A reasonable amount of government debt is not a problem in a strong economy. If countries take on debt wisely and grow their economy paying the interest on that debt isn’t a problem. But as that debt grows as a portion of GDP risks grow.
Debt borrowed in other currencies is extremely risky, for substantial amounts. When things go bad they snowball. So if your economy suffers, your currency often suffers and then the repayment terms drastically become more difficult (you have to pay back the debt with your lower valued currency). And the economy was already suffering which is why the currency decreased and this makes it worse and they feed on each other and defaults have resulted in small economies over and over from this pattern.
If a government borrows in their currency they can always pay it back as the government can just print money. They may pay back money not worth very much but they can pay it back. Of course investors see this risk and depending on your economy and history demand high interest to compensate for this risk (of being paid back worthless currency). And so countries are tempted to borrow in another currency where rates are often much lower.
If you owe debts to other countries you have to pay that money outside the system. So it takes a certain percentage of production (GDP) and pays the benefit of that production to people in other countries. This is what has been going on in the USA for a long time (paying benefits to those holding our debt). Ironically the economic mess created by central banks and too-big-to-fail banks has resulted in a super low interest rate environment which is lousy for lenders and great for debtors (of which the USA and Japanese government are likely the 2 largest in the world).
The benefits to the USA and Japan government of super low interest rates is huge. It makes tolerating huge debt loads much easier. When interest rates rise it is going to create great problems for their economies if they haven’t grown their economies enough to reduce the debt to GDP levels (the USA is doing much better in this regard than Japan).
Japan has a much bigger debt problem than the USA in percentage terms. Nearly all their debt is owed to those in Japan so when it is paid it merely redistributes wealth (rather than losing it to those overseas). It is much better to redistribute wealth within your country than lose it to others (you can always change the laws to redistribute it again, if needed, as long as it is within your economy).
While inflation can allow you to payoff debt with less valuable dollars (or yen or whatever) and thus reduce the value of what is given to other countries (also to retirees and other holders of government debt but for the matter of losing wealth to other countries that isn’t a factor). But markets adjust and unless you have now paid off all your debt and owe nothing you have to borrow again, and lenders will demand larger interest payments to make up for the risk of your debasing the currency to pay them back worthless dollars. So while this can maybe work in the short term if you fool the markets it most likely doesn’t work in the long term for the USA.
It seems to me (it is up for debate) that debt to GDP levels above 70% are starting to be risky and above 100% are very risky. The USA and Japan can (at this time) get away with much higher levels than other countries for a number of reasons (Japan needing little foreign capital, the USA bing a huge economy that is still perceived as the safest store of money, other countries wanting to drive down their currency in relation to the $ to aid their businesses competitiveness with the USA…). While driving down their currency value does aid business competitiveness it is also a tax on consumers so I think the USA benefits more from these policies than others do, but for the time being they continue to pursue lower currency values.
Europe has added issues due to the complication of the Euro (it isn’t a currency the individual countries can just print). And government debt levels in Europe are bad (and economic growth is poor). China is also becoming a large debtor (though in very opaque and confusing ways to analyze). China’s debt is largely local (not federal) and locally owned (which is better than foreign owned – in as much as paying off production to service the debt, though it will be a problem when that debt is defaulted, which seems likely to happen to large amounts, say hundreds of billions of US$). But China is also very difficult to read it is requires having to makes guesses without clear visibility.
The government debt problem is even greater for other countries. Small and medium sized economies can quickly become unstable and debt levels can quickly go from acceptable to a huge economic problem as economic problems in the country compound upon themselves. This is especially true with large amounts of foreign held debt (when the foreigners decide they don’t like how things look they sell and likely prices collapse and more people panic… and even if the panic is held back if foreigners don’t keep adding to their holdings that creates economic problems). For these countries I think debt above 50% of GDP is risky. And if the debt is not in the country’s currency things can much more quickly get very bad.
2-year chart of Malaysian Ringgit (MYR) to US dollar (USD) from Yahoo Finance. See current 2 year chart.
Malaysia provides a recent example. The budget is based on government profits from natural resources and even with that has been running up large debts. With risks of USA raising interest rates the Malaysian Ringgit took a beating in the summer (as did several currencies). In many ways Malaysia has a strong economy but it is built with too much debt, both government and consumer debt. The amount of foreign borrowing was also high and when things started to become precarious for currencies in the summer Malaysia was one that investors ran from.
Now, with the collapse of oil prices in appears the economic risks became to great and the Ringgit was hit very hard. It has fallen from 32 to 33 US cents per Ringgit over the last few years to 30 to 31 cents in the fall, and about a week ago dropped another 7% to 28.5 cents.
The numbers seem a bit less dramatic because of the small values but $100,000 in Ringgit has lost $13,600 in about a year. This increases the prices of foreign goods you want to import (say Apple iPhones) and when your citizens travel internationally their costs have gone up 14% even in the prices didn’t increase in the local currency. This drastic drop is what happens as economic issues quickly compound and currencies amazingly quickly. It decreases the value of assets people hold though it does aid businesses competing internationally (though it is a bit tricky as when they need to buy good, they have increased costs due to their devalued currency).
Very likely interest rates in Malaysia will have to increase to tempt the foreign investors given the debt level (government and consumer) Malaysia finds itself with. And that means that debt will take an increasing share of economic productivity overseas (because of the higher interest levels on the debt). Higher interest rates will harm consumers with heavy debt loads, driving down consumption and creating more economic problems. Luckily the oil crisis probably won’t last years (in my opinion) and Malaysia has other strengths in the economy that may allow things to stop from deteriorating. But high debt levels put the country at risk and spending above even what the high profits from natural resources could provide may prove to have been too big a risk to take.
Related: Which Currency is the Least Bad? – Who Will Buy All the USA’s Debt? – USA Federal Debt Now $516,348 Per Household (2007) – Looking at the Malaysian Economy