Understanding Government Debt: How Much Should We Worry?

Debt: a word with negative connotations – especially when it comes to your own financial situation. However, not only private households and companies get into debt, but also states. How much should we worry about government debt?

“Government debt is not bad per se,” says Hans Pitlik, economist at the Austrian Institute for Economic Research (WIFO). Because states take on debt, for example for public investments. Government debt exists when government spending is greater than revenue. These expenses result from liabilities and loans. The key figure here is the debt ratio: It indicates the ratio of debt to gross domestic product, i.e. total economic output. In Austria, the debt level in 2022 was 350.8 billion euros, the debt ratio was 78.4 percent. In the two years before that, it was over 80 percent due to spending in the Covid pandemic. The debt ratio of the European Union was 85.3 percent last year.

These values ​​are far above the guideline set by the EU in the 1992 Maastricht Treaty: 60 percent. The agreed debt ratio was defined very arbitrarily, says Pitlik from WIFO. “You can’t say exactly how high the national debt should be,” he points out. If a state has a high credit rating and investor confidence, a higher debt ratio is acceptable.

The state takes out loans

And here we come to the question of how the minus in the budget is financed: The state takes out loans for this, primarily government bonds. This is a form of investment in which the state is the debtor and pays back the amount with interest over a defined period of time. In Austria, the Federal Financing Agency is responsible for this. The effective interest rate, i.e. the total burden of debt financing including fees, was 1.47 percent at the end of June 2023 and 1.2 percent at the end of 2022.

How expensive the debt is for the federal government depends not only on macroeconomic developments such as the increase in key interest rates, but above all on the confidence in the market already mentioned. Rating agencies constantly assess the solvency of countries. According to economist Hans Pitlik, if the debt increases, this affects the valuation and leads to higher interest rates. If a state spends more than it earns over a longer period of time, it jeopardizes its creditworthiness, while at the same time borrowing causes even more expenditure due to the actual burden.

Government debt makes companies and households more cautious

“Government debt is tomorrow’s taxes,” Pitlik continues. With high levels of debt, both companies and private households are therefore more cautious when it comes to spending, which in turn can have a negative impact on economic growth. The current high level of inflation is having a positive effect on the debt ratio in the short term because the state is generating more income as a result of inflation. At the same time, however, public investments are also becoming more expensive, and the slowdown in economic growth means a lower gross domestic product. Marcell Göttert, an economist at the liberal think tank Agenda Austria, warns that because income is not rising as rapidly as expenditure, debt can quickly rise if countermeasures are not taken.

European Commission expects debt ratio to fall

The European Commission expects the debt ratio to fall both in the EU and in Austria this year and next. According to a forecast by Agenda Austria, the rate would increase in the years and decades that follow if the state does not act. “We don’t have an income problem in Austria, we have an expenditure problem,” says Göttert. In order to get the debt ratio under control, the national budget must be restructured. Among the possible measures for this, the two economic researchers include raising the retirement age or structural reforms. Pitlik from WIFO advocates more “fiscal policy discipline” by the federal government, after the focus on spending in recent years due to the pandemic. Göttert points out that the state largely relies on taxes from the residents for its income. A high debt ratio is therefore noticeable for the citizens even with a good investment strategy of the Federal Financing Agency.