Introduction
Every year, the UK Government borrows billions of pounds.
The money helps fund public services, supports investment in long-term projects and allows the government to respond to unexpected events such as economic crises or natural disasters.
But where does all this money actually come from?
Many people imagine that governments simply borrow from a large bank in the same way that households take out a mortgage or businesses apply for a loan.
In reality, government borrowing works quite differently.
Instead of relying on a single lender, governments usually borrow from thousands of investors by selling government bonds. These bonds are purchased by organisations and individuals around the world, allowing governments to raise the money they need while promising to repay it in the future.
Although this may sound complicated, the basic idea is surprisingly straightforward.
In the previous chapter, we learned that governments sometimes spend more money than they receive in income. When this happens, they run a budget deficit, and repeated deficits increase the national debt over time.
This chapter answers the next obvious question:
If governments need to borrow billions of pounds, who actually lends them the money, and how does the borrowing process work?
By the end of the chapter, you’ll understand what government bonds are, who buys them, why investors are willing to lend billions of pounds to governments and why government borrowing is a normal part of managing the public finances in most modern economies.
The One Big Idea
Governments do not usually borrow money from a single bank.
Instead, they borrow from thousands of investors by selling government bonds.
A government bond is simply a promise.
An investor lends money to the government today.
In return, the government promises to:
- pay interest for an agreed period; and
- repay the original amount on a specified future date.
In the United Kingdom, government bonds are known as gilts, or gilt-edged securities.
Everything else in this chapter builds on this simple idea:
A government bond is simply an IOU issued by the government.
Why Governments Borrow
As we saw in the previous chapter, governments sometimes spend more money than they receive in income.
When this happens, borrowing allows them to continue funding public services without immediately raising taxes or reducing spending.
Governments also borrow to invest in projects that are expected to benefit the country for many years.
Building a new railway, expanding renewable energy infrastructure, improving flood defences or constructing hospitals and schools can require large sums of money today while providing benefits for decades to come. Borrowing allows these costs to be spread over time rather than being paid entirely by today’s taxpayers.
Borrowing also provides flexibility when unexpected events occur.
Financial crises, wars, natural disasters and pandemics can require rapid spending that could not have been anticipated when the Budget was prepared. Borrowing allows governments to respond immediately instead of waiting until additional tax revenue has been collected.
It also helps governments manage day-to-day cash flow.
Government income arrives continuously throughout the year, while salaries, pensions and payments for public services must also be made continuously. Borrowing helps smooth these differences so that public services can continue operating without interruption.
The reasons for borrowing were explored in the previous chapter.
The question we will focus on here is how governments actually obtain the money they borrow.
Who Lends Money to Governments?
If governments are not borrowing from a single bank, who provides the money?
The answer is surprisingly diverse.
Governments borrow from a wide range of investors, both in the UK and overseas.
Some of the largest lenders are pension funds.
These organisations manage retirement savings on behalf of millions of people. Because pensions may not need to be paid for many years, pension funds often look for investments that provide steady, predictable returns over long periods. Government bonds are one of the investments that can help meet this need.
Insurance companies are also major investors.
Insurance firms collect premiums today but may not need to pay claims until many years later. Government bonds provide a relatively stable place to invest some of this money while earning interest.
Banks also purchase government bonds.
Some buy them as part of their investment portfolios, while others hold them because government bonds are generally considered to be among the safer financial assets available.
Large investment funds may also invest in government bonds on behalf of individuals, businesses and charities.
In addition, governments borrow from overseas investors. Pension funds, banks and investment companies in other countries often buy UK government bonds because they see them as relatively secure investments.
Even individuals can own government bonds, although today most are held by large financial institutions.
Some investors buy bonds intending to keep them until they mature, while others buy and sell them as part of managing their investment portfolios. Either way, they are helping to provide governments with access to borrowing.
The important point is that governments do not depend on a single lender.
Instead, they borrow from a large and diverse group of investors. Each investor may lend only a tiny fraction of the total amount, but together they provide the billions of pounds that governments sometimes need to borrow.
Why So Many Different Investors?
At first, it may seem surprising that so many organisations are willing to lend money to governments.
The reason is that governments have historically been regarded as some of the most reliable borrowers in the economy.
Unlike most individuals or businesses, governments have the power to raise revenue through taxation. They also oversee large economies and generally continue to exist indefinitely. These factors mean that investors often view lending to stable governments as relatively low risk compared with lending to many private companies.
Of course, no investment is completely risk-free, and investors still pay close attention to a country’s economic performance and public finances. However, governments with stable economies and a strong history of meeting their financial commitments are generally able to borrow more easily than many other organisations.
This confidence has made government borrowing an important part of modern financial systems.
In the next section, we’ll look more closely at the financial instrument that makes this borrowing possible:
the government bond.
What Is a Government Bond?
The mechanism that allows governments to borrow money is surprisingly simple.
Instead of borrowing from a single bank, governments sell government bonds.
A government bond is essentially an IOU.
When an investor buys a government bond, they are lending money to the government.
In return, the government makes two promises:
- to pay interest on the money that has been borrowed; and
- to repay the original amount on an agreed future date.
Imagine the UK Government needs to borrow £100.
Rather than asking one bank for a loan, it could issue a government bond that effectively says:
“Lend us £100 today. We will pay you interest each year, and in ten years’ time we will repay your £100.”
An investor who is happy with those terms buys the bond and lends the money.
Now imagine that process happening not once, but millions of times.
Thousands of investors each buy government bonds, and together they provide the billions of pounds that governments sometimes need to borrow.
Although the sums involved are enormous, the underlying principle is remarkably simple.
Every government bond is simply a written promise to repay borrowed money in the future.
What Are Gilts?
In the United Kingdom, government bonds are usually known as gilts, or gilt-edged securities.
The name dates back more than a century, when paper bond certificates were printed with gilded, or gold-coloured, edges to indicate their high quality and reliability.
Today, these certificates have almost entirely disappeared because ownership is recorded electronically, but the name gilts has remained.
Whenever you hear news reports referring to the gilt market or UK gilts, they are simply talking about UK government bonds.
Other countries use different names.
For example, the United States issues Treasury bonds, while many other governments simply refer to them as government securities or sovereign bonds.
Although the terminology varies from country to country, the underlying idea is exactly the same.
Governments borrow money by issuing bonds, promising to pay interest and repay the original amount at a future date.
Why Investors Buy Government Bonds
This raises another important question.
Why would anyone lend billions of pounds to a government?
The answer is that government bonds offer several features that many investors find attractive.
A Predictable Income
Government bonds usually provide regular interest payments throughout their lifetime.
For organisations such as pension funds and insurance companies, this predictable income is extremely valuable.
A pension fund, for example, needs to pay pensions to retired members every month. Receiving regular interest from government bonds helps it plan for these future payments with greater certainty.
Similarly, insurance companies need money available to pay claims whenever they arise. Government bonds provide one way of generating reliable income while preserving much of the original investment.
A Relatively Stable Investment
Many investors also value government bonds because they have historically been regarded as relatively stable investments.
Companies can fail.
Businesses can go bankrupt.
Share prices can rise and fall dramatically.
Governments, however, generally continue collecting taxes, managing the economy and providing public services over very long periods of time.
This long-term stability often makes government bonds attractive to investors seeking dependable returns.
This does not mean government bonds are completely risk-free, but governments with stable economies and a strong history of meeting their financial commitments are generally viewed as reliable borrowers.
Diversifying Investments
Most large investors do not place all of their money into a single type of investment.
Instead, they spread their investments across different assets such as company shares, property, cash and government bonds.
This approach is known as diversification.
The idea is simple.
If one type of investment performs poorly, another may perform better, helping to reduce the overall level of risk.
Government bonds therefore often play an important role in diversified investment portfolios because they may behave differently from company shares or other financial assets.
Meeting Legal and Financial Requirements
Some financial institutions are also required by regulators to hold assets that are considered relatively safe.
Government bonds often help meet these requirements.
For banks, insurance companies and pension funds, holding government bonds therefore forms part of prudent financial management as well as satisfying regulatory expectations.
Why Governments Pay Interest
Whenever someone lends money, they usually expect something in return.
That “something” is called interest.
Interest is simply the price paid for borrowing money.
If you take out a mortgage, you pay interest to the bank.
If a business borrows money to expand, it usually pays interest to its lenders.
Governments work in exactly the same way.
When investors lend money by purchasing government bonds, they expect to receive interest as compensation for allowing the government to use their money for a period of time.
Without interest, most investors would have little incentive to lend.
After all, they could choose to invest their money elsewhere.
The level of interest offered therefore influences how attractive government bonds appear to potential investors.
For governments, these interest payments become part of annual public spending.
As we saw in Where Government Money Goes, one category of government expenditure is interest on the national debt.
These payments are not funding new schools, hospitals or roads. Instead, they represent the cost of borrowing money in previous years.
This is one reason why governments pay close attention to the size of the national debt.
The more money that has been borrowed, the greater the amount that may need to be spent on interest each year. Money used to pay interest cannot be spent on other public services unless government revenue also increases.
However, borrowing that is used wisely can also strengthen the economy. If investment leads to higher productivity, stronger economic growth or improved infrastructure, the government may receive higher tax revenues in the future.
Once again, the important question is not simply how much governments borrow, but how wisely the borrowed money is used.
A Simple Way to Think About Government Bonds
By this point, it is worth returning to the central idea introduced at the beginning of this chapter.
A government bond is simply a promise.
An investor says:
“I will lend you money today.”
The government replies:
“Thank you. We will pay you interest each year and repay your money on the agreed date.”
That simple agreement is repeated thousands of times every day between governments and investors around the world.
Understanding this idea removes much of the mystery surrounding government borrowing.
Government bonds are not complicated financial magic or secret financial instruments.
They are simply one of the ways modern governments raise the money they need when borrowing becomes necessary.
The next question is equally important:
What happens when those bonds reach the end of their agreed term?
What Happens When Bonds Mature?
Government bonds are not designed to last forever.
Every bond has a maturity date—the date on which the government promises to repay the original amount that was borrowed.
Some government bonds mature after only a few years, while others remain in place for several decades.
Suppose the government issues a bond that lasts for 10 years.
During those ten years, it pays regular interest to the investor.
When the ten years have ended, the government repays the original amount that was borrowed, and the bond comes to an end.
At first, this might seem to create a problem.
If governments have borrowed hundreds of billions of pounds, where do they find the money to repay it when bonds mature?
The answer is that governments normally manage their borrowing rather than trying to repay the entire national debt at once.
Some bonds are repaid using government revenue. More commonly, governments issue new bonds to replace older ones that have reached maturity. This process is known as refinancing or rolling over debt.
An everyday example may help.
Imagine you have a mortgage that is coming to the end of its fixed-rate deal. Rather than repaying the entire mortgage immediately, you might arrange a new mortgage to replace the old one and continue making repayments over time.
Governments manage much of their borrowing in a similar way.
This is why the national debt is generally managed continuously rather than being viewed as one enormous bill that must one day be paid in full.
The important question is therefore not simply how much debt exists, but whether governments can continue managing that debt responsibly over the long term.
What Determines How Much Governments Pay to Borrow?
Just as different people pay different interest rates on mortgages or loans, governments also pay different interest rates when they borrow.
Several factors influence how expensive borrowing becomes.
Confidence
Perhaps the most important factor is confidence.
When investors believe that a government has a strong economy, stable public finances and a good record of repaying its debts, they are generally willing to lend money at lower interest rates.
If investors become less confident, they may still be prepared to lend, but they often expect higher interest payments to compensate for the additional risk.
Confidence therefore has a direct influence on the cost of government borrowing.
It is often said that confidence takes many years to build but can be lost much more quickly. Governments therefore work hard to maintain the trust of investors by managing the public finances responsibly and honouring their borrowing commitments.
Interest Rates
General interest rates across the economy also affect government borrowing.
When interest rates are relatively low, governments can often borrow more cheaply because investors are willing to accept lower returns.
When interest rates rise, governments usually have to offer higher interest payments to attract investors.
This means that borrowing becomes more expensive.
Because governments regularly issue new bonds, changes in interest rates gradually influence the overall cost of servicing the national debt.
Inflation
Inflation also influences borrowing costs.
If prices are expected to rise rapidly over the coming years, investors know that the money they receive in the future will buy fewer goods and services than it does today.
To compensate for this loss of purchasing power, they usually expect higher interest payments when lending money.
This is one reason why periods of high inflation often make government borrowing more expensive.
The Strength of the Economy
Investors also pay close attention to the overall health of the economy.
Factors such as economic growth, employment, political stability and the government’s ability to raise tax revenue all influence how investors view a country’s finances.
Countries with stable economies and a long history of meeting their financial commitments generally find it easier to borrow at lower interest rates than countries experiencing prolonged economic or political instability.
Can Governments Ever Run Out of Borrowers?
This is a question that is sometimes asked during periods of economic uncertainty.
For countries with stable economies and well-established financial systems, there is usually a large pool of investors looking for relatively secure places to invest their money.
However, this does not mean borrowing is unlimited.
If investors begin to doubt whether a government can manage its finances responsibly, they may demand higher interest rates before agreeing to lend. In more serious situations, some investors may decide to lend less money or invest elsewhere instead.
This is why maintaining confidence is so important.
Governments do not simply need people who are willing to lend—they need investors who remain confident that lending to the government is a sensible long-term investment.
Confidence can be influenced by many factors, including economic performance, political stability, inflation and the government’s overall approach to managing the public finances.
For this reason, responsible borrowing is about more than simply raising money today. It is also about maintaining the trust that makes future borrowing possible.
The Role of the Bank of England
At this point, it is helpful to clear up another common misunderstanding.
Many people assume that the government simply borrows money directly from the Bank of England.
In normal circumstances, this is not how government borrowing works.
Instead, the government raises most of the money it borrows by selling government bonds to investors through the financial markets.
The Bank of England has a different role.
As the UK’s central bank, one of its main responsibilities is to help maintain price stability and support the wider economy through monetary policy, including setting interest rates.
This separation is deliberate. It helps ensure that decisions about monetary policy can be made independently of the government’s day-to-day political priorities.
Although the Bank of England can become involved in government bond markets under certain exceptional circumstances, these situations are separate from the government’s normal borrowing process.
For now, the important point is simply that the government normally borrows from investors, not directly from the Bank of England.
We will explore the Bank of England and its role in much greater detail later in the Understanding Society section.
Why Government Borrowing Matters
Government borrowing affects almost everyone, even if we never buy a government bond ourselves.
The amount a government borrows can influence how much it spends on interest payments, how much it can invest in public services and infrastructure, and how much flexibility it has when responding to future economic challenges.
Borrowing also connects today’s decisions with future generations.
Money borrowed today may finance investments that improve transport, healthcare, education or energy systems for decades to come. At the same time, today’s borrowing creates obligations that future governments will need to manage responsibly.
This is why discussions about government borrowing are about more than economics alone.
They also involve broader questions such as:
- How much should today’s generation invest for the future?
- How much borrowing is reasonable?
- How should the costs and benefits be shared across different generations?
There are no simple answers to these questions.
However, understanding how governments borrow provides an essential foundation for thinking about them in an informed and balanced way.
The next chapter returns to the income side of the government’s finances by asking a different question:
How does the tax system raise the money that governments spend?
Common Misunderstandings
Government borrowing is discussed regularly in the news, yet the way it works is often misunderstood.
Terms such as government bonds, gilts and national debt can sound technical, leading many people to assume that government borrowing is more complicated than it really is.
In reality, the basic principles are surprisingly straightforward.
Let’s look at some of the most common misunderstandings.
“The Government Borrows from the Bank of England”
This is probably the most common misconception.
Many people imagine that whenever the government needs money, it simply asks the Bank of England for a loan.
In normal circumstances, this is not how government borrowing works.
Instead, the government raises most of the money it borrows by selling government bonds to investors through the financial markets.
The Bank of England has a separate role. It is responsible for monetary policy and the stability of the financial system, not for providing the government’s day-to-day borrowing.
Although the Bank of England can become involved in government bond markets in certain exceptional circumstances, this is different from the government’s normal borrowing process.
Understanding this distinction makes it much easier to follow discussions about government borrowing and the role of the Bank of England.
“Only Banks Lend Money to Governments”
Banks are certainly among the organisations that buy government bonds, but they are far from the only investors.
Governments borrow from a wide variety of lenders, including:
- pension funds;
- insurance companies;
- investment funds;
- overseas investors;
- banks; and
- sometimes individual investors.
No single organisation provides all of the government’s borrowing.
Instead, thousands of investors each lend relatively small amounts which, when combined, provide the billions of pounds governments sometimes need to borrow.
“Government Bonds Are the Same as Company Shares”
Government bonds and company shares are both investments, but they work in very different ways.
When you buy shares, you become a part-owner of a company. Your return depends largely on how successful that company becomes.
When you buy a government bond, you are not buying part of the government.
Instead, you are lending money for an agreed period.
In return, the government promises to pay interest and repay your original investment when the bond reaches its maturity date.
Understanding this difference helps explain why many investors hold both shares and government bonds as part of a balanced investment portfolio.
“Borrowing Means the Government Is in Financial Trouble”
Borrowing does not automatically mean that a government is experiencing financial difficulty.
Most developed countries borrow money as a normal part of managing their public finances.
Borrowing may be used to invest in infrastructure, respond to emergencies or finance temporary budget deficits while the economy recovers.
Whether borrowing is appropriate depends on many factors, including the purpose of the borrowing, the amount involved and whether it remains affordable over the long term.
The existence of borrowing alone tells us very little about the overall health of a country’s economy.
“Government Debt Has to Be Repaid All at Once”
Another common misunderstanding is that the national debt is like a single enormous loan that will eventually become due on one particular day.
In reality, government borrowing consists of thousands of individual bonds, each with its own maturity date.
Some bonds mature after only a few years.
Others remain in place for several decades.
As older bonds mature, governments normally repay them and often issue new bonds to replace them.
Government borrowing is therefore managed continuously rather than being repaid through one huge payment.
The important question is not whether every pound of debt can be repaid tomorrow, but whether borrowing can continue to be managed responsibly over time.
Conclusion
In the previous chapter, we learned that governments sometimes spend more money than they receive in income.
This chapter has explained what happens next.
Rather than borrowing from a single bank, governments usually raise money by selling government bonds to thousands of investors.
These investors lend money today in return for regular interest payments and the promise that their original investment will be repaid in the future.
In the United Kingdom, these government bonds are known as gilts.
Understanding this process helps explain how governments finance budget deficits, invest in long-term projects and respond to unexpected events without immediately increasing taxes or reducing public spending.
It also explains why confidence matters.
Governments that are seen as responsible borrowers can usually borrow more easily and at lower interest rates than those whose finances are viewed as less stable.
Government borrowing is not a mystery.
It is simply one of the ways governments raise money when current spending is greater than current income or when long-term investment is needed. Like any form of borrowing, it brings both opportunities and responsibilities.
The important questions are why governments borrow, how the money is used and whether borrowing remains sustainable over time.
Understanding these ideas provides another essential building block in understanding how the UK’s public finances work.
Continue Learning
We have now completed the borrowing side of the government’s finances.
So far, you have learned:
- what the UK Budget is;
- where government money comes from;
- where it goes;
- what happens when spending exceeds income;
- why governments borrow; and
- how governments borrow by issuing bonds.
The next chapter returns to the income side of the government’s finances by asking a different question:
How does the government raise the money that it spends?
In How Taxes Work, we’ll explore the principles behind the UK’s tax system, why taxes exist, the different ways governments raise revenue and how taxation supports public services and the wider economy.
That chapter also provides the foundation for the pages that follow on Income Tax, National Insurance, VAT and Corporation Tax.
By this point, you will understand both sides of the government’s finances:
- how it raises money;
- how it spends money; and
- how it borrows when necessary.
Together, these chapters form the foundation for understanding the wider economy and many of the political and economic debates that shape modern Britain.