Government Debt: - Should We Be Unduly Alarmed - Case Study Example

Government debt: Should we be “unduly” alarmed? Is the ment “one should not be unduly alarmed by the size of government debt as it does not needto be repaid because it is only a debt that we owe to ourselves” valid? Recently, in the Caucasus Research Resource Centre program funded by the Carnegie Foundation of New York, Kyurumyan (2009) took the position that we should not be alarmed on the size of government debts and asserted that incurring domestic debts continue to be a sustainable means for addressing public deficits in the medium to the long runs, at least for South Caucasus. A similar view is the theory of Ricardian equivalence. The theory of Ricardian equivalence argues that financing debts through bonds is merely deferred taxation and is basically similar to current taxation (Dornbusch et al. 2011, pp. 336-337). Thus, because debts are merely taxation postponed, they have no effect on the economy (Miles and Scott 2005, p. 413, 487). The theory of Ricardian equivalence predicts that “fiscal deficits or surpluses do not influence the GDP” or the gross domestic product (Miles and Scott 2005, p. 593). Government debts result from government’s fiscal policy when fiscal policy is oriented towards providing fiscal stimulus and, consequently, a regime of s liberal spending policy is installed (Baumol and Blinder 2009, p. 226). Although “an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rates to rise, which reduces investment spending and puts downward pressure on aggregate demand” (Mankiw 2009, p. 375). The increase in interest rates decreases the demand for goods and services (Mankiw 2009, p. 376). The ultimate falling out in aggregate demand resulting from fiscal expansion when the fiscal policy inflates the interest rates is known as crowding out (Mankiw 2009, p. 375). Dornbusch pointed out that interest rates do not rise up necessarily when government spends and, thus, crowding out do not always happen (2011, pp. 267). According to Dornbusch et al., this is possible because of a fiscal expansion that permits money supply to rise (2011, p. 267). This represents an accommodating monetary policy. Monetary policy is accommodating when monetary expansion enhances fiscal expansion (Dornbusch et al., 2011, p. 267). Dornbusch et al. (2011, p. 267) articulated that the combination of fiscal and monetary expansion has been known as “monetizing the budget deficit.” In situations in which the budget deficit is monetized, the monetary authority prints the money “to buy the bonds” that government will use to finance its deficits (Dornbusch et al. 2011, p. 267). However, monetizing deficits is inflationary and citizens acquire the budget deficit with a higher inflation rate. The effect of and expansionary fiscal policy will also depend on whether the fiscal deficit is bond-financed or financed through the creation of money. If the expansionary fiscal policy is financed through government sales of bonds, then government will have debts which citizens will have to repay through higher taxes in the future. If the expansionary fiscal policy is financed through the creation of money then citizens will have to pay for the fiscal expansionary policy through higher inflation. Because citizens ultimately pay for the expansionary fiscal policy, governments may adopt a policy of fiscal consolidation. In the fiscal consolidation, governments attempts to reduce both government deficits and accumulated debts (OECD 2001). The framework for fiscal consolidation can take the form of stabilizing the debt-to-income ratio to equal income growth. Following this principle serves as a form of debt ceiling. The policy can be supplemented by Tobin taxes intended to keep exchange and interest rates volatilities low so the macroeconomic effects of public debts on the economy are kept controlled or moderated. Tobin taxes has been proposed in G-20 meetings but elicited a lukewarm response from the International Monetary Fund (Stuckler et al. 2010, p. 303). Tobin taxes are taxes on exchange rate, financial instruments, and debt transactions although James Tobin originally proposed the tax in the 1970s for exchange rate transactions only or mainly (Rajan 2002, pp. 1024-1026). Tobin taxes are being proposed to discourage speculative activity that exacerbates the effects of public debts (Uppal 2011, p. 6). However, Uppal (2011, p. 9) pointed out that theory supporting Tobin taxes are mixed: there are perspectives that support Tobin taxes but there also perspectives that focus on the lack tangible gains from Tobin taxes and its role in increasing volatility. If expansionary fiscal policy is financed or supported by money creation, citizens ultimately pay for the expansionary fiscal policy through seigniorage. Seigniorage refers to “the government’s ability to raise revenue through its right to create money” (Dornbusch et al. 2011, p. 494). Unfortunately, by creating more money and especially if the money is created in an accelerating manner, government also creates the forces for an inflationary spiral (Dornbusch et al. 2011, p. 494). Dornbusch et al. (2011, p. 494) emphasized that inflation are basically taxation because people will spend less with inflation. With taxes, government will spend more and the public will spend less “just as if the government had raised taxes to finance extra spending” (Dornbusch et al. 2011, pp. 494-495). Seigniorage is a condition wherein government is financing her deficits through printing money; thus, government is financing the deficit through an inflation tax (Dornbusch et al. 2011, p. 495). The tax revenue that the government earns from an inflation tax is given by inflation tax revenue = inflation rate x real money base (Dornbusch 2011, p. 295). Meanwhile, fiscal consolidation through a debt-to-GDP consistent with long-term income growth appears to provide a good stabilization framework or a framework for understanding better the macro economy. This is illustrated by the graphical model below which was discussed in class. In the model above, the vertical axis is the debt growth rate wile the horizontal axis is the debt-to-income ratio. The g represents the long-term growth of income. A stable economy results when the debt growth rate is equal to the long-term growth of income. This will imply a long-term or constant debt-to-income ratio. Another way of looking at the model is that a stable debt-to-income ratio consistent with the equilibrium between the debt growth rate and income growth rate promotes economic stability. The graphical model suggests that when the debt growth rate is lower than the income growth rate, the economy moves to the left or to a lower debt-to-income ratio. The implication is that society’s income will increase as the economy moves to a lower debt-to-income ratio. On the other hand, when the debt growth rate is higher than the income growth rate, society moves to the right or to a higher debt-to-income ratio. This also implies that society’s income will decrease. The economy will converge to a constant or long-term debt-to-income ratio that leads to equilibrium between the debt growth rate and the income growth rate. A constant or long-term debt-to-income ratio is therefore implied---suggesting that fiscal consolidation, when understood in terms of absolutely decreasing public debts, will not be reached but will converge instead to a long-term or constant rate associated with a condition that promotes equilibrium between the debt growth rate and the income growth rate. It follows that in the long-run, we need not be alarmed of our public debts because our national debts will ultimately converge to a constant or long-term debt-to-income ratio. At the same time, however, budget deficits or public debts are not entirely costless for society. Citizens will have to pay for the debts through crowding out, inflation taxes, or other taxes that in turn create distortions. Thus, yes, in the short to the medium run, we should be alarmed with large public debts even if the long run scenario is a movement to a long-term or constant debt-to-income ratio. Debts can be internal or external. Internal debts are debts incurred from corporate or individual citizens while external debts are incurred abroad or with foreign lenders. A large debt or debt in relation to government revenues or our gross domestic product can decrease our national credit rating or on our ability to incur external debt. Credit ratings are rankings or assessments made by credit agencies on our economy. Bad credit rating means we are less able to access investor funds. Credit agencies take a special look at our primary deficits or the budget deficits with interest payments taken out as a fundamental basis for the ratings (Dornbusch et al. 2011, p. 609). Government can be a major lender or borrower. Net government lending or borrowing indicates whether government adopted an expansionary or tight fiscal policy. Government sells bonds for their borrowings. The bonds have a coupon rate or periodic interest rate paid to the owner of the bond (Dornbusch et al. 2011, p. 598). Higher interest rates implies a higher debt-to-income ratio and, based on our earlier graphical model, would have a bearing on whether the income growth rate would be higher or lower compared to the debt growth rate. On the other hand, a higher income implies a lower debt-to-income ratio. When interest rates increase, higher allocations must be provided for debt payments thereby increasing the debt-to-GDP ratio. Higher inflation that may result from monetizing a deficit or expansionary fiscal policy (as discussed earlier) can also result to higher debt-to-income ratio. On the other hand, a decreasing inflation rate resulting from a more conservative fiscal policy can reduce the amount of debt. All these affirm that public debts are not costless for society because society ultimately pays for the debt. Meanwhile, another perspective on the debt-to-income ratio is from Huang and Xie (2008). In particular, Huang and Xie (2008) devised a procedure for determining a sustainable frontier between the debt-to-GDP and the expenditure-to-GDP ratios. However, the model which we discussed in class appears more elegant and useful. References Barro, R., 1974. Are government bonds net wealth? Journal of Political Economy, 82 (6), 1095-1117. Barro, R., 1996. Reflections on Ricardian equivalence. NBER Working Paper 5502. Cambridge: National Bureau of Economic Research. Buchanan, J., 1976. Barro on the Ricardian equivalence theorem. Journal of Political Economy, 84 (2), 337-342. Baumol, W. and Blinder, A., 2009. Macroeconomics: Principles and policy. 11th ed. South-Western CENGAGE Learning. Dornbusch, R., Fischer, S., and Startz, R., 2011. Macroeconomics. 11th ed. McGraw Hill Irwin. Hall, R. and Lieberman, M., 2005. Macroeconomics: Principles and applications. 3rd ed. Thomson South-Western. Huang, H. and Xie, D., 2008. Fiscal sustainability and fiscal soundness. Annals of Economics and Finance, 9 (2), 239-251. Kyurumyan, A., 2009. Domestically issued public debt as a sustainable alternative instrument for debt managers to meet the needs of public budget deficit in countries of South Caucasus in the medium to long run. New York: Carnegie Corporation Caucasus Research Resource Centre (CRRC) Armenia Research Fellowship Program. Mankiw, N., 2009. Brief principles of macroeconomics. 5th ed. CENGAGE Learning. Miles, D. and Scott, A., 2005. Macroeconomics: Understanding the wealth of nations. West Sussex: John Wiley & Sons, Inc. OECD, 2001. Glossary of statistical terms. Organization for Economic Cooperation and Development (OECD). Retrieved 29 November 2011 from http://stats.oecd.org/glossary/detail.asp?ID=984 Rajan, R., 2002. Tobin tax revisited: A global tax for global purposes? Economic and Political Weekly, 37 (11), 1024-1026. Stuckler, D., Basu, S., McKee, M. and Suhrcke, M., 2010. Responding to the economic crisis: a primer for public health professionals. Journal of Public Health, 32 (3), 298-306. Uppal, R., 2011. A short note on the Tobin tax: The costs and benefits of a tax on financial transactions. London: EDHEC-Risk Institute. Read More