The public debt is how much a country owes to lenders. These can include individuals, businesses, and even other governments. The term "public debt" is often used interchangeably with the term "sovereign debt."
Public debt usually only refers to the national debt. Some countries also include the debt owed by states, provinces, and municipalities. Therefore, be careful when comparing public debt between countries to make sure the definitions are the same.
Regardless of what it's called, public debt is the accumulation of annual budget deficits. It's the result of years of government leaders spending more than they take in via tax revenues. A nation’s deficit affects its debt and vice-versa.
Key Takeaways
- Public debt is the amount of money that a government owes to outside debtors.
- Public debt allows governments to raise funds to grow their economies or pay for services.
- Politicians prefer to raise public debt rather than raise taxes.
- Public debt is part of the national debt and when the national debt reaches 77% or more of gross domestic product (GDP) the debt begins to slow growth.
Public Debt vs. Gross External Debt
Don't confuse public debt with gross external debt. That's the amount owed to foreign investors by both the government and the private sector. Public debt impacts external debt, but they are not one and the same. If interest rates go up on the public debt, they will also rise for all private debt. That's one reason most businesses pressure governments to keep public debt within a reasonable range.
When Is Public Debt Good?
In the short run, public debt is a good way for countries to get extra funds to invest in their economic growth. Public debt is a safe way for people in other countries to invest in another country's growth by buying government bonds.
This is much safer than foreign direct investment. That's when people from other countries purchase at least a 10% interest in the country's companies, businesses, or real estate. It's also less risky than investing in the country's public companies via its stock market. Public debt is attractive to risk-averse investors since it is backed by the government itself.
When used correctly, public debt can improve the standard of living in a country. It allows the government to build new roads and bridges, improve education and job training, and provide pensions. This encourages people to spend more now instead of saving for retirement. This spending further boosts economic growth.
When Is Public Debt Bad?
Governments tend to take on too much debt because the benefits make them popular with voters. Increasing the debt allows government leaders to increase spending without raising taxes. Investors usually measure the level of risk by comparing debt to a country's total economic output, which is measured by GDP. The debt-to-GDP ratio gives an indication of how likely the country is to pay off its debt.
Note
Investors usually don't become concerned until the debt-to-GDP ratio reaches a critical level. The World Bank has said the tipping point is 77% or more.
When debt approaches a critical level, investors usually start demanding a higher interest rate. They want more return for the greater risk. If the country keeps spending, then its bonds may receive a lower credit rating. This indicates how likely it is that the country will default on its debt.
As interest rates rise, it becomes more expensive for a country to refinance its existing debt. In time, income has to go toward debt repayment, and less toward government services. Much like what occurred in Europe, a scenario like this could lead to a sovereign debt crisis.
In the long run, public debt that's too large causes investors to drive up interest rates in return for the increased risk of default. That makes the components of economic expansion, such as housing, business growth, and auto loans, more expensive. To avoid this burden, governments need to carefully find that sweet spot of public debt. It must be large enough to drive economic growth but small enough to keep interest rates low.
The U.S. Treasury Department manages the U.S. debt through its Bureau of the Fiscal Service. It measures debt owned by the public separately from intragovernmental debt. Together, debt held by the public and intragovernmental debt make up the national debt.
Public debt includes Treasury bills, notes, and bonds, which are bought by investors. You can become an owner of the public debt by purchasing savings bonds and Treasury Inflation-Protected Securities (TIPS). In 2021, debt held by the public was more than $22 trillion.
Note
Intragovernmental debt is the amount owed to federal retirement trust funds, most importantly the Social Security Trust Fund. In 2021, it was more than $6 trillion.
The total national debt has hit several milestones over the years. For example, it jumped from $23 trillion in October 2019 to over $29 trillion by December 2021. That's more than $5 trillion in just 1.5 years. In 2021 the national debt was also about 125% of GDP—much higher than the suggested tipping point of 77%.
That could make the owners of the U.S. debt insist on higher interest rates. The largest foreign owner of the U.S. debt is Japan, which China coming in second. Both countries export a lot to the U.S. and thus receive a lot of U.S. dollars as payments. They use those dollars to purchase Treasurys as a safe investment.
While foreign investors like Japan and China hold a large amount of the U.S. public debt, the largest domestic owner is U.S. taxpayers through Social Security.
Frequently Asked Questions (FAQs)
How does a deficit lead to public debt?
A deficit occurs when the government doesn't bring in enough revenue to pay for all the spending it plans to do. If the government doesn't cut back on its spending, then it borrows money from another source to close the deficit gap. That borrowing creates a debt that must eventually be repaid.
How is public debt calculated?
You can quickly estimate public debt by adding budget deficits (or subtracting surpluses) over the years you want to measure. This doesn't account for details like the cost of servicing debt, so some analysts prefer to add together all liability categories separately. These categories include debt securities, pensions, and other accounts payable.