How Governments Reduce the National Debt

Which methods of reducing government debt have proved most successful throughout history? Remittances generally don't cover it. The answers might surprise you.

Fiscal and monetary policy are areas where everyone has an opinion, but few people can agree on any given idea. While reducing debt and stimulating the economy are the general goals of most governments in developed economies, achieving those objectives often involves tactics that appear to be mutually exclusive and sometimes downright contradictory.

Issuing Debt With Bonds

Take, for example, the issuance of government debt. Governments often issue bonds to borrow money. This enables them to avoid raising taxes and provides money to pay expenditures, while also stimulating the economy through public spending, theoretically generating additional tax income from prosperous businesses and taxpayers.

Issuing debt seems like a logical approach, but keep in mind that the government must pay interest to its creditors, and at some point, the borrowed money must be repaid. Historically, issuing debt has provided an economic boost to various countries, but in and of itself, the improved economic growth has not been particularly effective in reducing long-term government debt directly.

When the economy is in pain like during periods of high unemployment, governments can also seek to stimulate the economy by buying the very bonds they have issued. For example, the U.S. Federal Reserve implemented quantitative easing a couple of times since November 2008, which was a plan to buy large amounts of government bonds and other financial securities to spur economic growth and aid recovery from the financial crisis in 2007-2008.

Many financial experts favor a quantitative-easing tactic in the short-term. Over the longer term, however, buying one's own debt has not proved to be any more effective than borrowing one's way to prosperity by issuing bonds.

Interest Rate Manipulation

Maintaining interest rates at low levels is another way that governments seek to stimulate the economy, generate tax revenue, and, ultimately, reduce the national debt. Lower interest rates make it easier for individuals and businesses to borrow money. In turn, those borrowers spend that money on goods and services, which creates jobs and tax revenues.

Low interest rates have been the policy by the United States, the European Union, the United Kingdom, and other nations during times of economic stress, with some degree of success. That noted, interest rates kept at or near zero for extended periods of time have not proved to be a panacea for debt-ridden governments.

Instituting Spending Cuts

Canada faced a nearly double-digit budget deficit in the 1990s. By instituting deep budget cuts (20% or more within four years), the nation reduced its budget deficit to zero within three years and cut its public debt by one-third within five years. Canada accomplished all this without raising taxes.

In theory, other countries could emulate this example. In reality, the beneficiaries of tax-payer fueled spending often balk at proposed cuts. Politicians are often voted out of office when their constituents are disgruntled with policies, so they often lack the political will to make necessary cuts. Decades of political wrangling over Social Security in the United States is a prime example of this, with politicians avoiding action that would anger voters. In extreme cases, such as Greece in 2011, protesters took to the streets when the then government spigot was turned off.

Raising Taxes

Governments often raise taxes to pay for expenditures. Taxes can include federal, state, and in some cases, local income and business tax. Other examples include the alternative minimum tax, sin taxes (on alcohol and tobacco products), corporate tax, estate tax, Federal Insurance Contributions Act (FICA), and property taxes.

Although tax hikes are common practice, most nations face large and growing debts. It is likely that the higher debt levels are largely due to the failure to cut spending. When cash flows increase and spending continues to rise, the increased revenues make little difference to the overall debt level.

Lowering Debt Successes

Sweden was near financial ruin by 1994. By the late 1990s, however, the country had a balanced budget through a combination of spending cuts and tax increases. U.S. debt was paid down in 1947, 1948, and 1951 under Harry Truman. President Dwight D. Eisenhower managed to reduce government debt in 1956 and 1957. Spending cuts and tax increases played roles in both efforts.

A pro-business, pro-trade approach is another way nations can reduce their debt burdens. For example, Saudi Arabia reduced its debt burden from 80% of the gross domestic product in 2003 to just 10.2% in 2010 by selling oil.

National Debt Bailout

Getting rich nations to forgive your national debts or hand you cash is a strategy that has been employed more than a few times. Many nations in Africa have been the beneficiaries of debt forgiveness. Unfortunately, even this strategy has its faults.

For example, in the late 1980s, Ghana's debt burden was significantly reduced by debt forgiveness. In 2011, the country is once again deeply in debt. Greece, which had been given billions of dollars in bailout funds in 2010-2011, was not much better after the initial rounds of cash infusions. U.S. bailouts date all the way back to 1792.

Defaulting on national debt, which can include going bankrupt and or restructuring payments to creditors is a common and often successful strategy for debt reduction. North Korea, Russia, and Argentina have all employed this strategy. The drawback is that it becomes harder and more expensive for countries to borrow in the future after a default.

Controversy with Every Method

To quote Mark Twain, "There are three kinds of lies: lies, damned lies, and statistics." Nowhere is this truer than when it comes to government debt and fiscal policy.

Debt reduction and government policy are incredibly polarizing political topics. Critics of every position take issues with nearly all budget and debt reduction claims, arguing about flawed data, improper methodologies, smoke and mirrors accounting, and countless other issues. For example, while some authors claim that U.S. debt has never gone down since 1961, others claim it has fallen multiple times since then. Similar conflicting arguments and data to support them can be found for nearly every aspect of any discussion about federal debt reduction.

While there are a variety of methods countries have employed at various times and with various degrees of success, there is no magic formula for reducing debt that works equally well for every nation in every instance. Just as spending cuts and tax hikes have demonstrated success, default has worked for more than a few nations (at least if the yardstick of success is debt reduction rather than good relations with the global banking community).

Overall, perhaps the best strategy is one by Polonius from Shakespeare's Hamlet and espoused by Benjamin Franklin when he said: "Neither a borrower nor a lender be."