Debt-to-GDP ratios and debt ceilings explained

So, why do governments borrow money in the first place? Why are countries such as Japan (with a debt-to-GDP ratio of 240 per cent) aren’t freaking out? And what’s stopping governments – including the Australian government – from just continuing to borrow?

Well, borrowing a bit of money is generally a good thing.

As independent economist Saul Eslake puts it, most households want to pay off their debt at some point in their life so as not to leave debts behind for their children. But it’s a different matter for governments and well-run companies because they don’t (usually) die.

Australia, right now, is better positioned than most countries when it comes to the money our government owes.

In fact, he says funding some infrastructure spending – such as on a new railway, hospital or renewable energy technology – is a reasonable way of making sure future generations contribute something to the cost of creating something they will benefit from, rather than the entire burden falling on the current generation.

Of course, it also depends on what that borrowed money is spent on. Relying on it to pay for day-to-day expenses such as salaries and wages is probably less fruitful than investing it in big projects like a new train line that people can use for years to come.

It also depends on the state of the economy. When growth is weak or receding, there’s a stronger case for the government to borrow money to pump into the economy. But when things are going well and business is booming, borrowing can drive up demand and push up prices.

It’s also less worrying for the government to be borrowing when interest rates are low. When the cost of borrowing starts to creep up, that’s when a big pile of debt can be problematic.

Then, there’s also the question of whether the government is borrowing from within the country, or outside it.

The Japanese government, for example, borrows mostly from its own Bank of Japan, Japanese financial institutions and Japanese citizens. That means, despite its huge debt, it tends to pay lower interest rates because there’s a huge supply of savings within the country and lower transaction costs than if they were to borrow more from overseas. It also takes out loans in its own currency: the Japanese yen. By comparison, only about one third of Australian government debt is held domestically.

Most debt crises, including the infamous Greek debt crisis in 2009, came to a head partly because those countries were borrowing from outside their borders or in currencies that weren’t their own. That left them vulnerable to sudden global movements and also meant they couldn’t just print off money to pay down their debt.

Of course, it’s not really a strategy at all for governments to just print money.

As we saw during the COVID-19 pandemic, a larger supply of money floating around the economy pushed down its price, or value. In other words, printing too much money leads to inflation because everyone’s money becomes less valuable and, therefore, they are less able to buy things.

But back to the Australian government’s debt, which Treasurer Jim Chalmers managed to trim back to 38 per cent of GDP, then 34 per cent, before this year letting it creep back up to 36 per cent.

This year, the federal government has set aside $28 billion towards interest payments. That works out to about $1400 per Australian taxpayer. But it’s also only $3 billion shy of one of our most expensive government programs: Medicare.

There’s no hard and fast rule for how much debt is optimal. And for now, with an AAA credit rating – the best possible mark for a country’s ability to repay its debts – the Australian government can borrow at lower interest rates than many other countries.

If anything, it’s our state governments that have received a warning from one of the world’s biggest ratings agencies that their rating could be dropped to AA if they don’t rein in their spending.

And while Australia’s government debt is far from being at crisis level, it is important to keep in mind that it comes at a cost. We know that printing money comes with its own problems. But higher debt also means the government will have to hike taxes, reduce spending, or a combination of the two, to pay it off.

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Losing that AAA rating is not the end of the world for the states or for the federal government. But it does mean our borrowing options will shrink a bit, and the interest costs will pick up.

Our government does most of its borrowing through the Australian Office of Financial Management (AOFM), which sells loans (also known as bonds or bills) on behalf of the government. These loans are then bought mostly by huge asset managers, including pension funds and insurers, hedge funds and central banks, including the Reserve Bank – with some of it bought by non-professional individual investors.

As Eslake points out, some of the big borrowers will be barred (by their own rules) from taking on more Australian government debt if our rating is knocked down a notch.

However, pressures on government spending will probably only rise in years to come as the population ages, the energy transition becomes more urgent and housing demands intensify.

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While a debt ceiling such as the one in the US is an arguably silly concept, it’s not a bad idea to have a debt-to-GDP target to measure up against.

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