LeoGlossary: National Debt
The national debt of a country is the amount of debt acquired by deficit spending. Instead of running a balanced budget, which has spending equating to tax revenues, governments spend more than is taken in.
To make up for the shortfall, debt is issued, usually in the forms of bonds, notes, and bills. This tends to be auctioned off by the central bank and sold through primary dealers.
This is typically called sovereign debt.
Asset And Liability
Like any form of debt, it can be both an asset or liability. It depends upon which side of the balance sheet it is appearing.
When a nation's treasury issues the debt, it is a liability to the government. The money is owed along with the associated interest payments.
The buyer of the debt has an asset. Bonds have a par value which is repaid at maturity. There is also a coupon rate that which is the amount of money paid on a yearly basis. This is the return for the asset holder.
Deficit Spending
John Maynard Keynes had a central premise that governments could compensate for a lack of demand from the private sector by engaging in deficit spending. He wrote during a time when governments ran balanced budgets.
Over the last few decades, this became the norm for most developed countries. Each year is met with more deficits, a situation that gets magnified in times of severe economic turmoil. The situation with COVID in early 2020 shows the playbook governments now use. Deficit spending skyrocketed as countries take action against the economic downturn as a result of the shutdown of the economy.
Simple accounting shows that if one repeatedly runs a deficit, the total amount of debt keeps growing. Unless offset by surpluses, governments just keep getting deeper in debt.
This is the norm throughout the developed world.
Selling Debt
The ability to sell the debt to finance the spending is what allows for the national debt to keep rising. As long as a country is able to do this, the status quo can continue.
When it comes to investing, the bond market is the largest in the world. Sovereign debt, especially U.S. Treasuries, are considered the best fixed income instruments. Due to many seeking yield, there tends to be heavy demand for these assets.
Nations run into problems if their debt is not desired. When the selling of the bonds slows, the rate paid usually has to increase to entice more buyers.
Central banks around the world took a zero interest rate policy (ZIRP) and negative interest rate policy (NIRP). This has caused investors to hunt for yield in other areas.
The Eurodollar system, also called wholesale or shadow banking, has historically had an appetite for sovereign debt. Due to the expansion of a bank balance sheet due to the addition of the asset, the ability to enter short-term funding agreements increased as this form of debt was used as collateral.
Post Great Financial Crisis, the appeal of sovereign debt was further enhanced as mortgage backed securities (MBS) blew up and revealed themselves not to be on par with US Treasuries like the Wall Street rating agencies claimed.
This changed when the negative interest rate policy took even. The ECB, BoJ, and many European central banks all followed suit. This left the United States as one of the few who kept their bond market in tact as they only went down to the zero threshold.
A collateral crisis was set off as US Treasuries became the major form of collateral in this market. Repurchase agreements provided the best interest rates and least amount of collateralization when bringing Treasuries to the table.
Serving Costs
One of the major issues, like any form of debt, is the cost to service. The amount outstanding is only one variable borrowers need to consider. On the other side is whether the payment is something one can afford.
With government debt we are dealing with a different animal. Governments can secure the payment of debt through taxations. It is possible for all tax revenue to be targeted towards servicing. This is what the full faith and credit concept means.
National debt is made up of financial instruments with different coupon rates. During the decline of interest rates, the older bonds were replaced with ones that had lower rates. This meant the cost of servicing the debt could have actually declined.
Unfortunately, the opposite happens when interest rates go up. Here the cost of servicing increases, a situation that is compounded by expanded deficit spending.
Slower Economic Growth
Countries that get heavily indebted tend to have slowing economic growth. This is due, in part, to the servicing costs.
Debt of this nature is ultimately backed by the economic productivity of a nation. The economy is what produces the revenue to service the debt. As the portion of the economy required to meet those costs increases, there is less of the economy left to actually grow.
The key variable if the growth rate of the overall economy exceeds the additional servicing costs. So far, the major developed economic zones have failed to do this as their debt-to-GDP ratios keep increasing.
With slowing growth rates, the spending levels can present a problem as tax revenues are hindered. This is compounded by the fact the business cycle is ever present, bringing recessions periodically as excess takes place. Governments tend to step up spending during these periods, following the Keynesian models.
Absent additional economic productivity, the increase costs in debt servicing cannot be offset.
Ponzi Debt
Governments keep issuing more debt. This is something that extended for many decades. It is evident, looking at the national debt totals, most of these countries will never pay the principal back.
Does this means that nations can keep going? At what point does this stop?
Debt will fund shortfalls in revenues for as long as the market is willing to buy the bonds. This is true no matter who is doing the issuing.
With increasing costs of servicing, it is possible for entities in this position to keep issuing more debt, eventually to pay these costs.
This is what Irving Fisher terms "Ponzi debt". Under this scenario, new debt is issued to replace the older debt. If the costs get too large, the new debt just goes to service the old. The national debt balance is never touched.
It is akin to just paying the minimum on a credit card.
Most nations engage upon this to a degree. Due to changes in the market, the only one who is likely to be able to keep this up in the future is the United States. That country has the advantage, for now, of never defaulting on its bonds or blowing up its currency.
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