Debt Government Management - Essay Example

Introduction According to Beck et al (2001, p.2), much of the work done in monetary economics indicates that well-functioning financial intermediaries and markets promote long-run economic growth. They further that particular legal codes, contract enforcement mechanisms, and information disclosure systems influence financial development and hence economic growth, as shown by researches done on cross-country level [King and Levine 1993a,b; Levine and Zervos 1998; LaPorta, Lopez-de-Silanes, and Shleifer 2000], as well as by firm-level studies [Demirguc-Kunt and Maksimovic 1998, 1999]. A diverse empirical literature is provided by research based on industry level-data [Rajan and Zingales 1998; Wurgler 2000], time-series research [Neusser and Kugler 1998; Rousseau and Wachtel 1998, 2000], and econometric investigations that use panel techniques [Beck, Levine, and Loayza, 2000] supports the view that financial systems are essential for economic growth. While a strong relationship exists how sound and well-functioning financial markets impact economic growth, Beck et al raise a critical question: ‘How did some countries develop well-functioning financial systems, while others did not? Why do some countries have particular laws and enforcement mechanisms that support the operation of free, competitive financial markets, while others do not?’ (2001, p.2). Particularly, why do some countries post huge budget surplus amounts while other states suffer prolonged effects of massive budget deficits? To Borrow or Not to Borrow? According to Petersen (1999), governments face the fundamental issue of using credit and raising funds in the present that will be repaid in the future with interest, a cost just like any other economic choice. Governments usually borrow in order to finance deficits (easier than to raise taxes), stabilize the economy in the short term and invest in productive infrastructure and economy upskilling in the long-term. Foreign borrowing allows a country to invest and consume beyond the limits of current domestic production and, in effect, finance capital formation not only by mobilizing domestic savings but also by tapping savings from capital surplus countries (Narayanan 2002). Petersen notes that national governments face more options in this regard because it has control over the money supply as well as the operation of the banking system and credit markets than its local counterparts but argues that the more open that national economies have developed, “the more even those options are curbed by the workings of the international economy” (Petersen 1999). That is, governments today are faced with more complex borrowing options as the global economy for savings has become more complicated over time. Debt Government Management: Changing the Legal System and the “Other” Costs of Borrowing Economies found with adequate savings, stable political systems, and sound financial institutions and good growth prospects tend to enjoy lower cost of borrowing. According to Lane and Tornell (1997, p.2), “two common characteristics of developing countries that have grown slowly in the last several decades are the absence of strong legal and political institutions and the presence of multiple powerful groups in society”. The importance of improved budget systems across all governments, Petersen (1999) quotes, must be seen as a crucial part of a strategy in developing better public sector reform. Storkey (2001, p.9) cites Ireland, New Zealand, Sweden and the United Kingdom as the countries that have set the highest standards in sovereign debt management because of these countries’ approach to sovereign debt management and their track record over the past 10-15 years, which has become the benchmark for other countries to follow. He also adds that governments in the OECD countries over the past 10-15 years took measures in addressing problems on sovereign debt management such as the limited understanding of a government’s risk preferences and its tolerance to risk by establishing an autonomous debt management office or agency with the sole responsibility for public debt management (2001, p.7). Examples include the New Zealand Debt Management Office (NZDMO). In her study on the external debt management assumed by India, Narayanan (2002) cited that the cost on borrowing is not limited on the interest cost but extends on the idea of dependency syndrome, which leads to the development of constituencies and electorates at the various levels of government to keep the borrowing momentum in full swing. To quote Narayanan’s words: “There is an element of uncertainty in regard to whether the loans will be available when most needed, with the uncertainty increasing in the event of any demonstration of national self-reliance in area unacceptable to the stockholders of the lending agencies. Third, neither the civil servants negotiating the loans nor their political bosses have a direct responsibility for loan repayment, with the result that there is bound to be a relatively high degree of laxity in ensuring the best and most productive use of the borrowed funds. Fourth, there is hardly any evidence to indicate that countries with heavy indebtedness really can ever develop to such an extent that they will be free from such indebtedness.” A crucial aspect as to how national legal systems should evolve in response to the complex changes that occur in the global economy is their capacity to enforce contracts. Beck et al provide that it is of great importance as to how legal systems can facilitate exchanges. This quite makes sense for how can a borrowing country meet its obligations to its debt payments when it cannot provide a sound environment for financial and commercial transactions. To quote Beck et al’s lines (2001, p.42): “Economies differ substantially in terms of the ability of private agents to write contracts and make transactions confidently… legal systems differ in terms of their abilities to facilitate private exchanges and in terms of their ability to adapt to support new financial and commercial transactions. The results hold strategic messages for policymakers.” However, Beck et al also note that even if a country cannot change its legal origin, that is, the way it enforces its policies, it can still reform its judicial systems through making contract enforcement efficient and certain and one that changes to support evolving economic conditions (2001, p.42). For instance, since heavily indebted countries are vulnerable to severe macroeconomics shocks-sharply higher interest rates in the lending countries or simply lenders cutting back on their commitments. Faced with these pressures, countries must then adjust by cutting private investment, decreasing government expenditures and or increasing government revenues (Naranya 2002). Lane and Tornell cite in their evaluation on the growth prospects of developing nations that are undergoing democratisation, the impact on growth of a switch from autocracy to democracy will depend on the effect that the shift has on the ability of powerful groups to extract transfers (1997, p.42). This is because when groups have the capacity to extract fiscal transfers, capital stocks in the formal sector of the economy are not really private. Since transfers must be financed by some form of taxation, higher transfers to one group result in higher taxes for the entire formal sector of the economy. In order to protect their profits from arbitrary taxation, agents shift a portion of their resources to where they are free from this levy. Agents can do this by investing in the “shadow sector” where they can flee from the control of fiscal authorities although these investment types yield a lower raw rate of return (Lane and Tornell 1997, p.3) Also, when governments in some form of autocracy decide to move to democracy in order to support international trade, these countries are faced with a challenge of redistributing resources. As a collapse in autocracy relaxes restrictions on the behaviour of the powerful groups in a society, democratisation may intensify the redistribution struggle in these countries. Lane and Tornell cite that this will lead to lower growth and poorer adjustment to windfalls. On the other hand, they further that if the move to democracy brings with it the destruction of entrenched interest groups, and power becomes more diffused, then growth performance and adjustment to windfalls will improve. Policies that favour competition, for instance, reducing barriers to market entry or exposing domestic monopolies to foreign competition - may be as important as in modifying a country’s capacity to randomly redistribute private wealth as in their direct impact on efficiency (1997, p.42). To Spend or not to Spend: The Crowding Out Story as told by US Medicaid Crowding out theoretically exists when governments increases its borrowing to bankroll increases in expenditures or tax cuts in excess of revenue. Increased borrowing bids up interest rates, hence a “higher price”. Since the private sector is sensitive to such raises in interest rates, the private sector then reduces investment due to a lower rate of return (here, private investment is “crowded out” instead of consumption). A fall in fixed investment can then harm potential long-term economic growth of the supply side by losing potential output in the future. Two studies with separate methodologies used found out that the expansion of Medicaid1 eligibility in the late 1980s and early 1990s (hence greater demand for health services the government has to finance with) led to an extent of crowding out of private health coverage. Using cross-state and cross-age variations in the magnitude and timing of Medicaid expansion in the United States to measure crowding out effect, Cutler and Gruber (1995) found out that approximately 50 percent of the increase in Medicaid coverage associated with eligibility expansions (meaning an increase in potential government cash-out), was offset by a decrease in private insurance coverage, a crowding out rate amounting to as much as 50 percent also. On the other hand, the results of the Dubay-Kenney study (1995) found that 21 percent of the increase in enrolment in Medicaid by children under age 11 and 45 percent of the increase in the enrolment by pregnant women was offset by reductions in private insurance while among poor children, the rate was only 8.5 percent. Using the combined results they obtained from the poor and near-poor populations studied, Dubay and Kenney concluded that an overall increase of 14 percent of the increase in Medicaid enrolment for pregnant women and 12 percent of the increase in enrolment under age 11 was brought about by the crowding out of private insurance coverage (Center for Studying Health System Change 1996, p.2). Intergenerational Equity: Costing Other Generations Combs and Dollery (2004, p.3) state that intergenerational fiscal imbalance is a form of cost shifting, that is, shifting a fiscal “burden” to other generations. The main question is if do we need to fill the fiscal gap through specific fiscal intervention or if future generations have the capacity to achieve higher productivity levels enough to cover the fiscal gap through the present public programs carried on to the next generation. Combs and Dollery also cite that GDP growth, real interest, and discount rates are the primary determinants of the magnitude of this shift costing. For one, if a sustained increase in the ratio of the debt to GDP is observed, the confidence of lenders that the government can still service its debt is undermined (2004, p.10). This is an important reason why countries with high structural deficits are given higher interest rates to pay. On the other hand, when the interest rate is higher than the perceived growth rate of the borrowing country, the debt ratio rises again since interest payments will add more debt than growth augments to GDP, a situation where fiscal position is unsustainable unless the government decides to raise the primary surplus in order to offset the effect. Finally, the choice of the discount rate is still a hot topic for debate in economic literature as governments use one that reflects the opportunity cost of capital (Coombs and Dollery 2004, p.10).2 So up to what extent must the government borrow in order to finance educational and social services and up to how much must each generation shoulder this borrowing of the government? Under the concept of intergeneration equity, if social investments by, say generation 1, can benefit generation 2, then the government can impose that generation 2 should share the cost by shouldering a portion of the debt incurred in establishing those investments. This is in contrast with the concept of fiscal sustainability, which holds that each generation must meet its own expenditures.3 On the other hand, if the benefit to generation 2 exceeds the cost of investment to generation 1, then the value of absolute debt becomes unnecessary but the debt to GDP ratio becomes the more important factor to be considered (Coombs and Dollery 2004, p.20). Most importantly, under the model of intergenerational equity, policymakers must not be constrained of balancing the budget but treat social expenditures e.g. education as investments rather than current expenses (Coombs and Dollery 2004, p.26). In their study on debt reduction and intergenerational equity in Canada, Lavoie and Babineau (2000) found in their preliminary results that the pace of debt reduction in Canada would tend to result in an unequal lifetime tax burden across generations. It also found out that if the Canadian governments only consideration was to balance the lifetime tax burden of the baby-boomers with that of their successors, it should put off major tax cuts until the boomers retire, and use the resulting temporary surge in revenue to reduce the debt. Particularly, if a government’s objective is to make even the lifetime tax burden across generations, it should put more emphasis on debt reduction today in order to give greater breathing space for future tax reductions. Conclusion Governments today are faced with a multitude of factors as to how they can finance social services to the public while still maintaining the level of output and interest rates in the economy. Furthermore, governments are also challenged on how they are to service debt payments while also allocating these payments to the present and succeeding generations. If governments are determined to meet their public obligations through social expenditures such as in educations through borrowing, they must first convince lenders that they provide a conducive environment where financial and commercial transactions can take place. Second, they must also weigh their financial options so as to keep their debt ratios at a fair level. Though cutting expenditures can lead to higher budget surpluses, the government should realize that there are expenses worth sacrificing and borrowing for. Reference List Beck, T, Demirgüç-Kunt, A, and Levine, R 2001, Law, Politics and Finance (February 26, 2001), World Bank. Retrieved 23 May 2006 from http://www.worldbank.org/wdr/2001 /bkgroundpapers/beck.pdf. Center for Studying Health System Change 1996, ‘Medicaid Eligibility Policy and the Crowding-Out Effect’ in Issue Brief (October), No. 3, Washington. Retrieved 25 May 2006 from http://www.hschange.org/CONTENT/78/78.pdf. Coombs, G and Dollery, B 2004, Intergenerational Fiscal Balance in Australia: Should We Use Fiscal Sustainability or Intergenerational Equity?, Economics Working Series No. 2004-2, University of England School of Economics, Australia. Retrieved 23 May 2006 from http://www.une.edu.au/economics/publications/econ_2004_02.pdf. Lane, P and Tornell, A 1997, Voracity and Growth, Discussion Paper No. 1807, November 1997, Harvard Institute of Economic Research, Massachusetts. Retrieved 24 May 2006 from http://post.economics.harvard.edu/hier/1997papers/1807.pdfNaranya, S 2002, External Debt Management – Case Study in India. Retrieved 25 May 2006 from http://129.3.20.41/eps/if/papers/0311/0311002.pdf. Lavoie, C and Babineau, B 2000, Population Aging, Debt Reduction, and Intergenerational Equity, International Atlantic Economic Society. Retrieved 25 May 2006 from http://www.iaes.org/conferences/past/charleston_50/prelim_program/e60-1/laboie.htm. Petersen, J 1999, Subnational Debt, Borrowing Process and Creditworthiness, Economic Development Institute, World Bank. Retrieved 24 May 2006 from http://www1.worldbank.org/wbiep/decentralization/Topic11_Intro.htm. Storkey, I 2001, Sovereign Debt Management: A Risk Management Focus, The Finance and Treasury Professional (May 2001), Storkey & Co. Limited. Retrieved 24 May 2006 from http://www.storkeyandco.com/Library/FTA_Article.pdf. Read More