Paying off Government Debt

Using a data set on government debt that was previously unavailable, the article analyzes who bears the burden of government debt. The database includes 12 countries with both debt and GDP data on the countries stretching back over a century. The paper shows that in addition to the level of the Debt/GDP ratio, anticipated future changes in this ratio, as well as the interest cost of covering the debt are important variables affecting the economy. Most nations have seen their government debt/GDP ratio exceed 100% in the past, but not all have sparked a financial crisis. The impact of the government debt/GDP ratio also depends upon the causes, whether the increase is short-term due to war or economy fluctuations, or secular due to unfunded increases in government spending. Reducing the Debt/GDP ratio is a political decision. The government must decide to reduce it by reducing compensation to government employees, recipients of government funding, through higher taxes, or an outright or inflationary default.

The current economic recession has led to unprecedented peacetime deficits and increases in government debt in developed countries. For only the second time in the history of the United States, government debt will soon exceed GDP. The long-run costs and the impact of this growing debt remains highly uncertain and is the chief topic of political debate in the current US elections. While the White House says these deficits are necessary despite the costs, others say the debts impose costs on future generations. Tea Party supporters say government expenditure must be cut.

Unfortunately, very little is known about the historical levels of government debt for different countries of the world outside of the United States and how different countries have dealt with large levels of government debt in the past. Global Financial Data has collected historical government debt and GDP data for the major world economies going back to the 1800s. This paper is based upon the findings of this research.

The Origin of Government Deficits

The government runs a deficit because it is unable or unwilling to collect a sufficient amount of taxes within any given year to cover its expenditures. For most of its history, the United States balanced its budget except in war time. After the war, the government ran surpluses to pay down the debt accumulated during the war or ran deficits less than the growth in nominal GDP. A long-term graph of US debt shows rises in the Debt/GDP ratio during the War of 1812, Civil War, World War I, and World War II.

The true cost to the economy of government is the expenditures it makes, not the taxes it collects. Government can either collect taxes today or issue promises (currency or bonds) to pay for its purchases in the future. When the government increases the money supply, it can cause inflation, and if it issues bonds, it can “crowd out” the private sector.

Running deficits implies less spending in the future since the government must pay interest or retire bonds. In some cases, short-run deficits can be justified. Just as consumers or businesses may wish to smooth out the cost of consumption over time, so can the government. If the government is building infrastructure which has long-term benefits, it may borrow money today to be paid off in the future. Similarly, the government may run a cyclical deficit during a recession which it can pay off when the economy recovers.

Structural deficits are another matter. A structural deficit that is used to pay for services or transfer income, unlike capital investment, does not add to the net wealth of society, and implies higher taxes or lower government services in the future to offset the accumulated structural deficits. As Robert Barro has shown, these types of structural deficits can have multipliers less than one because of their impact on incentives and the economic misallocations they create. Unfortunately, a portion of the current deficit the US is running is structural in nature.

A structural deficit implies structural adjustments in the future; however, it may be difficult to generate the future surpluses needed to pay off this debt for demographic reasons. An aging population implies both a higher recipient to taxpayer ratio and higher healthcare costs for the elderly. Calculations of the implied cost of the entitlement programs the government has promised in the future, such as Social Security, Medicare, Medicaid and other programs, predict large increases in these costs in the future without large reductions in the promised benefits. Any attempt to run surpluses to pay back the debt will require large increases in taxes.

Paying off the Government Debt

Paying off the debt is largely a political choice. Who bears the cost of paying off the debt? Is it government workers through lower pay and lower benefits? Is it individuals who see a reduction in government services or entitlements, either directly through cuts or indirectly through slower growth in benefits? Is it taxpayers who pay higher taxes and fees? Are the additional taxes born by the rich or the poor or both? Is it bondholders who get paid back in inflated currency or don’t get paid back at all?

Government debt as a share of GDP can be reduced or eliminated in a number of ways.

  1. Run surpluses and pay off the debt as happened in the US in the 1830s, or reduce the debt/ GDP ratio by running surpluses as occurred around 2000 under Bill Clinton. Here the cost of the debt is imposed directly on taxpayers with no loss to fixed income investors.

  2. Run a deficit that is less than the growth in nominal GDP so even if you continue to run a deficit, the debt/GDP ratio shrinks. The government may have to run a surplus before interest payments in order to achieve this. The lower the interest rate, the easier this is to do. This is largely what happened in the United States between 1945 and 1973. This imposes a lower cost on taxpayers in the short run, but raises the total cost of debt over time.

  3. Inflate your way out of the debt. If the inflation rate is high enough, nominal GDP can grow faster than the deficit reducing the debt/GDP ratio. This imposes high costs on bondholders who get paid back in inflated currency but relieves taxpayers of the burden. A hyperinflation as in Germany can wipe out fixed income investors. This relieves taxpayers of the interest and principal burden of the debt, but at a high cost to fixed income investors. This solution works well with non-recurring debt (wars), but not with secular social debts.

  4. Outright Default. This can be done through a currency reform if most government debt is held domestically (Germany, 1948), devaluation if the debt is held by foreigners but in the local currency, or a default on foreign currency bonds. Here the entire cost is born by bondholders to the benefit of taxpayers, but it becomes difficult to issue new bonds.

Just as the purpose of running a deficit is to hide the cost of government services and expenditures through indirect taxation (inflation tax) or delaying the costs (issuing bonds), so the goal of the government in paying down the debt will be to make the cost as indirect as possible, or to impose the costs on those without political power.

The rest of this paper will look at the experience of twelve major economies to see how they have created and paid off deficits in the past. Each country’s experience could be the subject of a book, so only the barest of outlines is possible. Nevertheless, these brief histories and their subsequent graphs will give an idea of the choices the major developed countries now face. We will look at both the debt/GDP ratio and Interest Share of GDP which equals the benchmark bond interest rate times the debt/GDP ratio.

Historically, there have been several factors which have caused increases in the debt/GDP ratio. One is war. Globally, the primary examples are World War I and World War II. The two wars were “paid for” differently.

Most governments used inflation to reduce the cost of debt accumulated during World War I and in Germany even used “inflationary default” as a way of eliminating the debt, wiping out bondholders completely. In the United States during World War II, government controlled prices and interest rates which produced a higher return of principal in real terms, but lower interest rates to investors. The debt was paid off by allowing economic growth to shrink the deficits. On the other hand, inflation in Italy and France wiped out their debt after World War II while Germany used a Currency Reform to eliminate its obligations.

Major recessions and depressions also increased government debt, the Great Depression of the 1930s and the current Great Recession being prime examples. Governments tend to grow their way out of the deficits generated by recessions. Wars and Recessions provide quick increases in government debt which can be reversed over time.

The final source of government deficits is the attempt to increase government benefits and entitlements faster than people are willing to pay for them. These deficits are secular in nature and generally require a restructuring of government expenditures and obligations to stop the accumulation of debt. Because of their structural nature, an outright or inflationary default is unlikely to work. Those who fear the current deficits will lead to inflation miss this point. Because of the politics involved in making these structural adjustments, reversing structural deficits is the most difficult of all.

Lenders are willing to tolerate deficits due to War and Recessions because they are temporary events that can be followed by surpluses after the cessation of war or a return to growth. Deficits that occur due to secular increases in government services that cannot be immediately reversed will inevitably lead to a financial crisis that ends in the repeal of these services.

The current growth in government debt is both structural and cyclical. Many people feel that once the government debt/GDP ratio exceeds 100%, a financial vurred. Unfortunately, history shows that governments have to be forced into a crisis to solve these problems, rather than addressing them before the crisis occurs.


Australia saw its Debt/GDP ratio rise steadily from 1850 to 1900 when it established itself as a Commonwealth. By 1900, the Debt/GDP ratio was over 100%. It rose above 100% again during World War I and peaked at almost 200% of GDP during the Great Depression. Significantly, the World War II Debt/GDP peak was below the Great Depression peak, though still over 180% of GDP. Since World War II, Australia has grown out of its Debt, which now represents less than 10% of GDP placing it in one of the most fiscally sound positions of any developed country.

Australia was able to increase its Debt/GDP ratio through 1900 because it was a growing colony. It could borrow money in London with little problem. As it grew, Australia moved its debt burden from international to domestic borrowers and has now almost completely eliminated the foreign debt portion of its government debt. Australia borrowed as it developed its economy, and has grown out of its debt successfully with few periods of high inflation. Returns to fixed income investors in Australia have been high as a result.


Unlike Australia, Canada kept its government debt relatively low until World War I, at which point it rose to 70% of GDP. The debt rose to over 80% of GDP during the 1930s and peaked at over 150% during World War II. The debt declined steadily until the 1970s. Canada reached a debt crisis in the 1990s when secular increases in government services and entitlements pushed debt to over 70% of GDP and the interest cost to over 6% of GDP. Even during World War II when debt exceeded 150% of GDP, the “interest cost” of the debt was only 4% of GDP.

The increase in government debt was clearly unsustainable. The Canadian government was forced to cut back on its spending to eliminate its deficits. Consequently, because Canada put its government finances in order in the 1990s, it has suffered less during the current Recession than other developed countries.


France saw rising deficits during the 19th century until it reached 100% of GDP by 1900. Most of this increase occurred after 1870 when Germany imposed a costly indemnity on France as a result of the Franco-Prussian War. Consequently, when World War I began, France’s Debt/GDP ratio exceeded 80% (vs. 3% in the US). Despite inflation during World War I, France’s Debt/GDP ratio rose to over 200% by the early 1920s. Because of this debt, it is no wonder France wanted to impose a large indemnity on Germany when Germany lost World War I.

By the beginning of World War II, France’s Debt/ GDP ratio was down to 100% but shot over 200% during World War II. With no prospect of an indemnity from Germany after World War II, France inflated its way out of its debt imposing heavy losses on bondholders, but to the benefit of taxpayers. This laid the foundations for France’s rapid growth after World War II. Despite the fact that France’s Debt/ GDP ratio has grown since the 1970s, it has not reached crisis levels due to high tax rates.

What is important to see about France is that after almost three decades (1915-1945) of having taxpayers bear a high debt cost, the government finally punished bondholders through an “inflationary default”.

Today, this would be more difficult to do because debt is issued in Euros rather than Francs or another local currency, and, as we have seen with Greece, the Euro countries will help countries that could default on their debt because of the costs of the default contagion effect. Nevertheless, there is no guarantee that a country such as Greece couldn’t remove the Euro strait jacket, abandon the Euro, convert its debt into Drachmas and inflate its way out. This possibility is what keeps Greek debt at its current high yields.


The graphs for Germany are deceiving because there are key periods, during World War I and World War II, when data on Germany’s debts are unavailable. Germany inflated its way out of its debts from World War I through hyperinflation, wiping out bondholders. In 1948, Germany used a currency conversion from Military Marks to Deutschemarks to effectively reduce its debt obligations by 90%.

In part, because Germany twice destroyed the assets of bondholders, it has been more fiscally responsible then other countries since World War II. Although its Debt/GDP ratio has been rising since the 1970s, it remains lower than most other countries. Holders of Confederate and German bonds know that if you lend to the losing side of a war, bondholders can be wiped out.


Although Italy has had a long history of running deficits, its Debt/GDP ratio has rarely exceeded 100% of GDP by a large margin. Like France, Italy inflated its way out of its debts after World War II, imposing large losses on bondholders. Unlike France, it consistently ran budget deficits after World War II and used inflation as a way of minimizing the true cost. In the 1990s it reformed its finances to stop the Debt/GDP ratio from growing more and upon joining the Euro benefitted from lower interest rates cutting the Interest Coverage Cost of its debt to more realistic levels. Significantly, despite its high Debt/GDP ratio, the yield on its government bonds has not risen as steeply as those of Ireland, Portugal, Greece and Spain.

The lesson for Italy is that persistently high deficits impose persistently high costs on investors even if the debt never hits ruinous levels. Because Italy has persistently refused to balance its budgets, it has provided the worst returns of any G-7 country to both equity and fixed income investors. This is because Italy has had consistently high inflation, yielding low or negative interest rates at the expense of bondholders.