The Relationship Between Government Expenditure and Interest Rates: Debunking the Myths

In recent years, discussions around the relationship between government expenditure and interest rates have intensified, often blaming high government spending and national debt for inflation and rising interest rates. But is this relationship as straightforward as it seems? Let's explore this in more detail.

Government Finances: A Complex Landscape

Government finances involve a combination of taxation and bond issuance to fund their spending. The bond market, too, scrutinizes spending and taxation to determine the government's fiscal surplus or deficit. In theory, if governments run large deficits, bond yields should rise. However, in practice, this isn't always the case.

Japan, for instance, has one of the highest debt-to-GDP ratios in the world and yet it pays among the lowest borrowing costs globally. Meanwhile, countries with smaller deficits can have higher bond yields. This complexity arises due to the bond yield serving as a market forecast for an economy's nominal growth potential. If one economy is weaker than another, its bond yield is likely to be lower, reflecting the incentive to save or invest in that economy's currency.

Interest Rates and Government Expenditure: No Immediate Impact

The key takeaway is that changes in interest rates have no immediate effect on government expenditure. Once a government has agreed on a fixed borrowing rate, it doesn't matter if that rate changes in the future. The only real impact occurs when the government needs to refinance its debt. For example, if a bond with a 1% yield matures and the government needs to issue new bonds at 2%, then the extra servicing cost becomes a concern. However, this is more about cash flow and solvency rather than immediate changes in expenditure.

For governments with longer-term debt, the pressure is even less significant. A government with an average debt duration of 10 years will face less pressure compared to one with a 5-year average duration. This is because, over the long term, the cost of servicing the debt becomes more manageable, allowing the government to continue funding its programs without major disruptions.

Building Up Slowly: The True Threat

The real danger of debt and interest rates lies in the glacial nature of the issue. While interest rates may rise over time, the full impact on government finances and public programs only becomes apparent during refinancing crises. When markets suddenly refuse to refinance the debt, governments face immediate cash flow and solvency problems that can lead to crises and embarrassing financial situations.

This highlights the importance of long-term debt management and fiscal sustainability. While short-term changes in interest rates do not directly impact government spending, the long-term implications of high debt levels and the increasing costs associated with debt servicing can lead to significant financial challenges for governments.

Conclusion

The relationship between government expenditure and interest rates is complex and multifaceted. While high government spending and debt can contribute to inflation and rising interest rates, changes in interest rates themselves do not immediately affect government spending unless there is a significant shift in the cost of debt. Governments must focus on long-term fiscal sustainability and debt management to avoid the glacial but potentially catastrophic effects of high debt levels.

Understanding these dynamics is crucial for policymakers and investors alike. By addressing the root causes of high debt and fostering economic growth, governments can mitigate the risks associated with rising interest rates and ensure sustainable long-term financial health.