January 2013|bsi|

Debt is not something governments brag about. On the contrary, ominous metaphors like ballooning debt burdens and exploding debt make it clear that, in political discourse at least, debt is a bad thing. And in the current economic climate, debt trends have become a major headache for economic policymakers in virtually all G20 economies.

Over on his blog, Matt Andrews takes a look (or two) at the relationship between debt size and income per capita. He notes that, in 2001, the richer the country was, the lower its debt (as a percentage of GDP). Over the last decade this relationship has reversed. As of 2010 – or one financial crisis later – the richer the country, the higher its debt. Matt wonders whether this worsening of rich countries’ debt position says something about their governance. If debt/GDP was a governance indicator, what would it tell us? Matt seems to lean towards thinking it’s not a good thing.

I think it could just possibly be a great thing.

Now, if a government takes on a large amount of debt over a short period of time, its situation hasn’t improved. Interest payments crowd out other, more useful, expenditures. Interest rates may well rise. When a lot of debt is held  by international lenders, the country becomes more vulnerable to external shocks. Furthermore, its ability to raise future debt may be reduced.

But what about that ability to raise debt? Surely being able to convince others to trust you with their money is a sign that you’re doing something right. To worry about a worsening debt in any one country is one thing; but let’s not forget that many governments are not in a position (or have not always been in a position) to raise a lot of debt in the first place.

Historically, a government’s ability to raise debt has been a crucial competitive advantage. Britain funded more than 80% of its spending on its late-17th-century wars with borrowed money. That option was not available to France, a serial defaulter at the time. It may be a stretch to say that Britain’s ability to out borrow France won it the war, but the two points are not unconnected. One can easily imagine that the decision of the bankers of Amsterdam and London to lend to one government but not the other was a vote of confidence in that government’s ability to win the war, do well in the future (and repay).


The same is true today. The graph above compares government debt as a percentage of GDP with Government Effectiveness scores. All figures are from the World Bank. I found matching data for 59 countries (I put together this quite quickly, so it shouldn’t be taken as conclusive). One can of course criticize the choice of indicator, but it would not be too much of a stretch to assume that a government effectiveness score is a reasonable impression of how effective a government is perceived to be (a lot of perception survey data is used for the government effectiveness index). This in turn is an approximation of how effective a government actually is.

The chart shows a clear positive relationship: the better your effectiveness score, the more debt you have. And countries seem to cluster together in an interesting pattern (I’ve tried to mark this out with the three red boxes). In the upper right quadrant, you find countries with high effectiveness scores and relatively high debt. The US is part of this cluster, and seems to be an entirely ordinary case. In the lower left quadrant, governments are not effective and debt is low. So if debt is indeed a governance indicator, it could be interpreted as a vote of confidence by lenders in a government’s effectiveness. Which in turn might be a reasonable proxy for their ability to service their debt.

In the upper left quadrant, a number of governments seem like they could borrow a lot more, but evidently choose not to, for whatever reason. But interestingly, there are hardly any countries in the lower right quadrant: not many countries with low effectiveness scores end up with lots of debt. If there is anything to the relationship between debt and effectiveness, it’s that governments perceived to be less effective are not capable of convincing lenders to give them more. A good indicator of effective governance?

The countries that do end up with more debt, people worry about. I don’t know about the Seychelles and Maldives, maybe being an international tourist destination skews this relationship somehow. But Italy and Japan are both well-known sources of debt concern. Greece’s debt crisis has its own Wikipedia entry.

So there are outliers, but otherwise there is an interesting relationship between debt and the effectiveness of governments. More effective governments are able to borrow more, and many do. Some that could, don’t. But hardly any governments that lack the corresponding level of effectiveness get away with high levels of debt. Perhaps worth some further investigation – and debate.

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