The Forgotten Benefits of Government Debt

Economic history indicates two possible scenarios resulting from high government debt.  Unfortunately, it is only the negative one which is generally remembered.  The alternative positive result occurred, for example, in the post 1939-45 war period in the UK (and the US).  This indicated that, in suitable economic conditions, what are now considered to be unacceptably high budget deficits and government debt levels can actually lay the basis for sustained economic growth. 

Both of these countries had government debts of over 100% of their GDP in the late 1940s, but this was followed by one of the most sustained economic booms either country has experienced before or since.  In the US the Federal debt alone (excluding state or local government debt) reached over 120% of GDP in 1946[1] and in the UK Government debt peaked at nearly 250%³ at around the same time.  However, the sustained economic boom of the 1950s and 1960s meant that these levels of debt were sustainable, could be accommodated and were eventually repaid. 

In the US the Federal Government debt had fallen to below 50% of GDP by 1964 as the economy had grown so consistently, although the actual dollar amount of the debt had grown by over 15% over the intervening years².

In the UK, Government debt rose in during the second world war to a peak of around 250% of GDP in the late 1940s^[2].  This would currently be considered a catastrophic level of debt, but again proved to be sustainable.  Despite consistent budget deficits of around 3% of GDP in the 1950s and 1960s, the UK Government debt had fallen to only 50% of GDP by 1975 and has remained around that level over the subsequent thirty years.

The steady and consistent decline in the level of debt relative to the GDP in the three decades after the end of the Second World War reflected a number of factors working in the same direction³.   It was not because the governments had a surplus to pay off their debt.  The following graph shows that most of this time there was a budget deficit:

UK Government Deficit as percentage of GDP:

Clark, Tom and Dilnot, Andrew, Measuring the UK Fiscal Stance Since the Second World War, The Institute For Fiscal Studies, Briefing Note No. 26

Reasons the UK Government debt proved to be sustainable and reduced to 40%:

First, the very high level of the initial debt ratio meant that significant borrowing would have been required to maintain it at this level, given that national income growth was positive.

Second, post-war inflation persistently turned out to be higher than anticipated. Little inflation was factored into interest rates when Government bonds were sold in the middle of the last century. So the Government benefited from low effective interest rates on its debt.

In the 1950s, prices trended upwards, and this increased inflation accelerated during the 1960s. As a result, the real value of the (cash-denominated) stock of debt eroded.

Finally, real economic growth in these years was fairly consistently high by historical standards, so the relative importance of a fixed stock of debt to national income tended to decline rapidly.

·         UK & US governments benefited from low real interest rates on its debt

–Global south faced high interest rates

·         Inflation eroded the stock of debt

–Devaluation increased local cost of debt

·         Real economic growth was high by historical standards, so debt to national income ratio declined

–Global south suffered a fall in national incomes

·         UK and US faced the opposite economic environment to the global south

In the case of both the US and the UK, governments borrowing linked to investment in public services and infrastructure had helped to lay the basis for one of the most consistent periods of economic growth these countries have ever seen.  Thus demonstrating that, in certain circumstances at least, relatively high levels of government borrowing can be beneficial for the national economy.

The historic economic experience of Britain also supports the view that government dept can be good. For most of the century between 1750 and 1850 and for much of the 20th century, periods associated with industrialisation and sustained economic growth, the UK national debt was above 100% of its national income.

The macro-economic demand for a balanced budget is also contradicted by the experience of developing countries during the decades immediately after the end of the Second World War. Thus, for example, research by two academics at Oxford University (Adam and Bevan, 2005[3]) shows an association between maximum economic growth and a government budget deficit of around 1.5% of GDP. In particular, they conclude that ‘deficits may be growth-enhancing if financed by limited seigniorage (printing of money). These results come from their study of 45 developing countries over the 30 years from 1945.

Unfortunately, the experience of many developing countries over more recent decades has been less successful. Their governments borrowed heavily in the late 1970s and then suffered from the twin effects of a substantial increase in the rate of interest levied on these debts and a world economic slow down in the early 1980s which reduced the value of their exports.

Around the same time, in the late 1970s and early 1980s the United States raised interest rates to nearly 20% in a battle to throttle back its persistent inflation[4]. The real (inflation adjusted) interest rates paid by developing countries increased from minus four per cent in 1975 to almost plus four per cent a decade later[5]. 

The rapid increase in world interest rates in the early 1980s on top of the oil price rises, led to a world economic recession.  As a result most developing countries faced a reduced demand for their exports whilst having to pay higher prices for their imports coupled with much higher interest rates on their government debts. 

As UNCTAD describes the effect on sub-Saharan Africa:

From just over $11 billion in 1970, Africa had accumulated over $120 billion of external debt in the midst of the external shocks of the early 1980s. Total external debt then worsened significantly during the period of structural adjustment in the 1980s and early 1990s, reaching a peak of about $340 billion in 1995[6].

The United Nations Food and Agricultural Organisation[7] estimated in 2005 that if commodity prices had maintained the same real value as in 1980, developing countries would be earning an additional $112bn in annual export revenues, which was double the current level of their aid receipts. Putting it another way, between 1970 and 1997 changes in the terms of trade cost non-oil producing African states (excluding South Africa) a total of 119% of their annual GDP, according to the World Bank[8].  External debt grew by 106% of GDP over the same period.  So all the external debt of African countries at the end of the twentieth century could be explained by falling prices for their exports and increasing prices of imports – both changes over which their governments had little or no control.

Thus the actual impact of government budget deficits and the resulting debt are not as simple as the advocates of fiscal responsibility would have us believe.  In certain situations, government debt at levels far in excess of levels which are currently regarded as prudent may have had a beneficial effect on the economy and have proved to be sustainable.

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[1] Office of Management and Budget (2007) Historical Tables Budget of the United States Government - Fiscal Year 2008, page 126, http://www.whitehouse.gov/omb/budget/fy2007/pdf/hist.pdf (17 September 2008)

[2] Clark, T and Dilnot, A, (2002) Measuring The UK Fiscal Stance Since the Second World War, Briefing Note No. 26, London, The Institute For Fiscal Studies

[3] Adam, C.S. and Bevan, D.L. (2005). Fiscal deficits and growth in developing countries, Journal of Public Economics, No. 89, pages 571–97

[4] Stiglitz, Joseph (2006) Making Globalisation Work (page 220)

[5] Bond, Patrick (2006) Looting Africa, Zed Press (page 13)

[6] UNCTAD (2004) Debt Sustainability: Oasis or Mirage (page 5)

[7] FAO (2005), The State of Agricultural Commodity Markets 2004, UN Food and Agricultural Organisation

[8] World Bank, 2000, Can Africa Reclaim the 21st Century?