Can Governments Afford Their Debt?

Understanding Debt Sustainability, Interest Costs, and the Limits of Government Borrowing

Introduction

Governments around the world have accumulated unprecedented levels of debt.

From the United States and Japan to France, Italy, and the United Kingdom, public debt has risen significantly over the past two decades. Financial crises, demographic pressures, pandemic-related spending, infrastructure investments, and rising interest costs have all contributed to larger government balance sheets.

Yet despite frequent headlines warning about debt burdens, most developed economies continue to borrow successfully.

This raises an important question:

Can governments actually afford their debt?

The answer is more complicated than simply comparing debt levels between countries. Governments do not operate like households, businesses, or individual borrowers. They possess unique advantages, including taxation authority, monetary flexibility, and access to deep capital markets.

At the same time, borrowing is not limitless.

Debt becomes problematic when investors begin questioning whether governments can manage future obligations without significantly increasing taxes, reducing spending, generating inflation, or relying on continued borrowing.

For bond markets, affordability is ultimately a question of confidence.

Why Debt Levels Alone Can Be Misleading

Public discussions often focus on debt-to-GDP ratios and while these metrics are useful, they provide only part of the picture. A country with debt equal to 120% of GDP is not automatically in worse condition than a country with debt equal to 80% of GDP.

The critical issue is not simply how much debt exists but the more important question is whether the economy can support that debt over time.

Several factors influence this assessment:

Debt sustainability depends on the interaction between these variables rather than any single number and this explains why countries with similar debt ratios can experience very different borrowing costs.

The Debt Sustainability Equation

At its core, debt sustainability is governed by a simple relationship because if economic growth exceeds the average interest rate paid on government debt, debt burdens become easier to manage.

When growth remains strong, tax revenues increase, economic output expands, and debt becomes smaller relative to the size of the economy.

Many problems emerge when borrowing costs consistently exceed economic growth and under these conditions, governments may need to issue additional debt simply to finance existing interest obligations.

Over time, this dynamic can create increasing fiscal pressure and bond investors pay close attention to this relationship because it influences long-term sovereign risk.

Why Interest Costs Matter More Than Debt

Many investors focus on total debt while overlooking interest expenses but in reality, debt servicing costs often provide a better measure of fiscal pressure.

Consider two hypothetical countries:

Country A has very high debt but pays extremely low interest rates.

Country B has lower debt but faces significantly higher borrowing costs.

In some cases, Country B may face greater fiscal challenges despite carrying less debt.

This is one reason rising interest rates have become such an important issue for sovereign bond markets and during the decade following the Global Financial Crisis, governments benefited from historically low borrowing costs. Even large debt burdens remained manageable because interest payments consumed a relatively small share of public budgets.

As debt is refinanced at higher rates, that advantage gradually diminishes.

The Role of Economic Growth

Economic growth remains one of the most powerful tools for managing public debt.

Stronger growth improves debt sustainability in multiple ways:

This is why governments often prioritize growth-enhancing policies when debt burdens rise and a rapidly growing economy can often support debt levels that would be difficult to sustain under weaker growth conditions.

For bond investors, growth expectations are therefore closely linked to sovereign risk assessments because when growth slows significantly, debt sustainability concerns tend to receive greater attention.

Inflation: Friend or Enemy?

Inflation occupies a unique position within debt sustainability discussions and moderate inflation can reduce the real value of outstanding debt over time. Because government debt is typically fixed in nominal terms, inflation effectively decreases the purchasing power of future obligations.

Historically, some governments have benefited from this effect, however, inflation is not a free solution.

Persistent inflation can increase borrowing costs if investors demand higher yields to compensate for declining purchasing power. Rising yields may eventually offset any benefits generated by inflation itself and this creates a delicate balance.

Bond markets generally tolerate moderate inflation, they become less comfortable when inflation appears unpredictable or difficult to control.

Can Countries Run Out of Money?

The answer depends on the country because nations that borrow in their own currency generally possess greater flexibility than those that rely heavily on foreign-currency debt.

Countries such as the United States, Japan, and the United Kingdom maintain significant monetary sovereignty. Their governments can issue debt denominated in currencies ultimately supported by their own central banks.

This does not eliminate risk.

It simply changes the nature of the risk and instead of outright default, investors may become concerned about inflation, currency depreciation, or fiscal credibility.

Countries that borrow heavily in foreign currencies face different challenges. They may be more vulnerable to exchange-rate shocks and refinancing difficulties because they cannot directly create the currency required to repay obligations.

What Bond Markets Watch

Professional bond investors rarely focus on debt levels alone.

Instead, they monitor a combination of indicators:

Debt-to-GDP Ratios

Provides a broad measure of indebtedness.

Fiscal Deficits

Indicates how rapidly debt levels are changing.

Debt Servicing Costs

Measures the burden of interest payments.

Economic Growth

Influences future fiscal capacity.

Inflation Expectations

Affects both borrowing costs and debt dynamics.

Sovereign Bond Yields

Reflect investor confidence in real time.

Auction Demand

Reveals actual market appetite for government debt.

Together, these indicators provide a more complete picture of debt affordability.

BondStats Research Insight

What Determines Whether Governments Can Afford Their Debt?