There is no easy answer. Japanese public sector debt is over 220% of GDP, yet bond yields are low. Countries in the Eurozone, such as Ireland, Portugal and Italy saw rapid increases in bond yields despite having lower debt levels. The amount governments can borrow depends upon many factors such as the level of private sector savings, confidence and expectations of future growth.
Levels of government debtAt times government debt has been very high:
- US 117% of GDP in 1945 (gross federal debt (1)
- UK 220% of GDP in early 1950s
- During WWII, UK national debt increased from £7.1 billion to £21 billion. In the early 1950s, UK public sector debt increased to over 200% of GDP much higher than in the financial crisis 2008-11.
- Japan has national debt over 230% GDP
Governments can finance their debt in two main ways
- Selling bonds to the private sector - either domestic or foreign
- The Central Bank can finance shortfall in revenue by increasing the money supply and buying bonds.
Factors which influence how much a government can borrow
- Domestic savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan has very high levels of public sector debt, but with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings to finance UK debt.
- Relative interest rates. If government bonds pay a relatively high interest rate compared to other investments, then ceteris paribus, it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low interest rates because government bonds are seen as more attractive than other investments. (e.g. in a recession government bonds are often preferred to buying shares (which are more vulnerable in a recession). This is why US bond yields fell 2008-11, despite growth in US government borrowing.
- Lender of last resort. If a country has a Central Bank willing to buy bonds in case of a liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of last resort (e.g. in the Euro) then markets have a greater fear of liquidity shortages and so are more reluctant to buy bonds.
- Prospects for Economic Growth. If one country faces prospect of recession, then tax revenues will fall, the debt to GDP ratio will rise. Markets will be much more reluctant to buy bonds. If there is forecast for higher growth. This will make it much easier to reduce debt to GDP ratios. The irony is that cutting government spending to reduce deficits, can lead to lower economic growth and increase debt to GDP ratios.
- Confidence and Security. Usually, governments are seen as a safe investment. Many governments have never defaulted on debt payments so people are willing to buy bonds because at least they are safe. However, if investors feel a government is too stretched and could default, then it will be more difficult to borrow. Therefore, some countries like Argentina with bad credit histories would find it more difficult to borrow more. Political uncertainty can make investors more concerned.
- Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt (Japan, China, UK). This foreign demand makes it easier for government to borrow. However, if investors feared a country could experience inflation and a rapid devaluation, foreigners would not want to hold securities in that country.
- Inflation. Financing the debt by increasing the money supply is risky because of the inflationary effect. Inflation reduces the real value of the government debt, but, that means people will be less willing to hold government bonds. Inflation will require higher interest rates to attract people to keep bonds. In theory, the government can print money to reduce the real value of debt; but existing savers will lose out. If the government creates inflation, it will be more difficult to attract savings in the future.
Why did Eurozone countries experience more debt problems than UK and US
Bond yields in Italy, increased despite Italy having a primary budget surplus. This was a similar story for other countries in the Euro. One issue is that (between 2011 and 2013) Italy had no Central bank willing to act as a lender of last resort. See more reasons for Italian Debt Crisis
However, when the ECB agreed to effectively intervene in the bond market, bond yields fell.
UK bond yields during a period of rising debt
This shows that during a period of higher government borrowing 36% of GDP increasing to 80% of GDP - bond yields fell from 9% to 2%