Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why Government Debt Is Not Free Money
Transcript
- Lucas: There's a phrase you hear a lot in policy debates — 'the government can just borrow more.' It sounds simple. But the real question is: at what cost? Luna: Right, because debt isn't free. Even if interest rates are low, there's always a price tag. Lucas: Exactly. And that price tag is often hidden in plain sight. We're going to look at one specific concept today: fiscal space. It's the room a government has to borrow without causing a crisis. And some countries have a lot less room than they think. Luna: Fiscal space — I've heard that term thrown around in IMF reports, but what does it actually mean in practice? Lucas: It's basically a measure of credibility. How much more debt can a government issue before investors start demanding much higher interest rates, or before they worry about default? The textbook example is Japan. Japan's debt to gdp ratio is over 250 percent — far higher than any other developed country. Yet Japan borrows at extremely low rates, near zero percent. Luna: So Japan has lots of fiscal space, even with massive debt? That seems counterintuitive. Lucas: It does, but there's a catch. Most of Japan's debt is held domestically — by Japanese banks, pension funds, and the central bank. That insulates it from foreign investor panic. But it's not unlimited space. The Japanese government now spends more on debt service than on defense or education. That's a real trade-off. Luna: So the fiscal space isn't just about the interest rate — it's about what you give up by servicing that debt. Lucas: Precisely. Every dollar — or yen — that goes to bondholders is a dollar not spent on infrastructure, healthcare, or tax cuts. And when a country's debt grows faster than its economy, that crowding out intensifies. The IMF has a rule of thumb: when a country's debt to gdp ratio passes about 80 percent, long-term growth starts to suffer. Not because of a cliff, but because of a gradual drag. Luna: I've heard some economists argue that if a country borrows in its own currency, it can always print money to pay back debt. So fiscal space is infinite. That's a version of modern monetary theory, right? Lucas: Yeah, that's the MMT argument. And there's a kernel of truth — a country like the US or Japan that issues its own currency can never be forced into default the way Greece was in 2010. But 'can't be forced' doesn't mean 'no consequences.' If the central bank prints money to finance debt, you risk inflation. If you avoid that by issuing bonds at market rates, you still have to pay those rates. Luna: So the constraint isn't a hard ceiling — it's a softer one, like rising inflation or higher borrowing costs. Lucas: Right. And we've seen what happens when markets lose confidence. Take the UK in September 2022. The government announced a set of unfunded tax cuts, and within days, the yield on 10-year gilts shot up by over 100 basis points. The Bank of England had to step in to stabilize the bond market. That's a real-world example of fiscal space evaporating quickly. Luna: And that was a country with its own central bank and a reserve currency. So even for the US, there's a limit. Lucas: Exactly. The US has historically had enormous fiscal space because the dollar is the world's reserve currency. But the Congressional Budget Office projects that by 2033, US federal debt held by the public will reach 118 percent of GDP. Interest payments are already over 600 billion dollars a year — that's more than the entire budget for Medicare. That's a real constraint. Luna: Let's talk about that crowding-out effect more concretely. What does it look like on the ground? Lucas: One clear example is infrastructure. In the US, the American Society of Civil Engineers gives the country's infrastructure a grade of C-minus. There's a massive backlog of repairs and upgrades. But when the government borrows heavily, it competes with private investment for capital. Higher government borrowing can push up interest rates, which discourages private firms from building factories or buying equipment. Luna: So the government's debt becomes a drag on the private sector's ability to invest and grow. Lucas: Correct. Economists call this 'crowding out.' And it's not just a theoretical idea — there's empirical evidence. A 2020 study by the Federal Reserve found that a one-percentage-point increase in the government debt to gdp ratio is associated with a 0.1 to 0.2 percentage point reduction in private investment growth. That might sound small, but it compounds over time. Luna: So what's the alternative? If a country needs to spend more — on, say, a pandemic response or a green transition — how do they create fiscal space without crushing the economy? Lucas: That's the trillion-dollar question. One answer is to borrow when the economy is weak and interest rates are low, then pay down debt during booms. That's the classic Keynesian approach. But in practice, governments rarely run surpluses during good times. They tend to cut taxes or increase spending instead. So debt ratchets up over cycles. Luna: Right, because it's politically easier to borrow than to tax or cut spending. Lucas: Exactly. And that's where institutions matter. Countries with independent fiscal councils — like the UK's Office for Budget Responsibility — tend to have more credible fiscal frameworks. They provide impartial forecasts and score the cost of policies. But even then, the politics often override the numbers. Luna: I'm thinking about developing countries. They don't have the same luxury as the US or Japan. Most of them borrow in foreign currency, so they're exposed to exchange rate risk. Their fiscal space is much more limited. Lucas: That's a critical point. For emerging economies, debt in dollars or euros means that if their currency depreciates, the real burden of debt skyrockets. Look at Sri Lanka in 2022 — it defaulted on its sovereign debt after running out of foreign reserves. That's the extreme outcome when fiscal space runs out. Luna: So the lesson is that fiscal space isn't a fixed number — it's a dynamic relationship between debt levels, economic growth, interest rates, and investor confidence. Lucas: Yeah, and it changes with circumstances. For example, after the 2008 financial crisis, many developed countries had high debt but very low interest rates. That gave them space to stimulate the economy. But in the 1970s, high debt combined with high inflation and high interest rates led to a very different environment. So the same debt level can feel very different depending on the macro backdrop. Luna: Let's bring this back to today, June 2026. Where are we in that cycle? Lucas: We're in a period where central banks have raised rates significantly from the near-zero levels of the 2010s. So the cost of servicing debt has gone up. In the US, the average interest rate on federal debt has risen from about 2 percent in 2021 to over 3.5 percent now. That adds hundreds of billions to the deficit before any new spending is approved. Luna: And that's exactly the kind of fiscal space squeeze that policymakers need to watch. Lucas: Right. It's not a crisis yet, but it's a slow bleed. And the risk is that a future shock — a recession, a war, a pandemic — finds governments with less room to respond than they had in 2020. Luna: Which is why the concept of fiscal space matters, even if it's not in the headlines every day. Lucas: And that's the kind of thing we try to cover on this show — the structural forces that shape policy behind the scenes. If walking through the economy with us has made something click, there's a simple way to keep it going. A couple of dollars a month is genuinely what keeps these ad-free — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, it really does make a difference. We don't have a big corporate budget, so listener support is what keeps us digging into these topics. Lucas: And speaking of digging — I want to come back to that UK example from 2022. One thing that often gets missed is that the market reaction wasn't just about the size of the tax cuts. It was about the process — the lack of a fiscal forecast from the Office for Budget Responsibility. That shattered credibility almost instantly. Luna: So institutions matter not just for the numbers, but for the signal they send to markets. Lucas: Exactly. And that's a key insight for any government trying to protect its fiscal space. The rules and norms around budgeting are just as important as the debt level itself. Luna: All right, so what's the one takeaway you want listeners to remember from this episode? Lucas: That fiscal space is real, but it's not a fixed ceiling. It's a judgment call that depends on growth, interest rates, currency, and institutional credibility. And the cost of using it up isn't always obvious until it's too late. Luna: And that's the kind of trade-off that never makes a campaign speech, but defines what a government can actually do. Lucas: Exactly. Thanks for listening — and if you want to support the show, you know where to find us.