Interest Rates
and Government Debt
I, .1 a much-cited address in August 1984 at
the 40th Congress of the International
Institute of Public Finance, Jacques de
Larosiere, then Managing Director of the IMF,
expressed his concern about the "explosion of
public debt" that was affecting developing
and developed countries alike. He outlined
various consequences of excessive indebted-
ness and called on governments to pursue
structural reforms in their public finances to
contain such an "explosion" and put their fis-
cal houses in order.
Given the high and growing public debts in
most industrial countries in recent years, the
renewal of such concerns is not unjustified.
There has been much controversy, in particu-
lar, as to whether an enlarged public debt
could raise interest rates. While earlier stud-
ies have examined the effects of fiscal deficits
and debt on real interest rates for individual
countries, there is a growing consensus that,
in view of the increasing integration of finan-
cial markets, which allows fiscal deficits of
one country to be financed by savings of
other countries, a better understanding might
be obtained by taking a global, rather than a
national, perspective. Thus, each country's
deficit has its impact on interest rates in the
world capital market.
For a detailed version, see "Interest Rates and
Government Debt: Are the Linkages Global Rather
than National?" by Vito Tanzi and Mark Lutz, IMF
Working Paper (WP/91/6), available from the
authors.
30 Finance & Development / December 1991
©International Monetary Fund. Not for Redistribution
Some linkages and consequences
Vito Tanzi and Mark S. Lutz
This article surveys various issues associ-
ated with the growth of public debt among
the Organization for Economic Co-operation
and Development (OECD) countries. It high-
lights the links between increases in the ratio
of government debt to GDP and increases in
real interest rates, between increases in inter-
est payments and reductions in capital spend-
ing, and between increases in interest pay-
ments and increases in taxation.
Reasons for concern
Debt financing substitutes for taxation. It
thus allows governments to maintain or in-
crease, at least temporarily, public spending
without the need to legislate tax increases. In
other words, it has the political advantage of
generating an immediate benefit (the public
expenditure) without an immediate cost (the
raising of tax rates). Given that governments
are likely to have short horizons and, thus, to
discount future costs at high rates—espe-
cially when there is a high probability that
these costs will be faced by another set of pol-
icymakers, or even by another party—the
temptation to finance spending through debt
is naturally strong.
If the additional spending is temporary, an
argument can be made that debt financing
will help smooth the required changes in tax
rates over time. Since sudden and temporary
changes in tax rates generate distortions and,
thus, welfare losses, with adverse effects on
growth, the use of debt finance will increase
the efficiency of the economy. This would be
the case especially when the increase in
spending is caused by wars, depressions, or
large public investments concentrated in a
relatively short time. In the latter case, if the
investment is productive, the debt would pay
for itself by raising the level of economic ac-
tivity and, therefore, the tax base.
If the increase in public spending is not
temporary and is financed by debt, the share
of public debt in national income may grow.
As a consequence, the cost of servicing the
debt will also grow, especially if interest rates
are high. Thus, ironically, the debt that may
have been used to keep tax rates down may
eventually force these rates up, since the
country will in time need to generate a "pri-
mary surplus" (the difference between rev-
enues and non-interest expenditures) to ser-
vice the debt. In cases where public spending
is difficult to cut, that primary surplus must
be generated mostly through higher taxes.
Over the 1975-87 period, for example, in spite
of the increase in the share of public debt
into GDP, the share of total taxes in GDP
grew substantially in most OECD countries,
largely to finance higher government interest
payments.
The growth of the ratio of debt to GDP is
influenced by the rate of growth of the econ-
omy, the interest rate on the debt, and the size
of the primary surplus. Thus, a high growth
rate and a low rate of interest will be major
contributors to restraining the growth of pub-
lic debt in GDP. The current fiscal stance, as
assessed through the primary surplus or
deficit, also plays an important role. In fact,
since countries generally cannot, over the
longer-term horizon, significantly influence
the rates of interest and the growth of the
economy, the policy variable available to
them is the primary surplus. If non-interest
spending cannot be reduced, then the tax rate
becomes the basic policy instrument.
 In the absence of comparable real effective
(i.e., inflation and growth-adjusted) interest
rates on the debt, comparisons of debt ratios
over time or across countries are not particu-
larly meaningful. In recent years, because of
large capital movements, interest rates have
tended to converge across countries. This im-
plies that global factors, as distinguished
from purely domestic factors, have played a
growing role in influencing domestic interest
rates. However, even if real world interest
rates tend to be influenced by the size of the
global debt, and if countries with higher than
average debt tend to pay some differential
over the international interest rates, then
cross-sectional comparisons still need to be
qualified.
Public debt in OECD countries
The ratio of general government gross debt
to GDP has been rising in most OECD coun-
tries, reaching very high levels by 1987 in
many of them. Between 1975 and 1987, the
ratio rose from 61.1 percent to 132.4 percent
in Belgium; from 11.9 percent to 57.2 percent
in Denmark; from 64.3 percent to 128.7 per-
cent in Ireland; from 60.4 percent to 92.7 per-
cent in Italy; and from 22.4 percent to 76 per-
cent in Japan. Chart 1 shows the behavior of
gross debt as a share of GDP for the United
States, Japan, and Germany combined (G-3),
as well as for the G-3 plus France, Italy, the
United Kingdom, and Canada (G-7). In addi-
tion, 13 OECD countries for which the statisti-
cal information was available were aggre-
gated to provide the G-13 group. In each of
these groups the weight of a country was
based on its gross domestic product, and the
conversion into dollars, on average official ex-
change rates.
Chart 2 shows the behavior of real long-
term government bond rates, reflecting the
average for the same groups of countries. A
comparison of Charts 1 and 2 reveals some
common trends: Until 1974, the ratio of debt
to GDP was falling and so was the real bond
rate. Between 1975 and 1980, there was some
increase in the debt ratio, as well as in the real
bond rate. From 1980 to 1985 the share of debt
in GDP rose very fast, tracking closely with
the real bond rate. After 1985, however, the
trends seem to diverge, with the debt ratio
continuing its upward trend, though at a
slower pace, while the real bond rate declined
somewhat.
Government debt and interest rates
We can no longer assume that the fiscal
deficits of any country will necessarily be
financed by the financial resources of that
country alone, or that there must be a strong
correlation between the total domestic
©International Monetary Fund. Not for Redistribution
Chart 1
General government
gross dept, 1970—87
(Percentage of gross domestic product)
Chart 2
Real long-term goverment
bond rate, 1970—87
(Percentage point)
Source: IMF Working Paper 91/6.
demand for savings (including investment
and fiscal deficits) and the total domestic sup-
ply. For the world as a whole, the demand for
financial savings must be equal to the supply
of financial savings. International interest
rates must play a major role in bringing
about this equilibrium. This means that the
impact of fiscal policy on interest rates is
more meaningful in a global context. This, of
course, does not mean that the fiscal policy of
a specific country will not have any effect on
the real interest rate of that country. Rather,
each country's financial policy, apart from its
impact on the world interest rate, influences
the difference between its interest rate and
the average international interest rate.
How can we capture the global link be-
tween world real interest rates and levels of
global government debt? The global real in-
terest rate can be modeled as being deter-
mined by the process equilibrating saving,
both public and private, and investment. The
demand for capital goods is seen to be
strongly procyclical, rising rapidly during pe-
riods of economic expansion and falling dur-
ing recessions, and, therefore, may be cap-
tured by a proxy variable reflecting the
business cycle. Saving decisions are made by
both the public and private sector. Therefore,
measures of government deficits and private
saving levels, both expressed as ratios to out-
put, were included in the model. The model
also tested the ratio of government debt to
GDP, as this may have a direct influence on
real interest rates, and other variables captur-
ing government consumption levels and mon-
etary policy.
A variety of tests were run for the three
groups of countries—the G-3, the G-7, and the
G-13, the latter being the largest group of
countries for which data over the entire sam-
ple period were available. Different concepts
for the level of government, the definition of
the deficit, the use of gross or net debt ratios
and saving rates, the type of exchange rates
used for aggregation, and various interactions
among the variables were used in order to
gauge the robustness of the results. The re-
sults show significant positive linkages be-
tween real interest rates on long-term govern-
ment bonds and the ratio of government debt
to GDP over the 1979-87 period. An increase
in the ratio of public debt to GDP by 1 per-
centage point increases real interest rates by
about 20 basis points, while an increase in the
deficit by a similar magnitude has an effect
that is eight to ten times as strong. Higher
stocks of reserve money lower real interest
rates, at least in the first year, while higher
levels of economic activity have the opposite
effect. Higher levels of net private saving were
seen to reduce interest rates, as expected.
Changes in government activity
Increasing ratios of government debt to
GDP, in addition to raising interest rates, also
have generally harmful consequences for the
level and pattern of government activity. An
increase in interest payments on the public
debt must result in (1) a higher fiscal deficit,
(2) a higher level of taxation, or (3) a crowding
out of other public expenditure. Of course, the
Finance & Development I December 1991 31
 increase in interest payments quire higher interest payments
as a share of GDP, in the ab- Changes in interest payments, debt ratios, and reductions in capital
sence of changes in real inter- spending.
tax levels, and capital spending. 198O—87
est rates, must be preceded by (In percent of SOP)
Thus, in the end, govern-
an increase in public debt. For ments that accumulated debt
industrial countries there has to avoid sudden adjustment in
Change m Change in
been far more discussion interest Change in Change in capital tax rates were forced to raise
among economists of debt fi- payments debt ratios lax ralio sponging
taxes to meet the increasing in-
nancing than of debt servicing. United Stales 1.7 13.7 0.5 -0.2 terest payments. The experi-
In fact, while those writing on Japan 1.3 24.0 4.7 -1.0 ence of the OECD countries
developing countries have of- Germany 0.9 11.3 -0.4 -1.1 shows that the growth of pub-
ten focused on the difficulties France 1.3 10.3 3.1 0.1 lic debt will eventually con-
of servicing these countries' Italy 3.2 33.8 6.0 0.3 tribute to the rise of tax levels.
debt, those writing on indus- United Kingdom -0.4 -4.6 2.2 -0.7
2.9
The pressure to increase taxes
Canada 2.8 23.9 -0.4
trial countries have focused far becomes stronger as interest
Ne! norlands 2.5 29.0 2.2 -1.0
more on the process of debt ac- Australia 1.6 0.7 2.3 -0.9 rates become significantly
cumulation. Sweden 2.5 17.2 7.3 -1.6 greater than the growth rates
The growth of public debt Belgium 4.5 52.5 2.6 -1.8 of the economies, as has oc-
has been defended by some Austria 1.5 20.1 1.2 -1.2 curred in the 1980s. In practi-
economists when it is associ- Denmark 4.4 23.7 6.5 -1.2 cally all countries, the ratio of
ated with wars and major pub- Finland 0.6 6.1 2.9 -0.1 tax revenue to GDP rose over
lic investments, since it pre- Norway 0.9 -1.2 1.2 -0.5 the period. Further, that ratio
vents the increase in tax levels, Ireland1 3.2 48.7 5.9 -0.7
seems to have risen the most
Spain' 3.1 29.7 9.0 —
with their attendant distorting in those countries that experi-
Switzerland -0.3 — 1.2 —
influences, that would be re- enced the largest increase in
Source: OECD
quired to finance the tempo- 'Through 1986. debt and, consequently, in in-
rary increase in public spend- — Indicates absence of dala.
terest payments. The increases
ing. How do these reasons in tax ratios were particularly
apply to the growth of public large in Belgium, Canada,
debt in our sample countries? Denmark, Ireland, Italy, Japan,
There were no such excuses for and Spain, and all countries
large-scale borrowing in the OECD countries interest expenditures. In other words, they try that experienced large rises in debt to GDP
during 1970-87. Thus, fortunately, war fi- to raise the primary surplus. The expendi- ratios and in interest payments to GDP ratios.
nancing cannot be an explanation for the tures most likely to be reduced are those that Although this analysis may be seen as too
growth in public debt in this period, as it had do not have strong support from interest simple, it does provide results that are consis-
been for the growth in American debt in the groups and those whose benefits occur only tent with what one would expect from general
1940s, or for British debt during the past cen- in the future so that their present (especially public choice considerations. Thus, the
tury. The explanation must be found some- political) value is low. Governments typically growth in public debt, with the accompany-
where else. encounter the least resistance if they cut capi- ing increases in interest rates, will in time
What about a bulge in public investment? tal expenditure. Other types of expenditures, lead to increases in tax ratios, as well as to
Is there any evidence of it? Our data indicate such as those for wages and salaries and op- changes in the structure of public expendi-
that, on the contrary, the share of general eration and maintenance, are also likely to be ture, with government investment being pro-
government investment spending in GDP fell squeezed. The table shows the negative rela- gressively squeezed out by rising interest
in practically all countries over the period. tionship between higher debt ratios, which re- payments.
Therefore, the argument that debt financing
would be self-financing, if associated with
major (and productive) capital projects, is not
valid for these countries.
So what has been behind the growth of
government debt ratios? For the countries
and period considered here, the major expla-
nation for rising deficits, and hence the in- Vito Tanzi Mark Lutz
a US citizen, is Director of a US citizen, is an
crease in debt ratios, is rapid increases in gov- Economist with the IMF's
the IMF's Fiscal Affairs
ernment "transfers." The largest of these Department. He is the au- Fiscal Affairs Department.
transfers has been for social security, which thor and editor of numer- He holds a PhD from the
demands greater resources because of aging ous books and articles. University of Maryland
populations, higher levels of eligibility of the and has worked at the
aged for pensions, and higher real pensions Council of Economic
per pensioner. Advisers.
As noted above, when countries face large
fiscal deficits, governments may try to limit
them by raising taxes and by reducing non-

32 Finance & Development / December 1991

©International Monetary Fund. Not for Redistribution