Debt-To-GDP ratio...What does it indicate?

Before we begin our discussion of the Debt-to-GDP ratio, we should first refine and define our terms. In a debt to GDP ratio, the word “debt” refers to the public debt (Kenton), which is “the amounts owed by the different levels of government and used to finance public deficits resulting from a higher level of program spending to budgeted income.” (OFILAC) In other words, it’s all the money that our government has borrowed as a nation.

On the other hand, a GDP (Gross Domestic Product) is a measure of all of a country's FINISHED product's market value. Basically, it’s the sum of the value of all the products available to consumers (Unravel Talks). In a statistical way, it is the common means to measure a nation's wealth.

The Debt-to-GDP ratio has two major implications for an economy. Firstly, it indicates how likely a government is to default on its loans. Secondly, it often determines the governmentally-paid interest rates for foreign loans (Kenton). Thirdly, it can significantly slow down an economy.

The first implication of a debt-to-GDP ratio is the likelihood to default on its loans. Recent examples include Greece in 2012 and Lebanon in 2020. These two countries accumulated a ridiculous amount of debt and a significant budget deficit, to the point where they were unable to pay it back, and all those who have loaned them money lost it (Kurt). Although the exact percentage where a debt-to-GDP becomes unstable or unsustainable, the Centre for Economic Policy estimates that a percentage of around 130% is where you begin seeing a significant risk of default. (CEPR)

The second implication of a debt-to-GDP ratio is the determination of governmentally-paid interest rates. This is a rather simple fact. The more debt you have, the higher interest rates are to compensate for the risk. Once you cross a certain point, like the 130% mentioned in the previous paragraph, you begin to pay a risk premium, just because of the amount of debt you already have. And the event of a national crisis, it becomes difficult to just pay the interest for the debt you have.

The third implication of a debt-to-GDP ratio is the economic repercussions. A study by the World Bank estimated that a debt rate above 77% slows down the economy significantly. (Kenton) Basically, every 5 percentage points of debt above this rate slows down the economy (and thus the GDP) by 1 percent. Considering that the US debt-to-GDP is at 118% as of Q1 2023. That would figure to an approximate 8% decrease in our economy's production. That’s a significant decrease! We are losing nearly a tenth of our potential economic output because of our government’s excessive debt.

So in conclusion, the debt-to-GDP ratio is a good way to estimate the likelihood a government is to default on its loans, to determine governmentally-paid interest rates, and to estimate the effect the public debt is having on the economy. It is also clear that having a low debt-to-GDP is advantageous to the economy.

Bibliography:

CEPR. “Public Debt and the Risk Premium: A Dangerous Doom Loop.” CEPR, https://cepr.org/voxeu/columns/public-debt-and-risk-premium-dangerous-doom-loop. Accessed 28 July 2023.

FRED Economic Research. “Federal Debt: Total Public Debt as Percent of Gross Domestic Product.” St. Louis Fed, 29 June 2023, https://fred.stlouisfed.org/series/GFDEGDQ188S.

Kenton, Will. “Debt-to-GDP Ratio: Formula and What It Can Tell You.” Investopedia, 3 July 2023, https://www.investopedia.com/terms/d/debtgdpratio.asp.

Kenton, Will. “What Is the World Bank, and What Does It Do?” Investopedia, 20 June 2023, https://www.investopedia.com/terms/w/worldbank.asp.

Kurt, Daniel. “Why and When Do Countries Default?” Investopedia, 2 May 2023, https://www.investopedia.com/articles/investing/102413/why-and-when-do-countries-default.asp. “OFILAC.” Observatorio Fiscal Del Latinoamerica y El Caribe, https://www.cepal.org/ofilac/en/public-debt. Accessed 28 July 2023.

Unravel Talks. “What Is GDP?” YouTube, 24 Mar. 2021, https://www.youtube.com/watch?v=v8eifqSOrh4&t=16s.