In a recent article, I described how the debt burden of the US has significantly increased relative to GDP in recent decades, yet the debt servicing costs have remained stable mostly thanks to low real interest rates on the debt. With higher debt servicing costs on the horizon, I concluded that it would be prudent (though perhaps not necessary) to reign in the debt to maintain economic stability and global confidence in the US dollar. So, how does a country go about reducing its national debt burden? There are various strategies that countries can employ to achieve this goal, each with its own set of consequences. This article will explore and compare five ways to reduce national debt: economic growth, reduced spending, increasing taxes, inflation, and default or debt restructuring.
Economic Growth > Debt Growth
One of the most effective ways for countries to reduce their national debt is through long-term, sustainable economic growth. A growing economy generates more tax revenue and reduces the relative size of the debt. This approach allows a country to “grow out” of its debt burden. As the economy expands, the debt-to-GDP ratio decreases, making the debt servicing costs more manageable. This method reduces the need for tax hikes and enhances investor confidence both of which can attract new foreign investment and boost domestic business activity. The downside to reducing debt through growth is that it can be time-consuming and requires fiscal discipline to ensure that economic growth outpaces growth of the national debt. Economic growth is also somewhat unpredictable and vulnerable to external factors such as global economic conditions.
Even if economic growth is slow, reducing government spending is another approach to decrease a nation’s debt. Governments can achieve this by cutting discretionary expenditures, eliminating waste, and reforming entitlement programs. By running budget surpluses, governments can more quickly pay down debt. While fiscal discipline helps a country to prioritize essential services and avoid wasteful spending, the flip side to the coin is that it can have a negative societal impact particularly to vulnerable populations or jeopardize other critical priorities (e.g., national defense). More drastic spending cuts (sometimes called “austerity measures”) can slow economic growth and lead to job losses, making it even harder to foster the (beneficial) long-term economic growth described above. Quite often, implementing spending reductions faces stiff resistance from interest groups and is politically untenable.
Raising taxes is a direct approach to increase government revenue and reduce national debt. This strategy involves imposing higher taxes on individuals, businesses, or specific goods and services. Taxes can be structured to ensure that those with higher incomes pay more, which helps maintain social cohesion and stability. The downside to higher taxes is that they discourage investment and economic activity. In extreme circumstances tax hikes can lead to “capital flight”, a phenomenon in which businesses and/or wealthy individuals relocate to avoid the tax. As with spending cuts, tax hikes often face political opposition and resistance from both citizens and businesses.
Inflation, also called the “silent tax”, can be used as a tool to reduce the real value of the national debt. When prices rise, the debt’s real burden decreases, as it is repaid with devalued currency. Simply put, inflation reduces the real value of the debt, making it easier to manage. Governments tend to like moderate inflation (the US targets 2-3%) as it can encourage consumer spending and investment. A major disadvantage of using inflation as a tool is the negative impact on retirees and those on fixed incomes who suffer most from reduced purchasing power. While moderate inflation is viewed as good, high inflation can erode consumer and investor confidence.
Default or Restructure Debt
The most extreme measure for reducing national debt is defaulting on debt obligations or restructuring the debt, which involves renegotiating terms with creditors. While defaulting or restructuring can provide immediate debt reduction and avert severe austerity measures, there are serious negative consequences to this approach. Defaulting damages a country’s creditworthiness and leads to higher future borrowing costs and may reduce access to global markets. It can also lead to legal actions by creditors, such as asset seizures. It also has the highest potential to create social unrest.
The Bottom Line
Reducing a country’s national debt burden is a complex undertaking with multiple consequences. Each strategy has its merits and drawbacks, and the choice of approach should align with a nation’s economic and political circumstances. Economic growth and inflation are often the most politically feasible and sustainable long-term solutions. Increasing taxes and reducing spending require careful balance to avoid social and economic repercussions. Default or debt restructuring should be considered a last resort due to the severe consequences it can entail. Ultimately, a combination of these strategies may be necessary to effectively reduce a nation’s national debt burden while safeguarding its economic stability and prosperity.