Why Countries Get into Debt: Causes and Consequences of Public Debt

Government borrowing is a complex but extremely important part of the functioning of an economy. By borrowing, governments maintain stability in times of crisis, stimulate economic growth and invest in the future. However, high levels of debt are accompanied by many risks, and the mechanism of how public debt works remains poorly understood by most people. How countries choose creditors, what happens in the event of insolvency, and why the mutual debt system cannot simply be simplified.

Why can't countries do without debt?

Governments borrow money to spend more than they can or want to get from general taxation. There are many economic reasons for this. When tax revenues fall, such as during a recession, governments borrow money to fund existing spending. This helps maintain public services such as schools and hospitals, and prevents the need to cut spending when the economy is already in crisis. This is what is known as “fiscal smoothing”. Governments can go further and try to stimulate growth by increasing spending or cutting taxes during a recession. Such “fiscal stimulus” is financed by issuing government bonds.

However, these reasons cannot explain the high public debt that exists in many countries. Another motive for debt is investment in the future. Sometimes governments borrow heavily to build new highways, power plants, and subways. The initial costs can be very high and debt repayment stretches over many years. However, the hope is that these investments will promote long-term growth and justify the borrowing. In addition to physical capital, governments can also invest in human capital, such as education and health care. Again, the long-term benefits should outweigh the costs of borrowing.

Where does the money come from? Who lends to governments?

Governments can be very resourceful in finding lenders willing to lend at the lowest interest rates. However, choosing a lender often involves trade-offs. For example, governments can borrow domestically or abroad. Direct loans from local banks, asset managers, or individuals can be a stable and reliable source of financing. However, in many cases, the amount of funds available is limited and repayment periods are usually short. Therefore, governments also rely on international capital markets. However, these markets can be volatile, especially for low-income countries. It is dangerous to assume that these financial institutions always provide readily available sources of finance.

The private sector lends to governments, too. For example, pension funds and other large investors buy government bonds because they are considered a safe and long-term investment. Banks hold a lot of government bonds too, especially in the countries where they operate. However, this can be risky. During the eurozone crisis in 2010-2012, weak banks reduced their investments in government bonds. This increased states' borrowing costs and worsened the economic situation. The result was a vicious circle: the economic downturn weakened the banks, and the banks' problems intensified the crisis. Now such risks are better understood and avoided.

Finally, governments may borrow from other governments or international organizations. Often these loans are not primarily motivated by commercial purposes (although the lenders may not say so). One government may lend to another to strengthen bilateral relations. The World Bank or the African Development Bank may lend to a country to build sanitation systems, immunize, or reform the energy sector. The IMF can also provide funds if a country has balance of payments problems.

Why can't we just zero out the debts?

If two countries owe each other, why can't they level their debts so that the more indebted side pays the difference between the debts? Here, as we have already discussed, the problem is with the creditors. To put it another way, the U.S. government does not owe the U.K. government $1 billion, the U.S. owes hundreds of individual British companies, people, banks and foundations a total of $1 billion. Conversely, the U.K. does not owe the U.S. Treasury $1 billion, it owes hundreds of individual U.S. companies, people, banks, foundations and government agencies a total of $1 billion. The people and organizations from whom the U.S. borrowed money from the U.K. are not the same people and organizations that borrowed money from the U.S.. What is interesting - most of the U.S. government debt is not held by foreign governments, but by various parts of the U.S. government.

What happens when a country defaults?

Like citizens and businesses, sovereign nations can have difficulty repaying their debts. This may be because they have borrowed too much or taken on too much risk, or because they are hit by an unexpected shock such as a severe recession or natural disaster. In these circumstances, the government must restructure its debts. Unlike citizens and businesses, however, the state does not have a bankruptcy court that can force debtors and their creditors to resolve their problems. Creditors want to recover as much money as possible, and the state wants to restore its “normal” position in the financial markets without having to repay large sums of money. Such restructurings are often costly to both debtors and creditors. For this reason, they are relatively rare. Well-known examples are Russia (1998), Argentina (2005), Greece (2012) and Ukraine (2015). Costs are generally much lower if an agreement can be reached before the government cancels payments due to a bond default. Such proactive restructuring is usually quick and with less impact on other economies and financial systems. However, when a country becomes insolvent, the restructuring process can be long and costly.

Public borrowing is a tool that can provide economic stability and development, but it carries serious risks if misused. Understanding the mechanisms of public debt, its consequences and how it is managed helps to better assess how countries are coping with economic challenges and building their future.