Government Deficits and Public Debt - Term Paper Example

Introduction Governments across the globe formulate budgets on how they are going to handle the needs of their general population. It is common practice among the countries to formulate annual budgets on how they are going to spend their funds. In seeking to have funds for their projects, governments sometimes in cur debts to enable it to fund its public projects. This government debt is a collection of IOUs issued and is outstanding. This occurs when the governments borrows from the general public. The deficit in this case is addition to the amount of debt owed by the government in a specific period. But the reverse is a negative deficit where the outstanding government debt falls. This negative deficit is referred to as a surplus. The borrowing by a specific government issues securities to the parties holding the IOU which lays down the terms of the amount borrowed. The total amount of these IOUs equals the total of the debt that the specific government has not paid. This includes all the amounts outstanding which are inclusive of interest to be paid and the principle amount. The government debt is unlike other private accounting procedures where debt is a measurement of assets and liabilities of a government. The changes in capital are measured by capital budgeting which takes into account assets and liabilities. Government Debt and Deficit Several types of debts that are given out by several different governments can be divided into several ways. One way of classify this debt is according to the specific type of government issuing the IOU. In the case of the United States, there are several divisions of government which includes Federal, state and the local debt. This debt can however be classified by the period it would take to mature from the date of issue, for example a five-year bond. Government deficit is expressed in real values rather than nominal values. This is because using nominal values would result in an overstatement of debt that is required to cover the government deficit. Moreover, the size of this government debt is measured by the debt ratio and also government debt is measured as a percentage of Gross Domestic Product. Deficit occurs in a situation where government purchases and transfers which form the government spending exceed income in form of tax receipts. To cover the deficit in such a case, the government must borrow. Effects of Government Debt and Deficits The finances of most industrial economies by the end of World War 1 were never as they are presently. The economic boom which followed after world war one led to the reduction of public debt by the first quarter of the century. Currently, debt levels that are hitting the roof are not going to go away because of the vigorous growth strategies major economies have adopted. Moreover, the ageing population is not going to make matters any easier and have been aggravated by recent recession. Hubbard identified costs of deficits to the economy together with other studies of Rogoff (2009). Conclusions about the cost of debt burden on growth pointed to the criticality of the situation. Friedman (1988) in his research paper, “Day of Reckoning” cautioned on the evils of high debts of the eighties. The rising of the federal government deficits led to the debates on the subject of effects of these debts on rates of interests. This featured prominently on the study by Friedman on capital formation. One of the models that try to explain this theory is the Keynesian IS-LM model or the IS-MP. The interest rates increase by the mere fact that deficits stimulate demand and keep the levels of output up (Hubbard and O’Brien 2011). However, the interest rate increase in the aggregate demand short run is different in a way in terms of effect than long run interest rate increase caused by the government debt shrouding private capital as discussed by Bernheim (1987). However, it is quite hard to construct a Keynesian platform for the measurement of the stimulus accrued from long term deficits and these covering up of private capital. Additionally, there are other factors apart from the government debt that affect interest rates. A good illustration of when other factors apart from government debt effects on interest rates, is when the authority on monetary issues look to purchase some of this government debt with the intention of expanding money supply, and keep the prices constant relatively (McCallum, 1984). This debt held by the monetary authority does not in any way cover up formation of private capital. However, many studies in respect of interest rates and government debt links mostly, ignore such held debt by the monetary authority. More complex empirical economic problems are caused by other crucial factors like loanable funds demand and supply in credit markets. Debt in the public sector, in private sector incurred with the aim of increasing consumption also has the potential of crowding formation of private capital. However such borrowing in the private sector is mostly not included in studies involving government debt. In a neoclassical model variant that involves Ricardian equivalence, any increases in the amount of government debt, with the marginal tax rates remaining constant are however offset by the saving done by the private sector, and so the capital stock remains unchanged by the government debt. In such a case the interest rate does not increase (Seater, 1993). This private sector saving is usually not included in the analyses of interest rates and government debts empirically. One the costs derived from the fact of excessive deficits are the effects that they have on interest rates. This can be divided into two effects. One this occurs where there is a possibility risk of default caused by an increase in the market of treasury bills. Even if public debt interest rates can be low, the quantity can only increase. The second source is from the risk of default. This risk can bring dangerous consequences. The more the fear of default, the more the interest rates that are asked in the market, to mitigate on this risk. This risk makes the solvency of that particular government in question problematic. Large public debts automatically lead to large interest rate. This is a burden that a country suffers and to cover this, tax rates are distorted. This high tax rate revenue finances the interest rate burdens of a country. So in essence the larger the public debt, the larger the interest rate burden and the more it is financed by tax revenues of that particular country. This distorted taxation rates brought about by public debts become important. The western countries have a high tax rate. The debt level closing in on the 100 percent mark of GDP for countries means that even a slight increases in rates lead to distorted tax rates. The flexibility of a country to deal with inflation is lost when a country has accumulated public debts. Any automatic stabilizers are also costly because of this dangerous debt. High debt countries may be obligated to deal with such high deficits even in times of recessions leading to toxic circles. The recession is made worse when a country with a large debt takes more stringent budget measures with more pressures to reduce these deficits. Conclusion Finding a way of dealing with the costs of ballooning public debt and means of reducing it are critical solutions for many economies in years to come. Economists need to understand more effects of alternative fiscal policies to be better prepared. References Bandyopadhyay, T., & Ghatak, S. (1990).Current issues in monetary economics. Savage, Md: Barnes & Noble. Friedman, B. M. (1988).The Day of Reckoning: The Consequences of American Economic Policy Under Reagan and After. New York: Random House. Hubbard, R. G., & O'Brien, A. P. (2011). Economics. Harlow: Pearson Education. MacCallum, B. T. (1984). Are bond-financed deficits inflationary?: A Ricardian analysis. Cambridge, Mass. Reinhart, C., and K. Rogoff. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. Ricardian equivalence: An evaluation of theory and evidence. (1987). S.l Read More