital goods is seen to be strongly procyclical, rising rapidly during periods of economic expansion and falling during recessions, and, therefore, may be captured by a proxy variable reflecting the business cycle. Saving decisions are made by both the public and private sector. Therefore, measures of government deficits and private saving levels, both expressed as ratios to output, were included in the model. The model also tested the ratio of government debt to GDP, as this may have a direct influence on real interest rates, and other variables capturing government consumption levels and monetary policy.

A variety of tests were run for the three groups of countries—the G-3, the G-7, and the G-13, the latter being the largest group of countries for which data over the entire sample period were available. Different concepts for the level of government, the definition of the deficit, the use of gross or net debt ratios and saving rates, the type of exchange rates used for aggregation, and various interactions among the variables were used in order to gauge the robustness of the results. The results show significant positive linkages between real interest rates on long-term government bonds and the ratio of government debt to GDP over the 1979–87 period. An increase in the ratio of public debt to GDP by 1 percentage point increases real interest rates by about 20 basis points, while an increase in the deficit by a similar magnitude has an effect that is eight to ten times as strong. Higher stocks of reserve money lower real interest rates, at least in the first year, while higher levels of economic activity have the opposite effect. Higher levels of net private saving were seen to reduce interest rates, as expected.

Changes in government activity

Increasing ratios of government debt to GDP, in addition to raising interest rates, also have generally harmful consequences for the level and pattern of government activity. An increase in interest payments on the public debt must result in (1) a higher fiscal deficit, (2) a higher level of taxation, or (3) a crowding out of other public expenditure. Of course, the increase in interest payments as a share of GDP, in the absence of changes in real interest rates, must be preceded by an increase in public debt. For industrial countries there has been far more discussion among economists of debt financing than of debt servicing. In fact, while those writing on developing countries have often focused on the difficulties of servicing these countries’ debt, those writing on industrial countries have focused far more on the process of debt accumulation.

The growth of public debt has been defended by some economists when it is associated with wars and major public investments, since it prevents the increase in tax levels, with their attendant distorting influences, that would be required to finance the temporary increase in public spending. How do these reasons apply to the growth of public debt in our sample countries? There were no such excuses for large-scale borrowing in the OECD countries during 1970–87. Thus, fortunately, war financing cannot be an explanation for the growth in public debt in this period, as it had been for the growth in American debt in the 1940s, or for British debt during the past century. The explanation must be found somewhere else.

What about a bulge in public investment? Is there any evidence of it? Our data indicate that, on the contrary, the share of general government investment spending in GDP fell in practically all countries over the period. Therefore, the argument that debt financing would be self-financing, if associated with major (and productive) capital projects, is not valid for these countries.

So what has been behind the growth of government debt ratios? For the countries and period considered here, the major explanation for rising deficits, and hence the increase in debt ratios, is rapid increases in government “transfers.” The largest of these transfers has been for social security, which demands greater resources because of aging populations, higher levels of eligibility of the aged for pensions, and higher real pensions per pensioner.

As noted above, when countries face large fiscal deficits, governments may try to limit them by raising taxes and by reducing non-interest expenditures. In other words, they try to raise the primary surplus. The expenditures most likely to be reduced are those that do not have strong support from interest groups and those whose benefits occur only in the future so that their present (especially political) value is low. Governments typically encounter the least resistance if they cut capital expenditure. Other types of expenditures, such as those for wages and salaries and operation and maintenance, are also likely to be squeezed. The table shows the negative relationship between higher debt ratios, which require higher interest payments and reductions in capital spending.

Changes in interest payments, debt ratios, tax levels, and capital spending, 1980–87(In percent of GDP)
Change in

interest

payments
Change in

debt ratios
Change in

tax ratio
Change in

capital

spending
United States1.713.70.5–0.2
Japan1.324.04.7–1.0
Germany0.911.3–0.4–1.1
France1.310.33.10.1
Italy3.233.86.00.3
United Kingdom–0.4–4.62.2–0.7
Canada2.823.92.9–0.4
Netherlands2.529.02.2–1.0
Australia1.60.72.3–0.9
Sweden2.517.27.3–1.5
Belgium4.552.52.6–1.8
Austria1.520.11.2–1.2
Denmark4.423.76.5–1.2
Finland0.66.12.9–0.1
Norway0.9–1.21.2–0.5
Ireland13.248.75.9–0.7
Spain13.129.79.0
Switzerland–0.31.2
Source: OECD.

Through 1986.

Indicates absence of data.

Source: OECD.

Through 1986.

Indicates absence of data.

Thus, in the end, governments that accumulated debt to avoid sudden adjustment in tax rates were forced to raise taxes to meet the increasing interest payments. The experience of the OECD countries shows that the growth of public debt will eventually contribute to the rise of tax levels. The pressure to increase taxes becomes stronger as interest rates become significantly greater than the growth rates of the economies, as has occurred in the 1980s. In practically all countries, the ratio of tax revenue to GDP rose over the period. Further, that ratio seems to have risen the most in those countries that experienced the largest increase in debt and, consequently, in interest payments. The increases in tax ratios were particularly large in Belgium, Canada, Denmark, Ireland, Italy, Japan, and Spain, and all countries that experienced large rises in debt to GDP ratios and in interest payments to GDP ratios.

Although this analysis may be seen as too simple, it does provide results that are consistent with what one would expect from general public choice considerations. Thus, the growth in public debt, with the accompanying increases in interest rates, will in time lead to increases in tax ratios, as well as to changes in the structure of public expenditure, with government investment being progressively squeezed out by rising interest payments.

Vito Tanzi and Mark S. Lutz

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