Typically, higher government borrowing raises these issues:
- Higher borrowing leads to higher interest rates as governments need to attract more people to buy bonds. This rise in interest rates is known as financial crowding out and can lead to lower growth.
- Higher borrowing leads to higher taxes
- Higher borrowing can create inflationary pressure, if the borrowing is financed by increasing supply of money.
- Higher borrowing can risk destabilising the exchange rate if markets fear there is a real inflationary pressure.
- Higher Borrowing can cause resource crowding out because the private sector has less funds for investment because it is holding more government bonds.
As Brad de Long notes (link), in the past 12 months, the US treasury has extended its marketable debt liabilities by $2.5 trillion (equivalent to 20% of all US equities) - yet, despite this huge rise in government borrowing, there has been practically no increase in interest rates.
Why Can government borrowing increase without causing Higher Interest Rates?
The reason is that in a recession, firms and individuals want to save. They also want to save in 'safe havens' of the bond markets. Thus the government deficit is mopping up the rise in private sector savings.
When growth is high demand for investment and loans is high, pushing up interest rates. When growth is low or negative demand for investment and loans falls. This pushes down interest rates.
Thus, as Paul Krugman notes, in the US we see an inverse relationship between budget deficits and interest rates. A budget surplus is consistent with high interest rates and a large budget deficit with low interest rates.
Does this mean we can borrow as much as we want?
Well no. The demand for government bonds will be high in a recession, but as the economy recovers, investors will be switching into more risky investments like equities and corporate bonds. As the economy recovers, demand for loans increases pushing interest rates back up.
Therefore in the depths of a recession, governments find it relatively easy to borrow. But, if the high deficits persist during economic growth, that is when we will see upward pressure on interest rates and the possibility of crowding out.