Question

Discuss the following statements: A large public debt to GDP ratio is a serious threat to sovereign solvability, especially when the real interest rate exceeds real economic growth.

Answer 1

The debt-to-GDP ratio is the metric comparing a country's public debt to its gross domestic product (GDP). By comparing what a country owes with what it produces, the debt-to-GDP ratio reliably indicates that particular country’s ability to pay back its debts. Often expressed as a percentage, this ratio can also be interpreted as the number of years needed to pay back debt, if GDP is dedicated entirely to debt repayment.

A country able to continue paying interest on its debt--without refinancing, and without hampering economic growth, is generally considered to be stable. A country with a high debt-to-GDP ratio typically has trouble paying off external debts (also called “public debts”), which are any balances owed to outside lenders. In such scenarios, creditors are apt to seek higher interest rates when lending. Extravagantly high debt-to-GDP ratios may deter creditors from lending money altogether.

• The debt-to-GDP ratio is the ratio of a country's public debt to its gross domestic product (GDP).
• If a country is unable to pay its debt, it defaults, which could cause a financial panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay back its debt and the higher its risk of default.
• A study by the World Bank found that if the debt-to-GDP ratio of a country exceeds 77% for an extended period of time, it slows economic growth.

When a country defaults on its debt, it often triggers financial panic in domestic and international markets alike. As a rule, the higher a country’s debt-to-GDP ratio climbs, the higher its risk of default becomes. Although governments strive to lower their debt-to-GDP ratios, this can be difficult to achieve during periods of unrest, such as wartime, or economic recession. In such challenging climates, governments tend to increase borrowing in an effort to stimulate growth and boost aggregate demand. This macroeconomic strategy is a chief ideal in Keynesian economics.

Economists who adhere to modern monetary theory (MMT) argue that sovereign nations capable of printing their own money cannot ever go bankrupt, because they can simply produce more fiat currency to service debts. However, this rule does not apply to countries that do not control their own monetary policies, such as European Union (EU) nations, who must rely on the European Central Bank (ECB) to issue euros.

A study by the World Bank found that countries whose debt-to-GDP ratios exceeds 77% for prolonged periods, experience significant slowdowns in economic growth. Pointedly: every percentage point of debt above this level costs countries 1.7% in economic growth. This phenomenon is even more pronounced in emerging markets, where each additional percentage point of debt over 64%, annually slows growth by 2%.

Examples of Debt-to-GDP Ratios:

Debt-to-GDP Patterns in the United States

According to the U.S. Bureau of Public Debt, in 2015 and 2017, the United States had debt-to-GDP ratios of 104.17% and 105.4%, respectively. To put these figures into perspective, the U.S.’s highest debt-to-GDP ratio was 121.7% at the end of World War II, in 1946. Debt levels gradually fell from their post-World War II peak, before plateauing between 31% and 40% in the 1970s—ultimately hitting a historic 31.7% low, in 1974. Ratios have steadily risen since 1980 and then jumped sharply, following 2007’s subprime housing crisis and the subsequent financial meltdown.