IB Economics 3.3.6 Sustainable Level of Government (national) Debt Notes

Two macroeconomic ideas shape the health of every economy: the size of the government (national) debt and whether that debt is sustainable, meaning the government can keep servicing it without being forced into damaging tax rises, spending cuts, or default.

Debt is sustainable when the government can meet its interest and repayment obligations out of ordinary revenue, so it never has to undermine economic stability or sacrifice future growth just to keep up with what it already owes.

Measurement of Government (National) Debt as a Percentage of GDP

Debt is judged as a percentage of GDP rather than as an absolute figure because GDP measures the income the economy generates each year, and it is that income the government taxes to service the debt. A larger economy can carry a larger debt for the same effort, so the ratio shows the true burden relative to the country's capacity to pay.

Expressing debt this way also allows international comparisons, because a ratio scales out differences in economy size and currency, so a small country and a large one can be compared on the same footing.

And the ratio signals a country's ability to repay, because a rising debt-to-GDP ratio means debt is growing faster than income, which warns lenders that servicing it is becoming harder and pushes up the interest they demand.

$$\text{Debt-to-GDP ratio} = \frac{\text{Government (national) debt}}{\text{GDP}} \times 100$$

Relationship between a budget deficit and government (national) debt

A budget deficit feeds directly into national debt, because a deficit must be financed by borrowing, and each year's borrowing is added to the accumulated stock the country already owes.

How budget deficits accumulate into debt:

• When the government spends more than it collects in a given year it runs a deficit, and it must borrow to cover that gap because it cannot spend money it does not have.
• That new borrowing is then added to the existing national debt, so this year's flow of overspending becomes a permanent addition to the stock the country carries forward.
• Repeated deficits mean repeated borrowing, so the debt rises year after year because each annual shortfall stacks on top of everything borrowed before.