Custom Search
Public debt is the legal obligation by the government to make interest payments to holders of designated claims. Government main options to finance its expenditure are either from taxes or by borrowing. Thus when the government issues debt there are two processes going one: first some people get the benefits and others are obstained from the benefit (taxes and spending). Secondly some people voluntarily give up their money to the government with no apparent benefits from the direct government spending. The PSBR is then the amount that government finances its spending by borrowing, as a percentage of current GDP.
There are quite a few major issues concerning the public debt, however, they can be grouped to two: ones that deal with the GDP growth and others that deal with inflation.
Behind the GDP issue is the Ricardian equivalence theorem that was recently re-explored by Barro and now allegedly forms the basis for new classical macroeconomics. When people have rational expectation, then by Ricardian equivalence, after an increase in public debt, people will expect taxes to be raised in the future. Thus they will increase their savings now and absorb all the increased issue of government debt. This is called portfolio adjustment, because it is the bonds that government issues to finance its investment that the people should buy. If the people don’t want all of them, then interest rate will increase, private investment will fall and thus crowding out will occur.
Before I will go into deeper New Classical economics I would just like to explore the history of economic thought associated with public debt.
Originally the classical economist thought that government, like individual, should balance its books. It could borrow to finance some sudden expenditure, like wars, but it should pay the debt back afterwards. Public projects that are profitable could also be financed if they can be more effectively managed than the private ones. However, the exact repayments should again be known.
After the Second World War Keynes’ ideas were adopted. He said that the borrowed money will go to unemployed resources that can be latter freed again without any intertemporal substitution. And as his theory predicted that the government spending will have a multiple effect on the economy, thus he urged governments to spend themselves out of recession.
On empirical matters it has been verified that the Ricardian equivalence does not hold, just the opposite, and that the Keynesian budget multiplier is very small. Thus one has no answer as to how exactly the public debt affects the economy. Furthermore, the concept of debt as such is not sufficient to establish any references to the future of economic growth. One needs to know where the money is spent as well (whether it is gone to transfer payments, capital expenditure or current expenditure).
Economists have tried to explain the empirical evidence by saying that the Ricardian equivalence(RE) does not hold, because it has numerous restrictive assumptions. And when they are eliminated, the standard ISLM approach can be used to determine the effects of government spending.
Firstly, RE assumes people have infinite life spans, or they value their children’s consumption as much as they value theirs. This is wrong, people actually value the future consumption by themselves a lot less valuable than should be for the Ricardian equivalence to hold (their discount factor is greatly above the l-term interest rate). Secondly the government is not credit constrained, as the individuals are. Thus government can borrow on behalf of individuals and also thus indirectly is able to act as a lender of first resort. The managing of the liquidity in private sector is probably the most important thing the national debt does, so I will discuss it later in greater detail. the third assumption the RE does not take into account is political popularity. People will prefer when the government finances out of debt for particular project, instead of taxing them. However, as politicians have started to abuse it, media has put large weight on the PSBR to show how prudent the government is, and how much it just cares about its political popularity. It is for the reason of simplicity that the PSBR, not anything more informative about current/capital spending, is used.
Once we have established that RE is not holding, then in ISLM framework, an increase in debt and saving will lead to rightward shift in the IS curve, and without monetary expansion(“accommodation”) the interest rate will raise leading to less private investment (actually investment by firms is redirected to stockmarket and bonds, not to production). This is called financial crowding out, because it can easily be fixed by increasing money supply. In an open economy this will happen automatically.
There is also a real crowding out that occurs due to government spending when firms run to supply side constraints and shortages of raw material occur. Thus debt should be used only in recessions where there is evidence of spare capacity.
These crowding outs will lead to inflation as the system adjusts. For example, when the aggregate demand is stimulated excessively by government spending, supply side constraints are hit and increasing prices will absorb the extra demand. Thus government PSBR often creates inflation. It has couple of advantages. First, the real value of government debt is eroded. One can argue that this is cheating of individuals, however, even government has to pay higher interest rate than the economic growth, and inflation together, thus it is reasonable for the government to erode its debt value. Also some writers argue that inflation serves to smoothen out shocks. With inflation the holders of debt as well as asset-holders will suffer, which is fair.
However, inflation can start spiralling when not controlled properly, as people will adjust their wage claims taking increasing inflation into account. Inflation tax will also penalise savers and discourage saving. Thus the use of inflation tax should be limited.
PSBR will also have redisributive effects as the tax payers and investors are different. Normally wealthy people hold bonds, thus PSBR makes the income distribution more unfair, and different marginal tax rates are needed to compensate for that.
All in all PSBR is a very useful policy tool both in short term policies to smooth out fluctuations and relieve recessions, and in long-term to redistribute the financial wealth and encourage investment. However, the precise operational mechanisms of PSBR are not known and it has become a political tool. Thus governments will try to overuse it to gain political popularity. And once public borrowing has started, it is very hard to finish. Thus despite of its advantages, some other policies (like monetary) are easier to implement and monitor and also terminate.