When governments spend more than they collect in taxes, they issue bonds to cover the gap. The Federal Reserve holds over $6 trillion in US bonds, and countries measure their debt burden using the debt-to-GDP ratio. Rising inflation makes borrowing more expensive and can trap governments in cycles of growing debt.
Chapters
What is government debt and why should we care? Well, simply, a government has to borrow when its expenditure on things like social services, education, and infrastructure exceeds the income it receives from tax receipts. If the government spends more than it earns, it is said to be in deficit, with each deficit adding to the debt from previous years. When the government realizes that it needs to raise money, it will conduct an auction, executed by the Fed in the US and the Debt Management Office in the UK. In this auction, the government sells bonds, which are called gilts in the UK and T-bills in the US, to pension funds, central banks, mutual funds, and foreign governments, who buy the debt as they seek safe and predictable long-term investments. Now, demand for US government bonds is extremely high, as in investors seek a low-risk, stable return on their investment. Therefore, institutional investors compete with foreign countries who use dollar-denominated bonds as a safe haven for their reserves. In addition, the Federal Reserve owns over $6 trillion of government bonds purchased during rounds of quantitative easing in the wake of the 2008 financial crisis. In fact, total US debt dwarfs other countries. When it comes to comparing government debt across countries, we use the debt-to-GDP ratio. A country might have a higher level of debt in absolute terms, but if debt is low relative to GDP, it's less concerning. When investing in government debt, the inflation outlook often plays an important role. Governments typically issue two types of bonds: fixed-rate and inflation-linked. In a low-inflation environment, central bank interest rates tend to be low, which means new government bond issuances are snapped up with very low interest payments. Inflation-linked bonds, where interest payments rise and fall in line with a measure of inflation, will remain low and manageable. However, in an inflationary environment where interest rates are rising to dampen inflation, new issuances will have higher interest payments and inflation-linked bonds will cost the government more. Now, the danger with taking on more government debt is that it can create a vicious cycle where more debt results in higher annual expenditure on debt servicing, or paying interest rates, which will increase a government's budget deficit, resulting in higher levels of debt, and then higher levels of debt servicing, and so on. So what happens when a government bond is due to be repaid? Well, there are two options. The first is simply to repay the bond out of a budget surplus, and the second is to refinance debt by issuing new bonds. If a country cannot repay their debt and no one wants to buy the new bond issuance, they are in default. Which is a horrible situation, meaning that borrowing money in the future will become a lot more difficult.
