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National debt: Causes and consequences

The global financial crisis and the eurozone debt crisis have increasingly spotlighted the causes and consequences of national debt. The following article takes a closer look at these topics.

16.09.2019 | Mathias Kobel

Coins, paper and a calculator on a table  (Source: iStock)
In 2001, Switzerland became the first country to introduce a debt brake, a mechanism for overall management of the federal budget (Source: iStock)

 

National debt is defined as the total amount of outstanding debt owed by a country at a certain point in time. It consists of internal (domestic) debt and external (foreign) debt. Internal debt is what a country owes its creditors in domestic currency, whereas external debt means that a country has borrowed foreign currency. A country becomes insolvent if it is no longer able to pay its external debt. The burden of debt is calculated using the following indicators: annual budget deficit, level of debt (total amount of all budget deficits) and gross domestic product (GDP).

The ratio of a country's debt to its economic performance – in other words, the ratio of budgetary deficit to GDP in a given year – equals the deficit ratio. What makes this deficit ratio a useful tool for assessing a country’s debt situation is that it compares the country’s debt to its macroeconomic performance.

Causes

How does a country accumulate debt? It may get into debt through making large investments or if confronted with an unprecedented, major emergency, such as a natural disaster. Supporting a vast state administration can be a further cause of debt.

Consequences

A country can balance its budgetary deficit to a certain extent by raising taxes. However, if this measure is not effective and the country is unable to repay its debt on the same terms under which it borrowed, this can lead to national bankruptcy. The consequences are a declining growth in national product and higher interest charges. Bankruptcy can also increase the risk of a banking or currency crisis. Financial insolvency leads to a loss of confidence in the state and to major losses by its citizens.

Support

Various international institutions analyse state budgets and assist countries that fall into financial difficulty. One such institution is the International Monetary Fund (IMF), which may support its member states with loans. A further body is the Paris Club, an informal group comprising 22 members that negotiates with insolvent countries on rescheduling debts following endorsement by the IMF. If necessary, the London Club also comes on board. The latter is a group of private banks that brings together creditor banks and debtor states for the purpose of debt rescheduling. The group does not have its own secretariat.

Debt brake

In 2001, Switzerland became the first country to introduce a debt brake, a mechanism for overall management of the federal budget. The mechanism is enshrined in the Federal Constitution and its purpose is to stabilise debt by using surpluses built up during economic prosperity to compensate deficits during a subsequent recession. Several EU states, including Germany, Spain and Bulgaria, have also adopted the debt brake mechanism.

 

 
 

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