Another 'new kid on the block' for IB Economics students (new syllabus)
What is the national (public) debt?
It refers to what a government owes to all of its lenders: ‘Public debt is created through government borrowing from individuals, corporations, institutions, and other governments’ [from the New Palgrave Dictionary of Economics]
è Debt is created when a government records a ‘budget deficit’: when G > T (when government expenditures exceed government income which is mostly tax revenues (T) but may also be any one-off proceeds from privatizations (the transfer [=sale] of state-owned assets to the private sector) and any profits from state-owned enterprises)
è It follows that the public debt is the sum of all past budget deficits minus any budget surpluses [‘the public debt a stock at any given point in time and represents the net accumulation of the associated deficits over all previous time periods’; from the New Palgrave]
è Given that a government borrows by issuing bonds (=selling to whoever is willing to buy these i.e. to lenders) it follows also that the debt is equal to the value of all outstanding bonds (i.e. bonds that are held by its creditors and thus have not yet ‘matured’ and been paid off)
è Government bonds may be held by domestic creditors (=lenders) or by foreigners (= external debt; denominated typically but not necessarily in USD); bonds are held by individuals, firms, banks, universities, pension funds, money managers etc. etc.
To compare the size of the debt of a country with other countries or to determine the extent to which it is ‘sustainable’ , the absolute ‘dollar’ size of the debt is expressed as a proportion of GDP (scaling for the size of the economy). We thus focus on the debt to GDP ratio.
(perhaps subscribe for free to Finance & Development, an IMF publication; the IMF will send you at your address every quarter the newest issue: https://www.imf.org/en/Publications/fandd
Perhaps read read: (a) https://www.imf.org/en/Publications/fandd/issues/2022/03/Balancing-act-Gaspar (b) https://www.imf.org/en/Publications/fandd/issues/2022/03/Deciding-when-debt-becomes-unsafe-Blanchard
Perhaps also check out the post on Jason Furman here: http://www.ibeconomics.org/2021/09/the-national-debt-expressed-as.html
A more appropriate metric of debt is the ‘debt service over GDP’. The reason is that debt is a ‘stock’ variable (measured at a point in time, (say, December 31st of the year) whereas GDP is a ‘flow variable’ (measured over a time period, typically over a year). If Janice earns income of $100000 per year and has borrowed to buy a house $300000 dollars (so owes banks $300000 (her debt)), then her debt to her income ratio is 300000/100000 or 300% of her income - but if she needs $10 000 per year to service her debt then the debt service to her income ratio is 20% and what matters to Janice is what she pays off annually to her creditor (the bank). That is why the debt service to GDP ratio is more informative than the simple debt to GDP ratio.
Cost of high debt
Cost of debt servicing:
- a. Opportunity cost of the funds sacrificed as these funds could have been invested by the government in pro-growth and pro-development goals i.e. on infrastructure investments, on education and on health care services; debt servicing thus restricts the ‘discretionary spending’ ability of the government
- b. Policymakers cannot as easily adopt expansionary fiscal policy (G up; and/or T down) since It would lead to more debt accumulating
- c. If debt is mostly domestically held (as it is in Japan) and if the country (unlike Greece- a member of the Eurozone) can issue its own currency, then, if debt is getting dangerously high, the government may be tempted to ‘monetize’ its debt i.e. to print more money to pay off its creditor; but then there is higher risk of inflation (remember Friedman’s helicopter money drop: ‘too much money chasing after too few goods’); on the other hand, if an attempt is made to pay off foreign lenders (in USD) by printing more domestic currency then the currency will massively depreciate also creating higher inflation as prices of imported goods will rise.
· Impact on credit rating:
Credit rating agencies (CRAs) measure the credit risk of debt for all types of investors. 'Their measurement of credit risk includes default probabilities…and serve an economic purpose as they reduce asymmetric information about issuers that investors face when making investments’(from the New Palgrave). Three agencies (Moody’s, Finch, Standard & Poor’s: the ‘big three’) rate the debt of countries and assign a ‘grade’. Top rated debt (bonds) is AAA which means ultra-safe: creditors will definitely get their money back. But if these agencies come to a realization that a country’s debt is becoming riskier then it will downgrade it. But then lenders will demand a ‘risk premium’ i.e. to earn higher interest rates. This automatically makes the debt burden heavier so a ‘feedback loop’ may be initiated that may lead to default [and here comes the IMF with its rescue packages (conditional lending at preferential interest rates) that (once 'agreed' upon) hopefully signal to private investors that the country is back on track to become creditworthy].
· Impact on future taxation and government spending:
This is where ‘austerity policies’ come into play: the debtor country is forced (‘agrees’= more like some ‘arm twisting’) to slash G and to raise T in order to achieve ‘primary budget surpluses’ (a primary budget surplus is recorded when government spending excluding debt servicing is less than government income (T) so that the government can start lowering its debt; Greece was required for a number of years to achieve primary budget surpluses equal to 3% of its GDP which were huge and inflicted significant pain on mostly low income Greek households
- Note an influential paper by Alberto Alesina and Silvia Ardagna that tried to show that fiscal contraction will not have the expected Keynesian result (to lead to recession) but will lead to expansion (referred to as ‘expansionary fiscal contraction’); Why? Because according to A&A the private sector would see that the government is rationalizing (cutting) its spending that would result in greater confidence levels and thus more investment and consumption from the private sector. Proved to not really be the case. Krugman called this the ‘confidence fairy’)(see https://www.bruegel.org/blog-post/expansionary-fiscal-contractions-and-uk-experiment)
- Also note paper by Kenneth Rogoff and Carmen Reihhart of Harvard that showed that when the debt to GDP level exceeds 90% then an economy will fall into recession. A graduate student at UMass @Amherst trying as an exercise in econometrics to duplicate their results couldn’t. He and his advisor found that R&R had (a) excluded from their sample countries which if they were included would NOT have led to recession but to continued growth and (b) that there were coding ‘errors’ in their excel files. Paper was largely discredited but it had already damaged many in debt-ridden economies.
- The ‘mea culpa’ of the IMF: The IMF had underestimated the Greek multiplier so that the agreed upon cut in Government expenditures by the Greek government led to a much bigger than projected decrease in national income (which meant that many more than expected suffered a loss in jobs/ income). Olivier Blanchard, then Chief Economist at the Fund (now at PIIE), was forced to issue a correction of the multiplier which was referred to as Blanchard’s ‘mea culpa’.
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