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Jan252013

What does debt mean for governance?

Author: ODI Researcher Philipp Krause

Debt is not something governments brag about. On the contrary, ominous metaphors like ballooning debt burdens and exploding debt make it clear that, in political discourse at least, debt is a bad thing. And in the current economic climate, debt trends have become a major headache for economic policymakers in virtually all G20 economies.

Over on his blog, Matt Andrews takes a look (or two) at the relationship between debt size and income per capita. He notes that, in 2001, the richer the country was, the lower its debt (as a percentage of GDP). Over the last decade this relationship has reversed. As of 2010 – or one financial crisis later – the richer the country, the higher its debt. Matt wonders whether this worsening of rich countries’ debt position says something about their governance. If debt/GDP was a governance indicator, what would it tell us? Matt seems to lean towards thinking it’s not a good thing.

I think it could just possibly be a great thing.

Now, if a government takes on a large amount of debt over a short period of time, its situation hasn’t improved. Interest payments crowd out other, more useful, expenditures. Interest rates may well rise. When a lot of debt is held  by international lenders, the country becomes more vulnerable to external shocks. Furthermore, its ability to raise future debt may be reduced.

But what about that ability to raise debt? Surely being able to convince others to trust you with their money is a sign that you’re doing something right. To worry about a worsening debt in any one country is one thing; but let’s not forget that many governments are not in a position (or have not always been in a position) to raise a lot of debt in the first place.

Historically, a government’s ability to raise debt has been a crucial competitive advantage. Britain funded more than 80% of its spending on its late-17th-century wars with borrowed money. That option was not available to France, a serial defaulter at the time. It may be a stretch to say that Britain’s ability to out borrow France won it the war, but the two points are not unconnected. One can easily imagine that the decision of the bankers of Amsterdam and London to lend to one government but not the other was a vote of confidence in that government’s ability to win the war, do well in the future (and repay).

The same is true today. The graph above compares government debt as a percentage of GDP with Government Effectiveness scores. All figures are from the World Bank. I found matching data for 59 countries (I put together this quite quickly, so it shouldn’t be taken as conclusive). One can of course criticize the choice of indicator, but it would not be too much of a stretch to assume that a government effectiveness score is a reasonable impression of how effective a government is perceived to be (a lot of perception survey data is used for the government effectiveness index). This in turn is an approximation of how effective a government actually is.

The chart shows a clear positive relationship: the better your effectiveness score, the more debt you have. And countries seem to cluster together in an interesting pattern (I’ve tried to mark this out with the three red boxes). In the upper right quadrant, you find countries with high effectiveness scores and relatively high debt. The US is part of this cluster, and seems to be an entirely ordinary case. In the lower left quadrant, governments are not effective and debt is low. So if debt is indeed a governance indicator, it could be interpreted as a vote of confidence by lenders in a government’s effectiveness. Which in turn might be a reasonable proxy for their ability to service their debt.

In the upper left quadrant, a number of governments seem like they could borrow a lot more, but evidently choose not to, for whatever reason. But interestingly, there are hardly any countries in the lower right quadrant: not many countries with low effectiveness scores end up with lots of debt. If there is anything to the relationship between debt and effectiveness, it’s that governments perceived to be less effective are not capable of convincing lenders to give them more. A good indicator of effective governance?

The countries that do end up with more debt, people worry about. I don’t know about the Seychelles and Maldives, maybe being an international tourist destination skews this relationship somehow. But Italy and Japan are both well-known sources of debt concern. Greece’s debt crisis has its own Wikipedia entry.

So there are outliers, but otherwise there is an interesting relationship between debt and the effectiveness of governments. More effective governments are able to borrow more, and many do. Some that could, don’t. But hardly any governments that lack the corresponding level of effectiveness get away with high levels of debt. Perhaps worth some further investigation – and debate.

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Reader Comments (3)

Nice post
I think the government effectiveness measure is a strong proxy of per capita income and hence the positive relationship you see is the same as that I started off seeing between a country's wealth and its debt levels. Would be interested to see if you saw a differnet relationship in 1998?
Apart from this technical point I agree completely with the idea that we can't say governance is good or bad when a country had high or low debt. It depends on what governments are authorized to do and how they are using their capacity to raise debt in this respect.
I blogged a response today, noting that the idea goes to other areas of governance and governance measurement too. Talking about good and bad governance might be misleading and problematic. As always, I'd love your comments and responce! http://www.typepad.com/site/blogs/6a0154326e1d1c970c01538e9b35a2970b/post/6a0154326e1d1c970c017c363fcdce970b/edit?saved_added=nu

January 25, 2013 | Unregistered CommenterMatt Andrews

Thanks for the comment Matt, the link you posted doesn't seem to bet working, so I'll repost for interested readers -
http://matthewandrews.typepad.com/mattandrews/2013/01/uncomfortable-thoughts-on-governance-can-we-ever-say-it-is-good-or-bad.html

January 25, 2013 | Unregistered CommenterRyan Flynn

I think it might well be the case that in 1998, this would have looked at least a bit different. The financial crisis of post-2008 must have had an effect there, and it would be fun to dig a bit more systematically.

On the larger issue, absolutely. If you're able to borrow a lot, and cheaply, that's a sign of capability (and trust in your capability by actual and potential lenders). It's also ultimately secured by your future tax revenues, which is a governance indicator if there ever was one.

A large actual debt burden is different. It could mean you've been 'encouraged' to borrow by a suzerain, or you're just poor at economic policy, or you're an otherwise well-governed country dealing with a temporary crisis. In each of these instances, the debt/gdp figure would be an incredibly meaningful indicator, it would just be a bit useless if employed across countries and over time.

And yes, I think one could make the same argument for many potential governance indicators as well...

January 27, 2013 | Unregistered CommenterPhilipp Krause

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