5th Chapter

Economics of Public debt

Meaning of public debt
Normally, the government of a country has a large
variety of debt obligation. Therefore, public debt
may be defined in several different ways covering
their alternative combinations and to suit the
purpose of the definition. Thus at one extreme, it
may include all financial liabilities of a
government (including its currency) while at
other extreme, it may include a few of them. A
clear cut stand has also to be taken regarding
inter-governmental obligations like loan from the
central government to the states.
Different types of government obligations of a
country
Firstly, there is the currency itself. Generally,
however, the government creates only a part of
the currency; the rest is created by the central
bank. Therefore, the entire currency circulating in
the market can be a part of the public debt only
if the central bank is classified as a part of the
government sector. In any case, currency
obligations normally remain dormant or inactive
and the government does not ‘pay them off’ – at
the most one set of currency is replaced by
another set and that is all.
Secondly, another set of obligations of the
government constitutes its short-term debt.
These obligations are normally of a maturity of
less than one year at the time of issue and consist
of items like the treasury bills.
Thirdly, some obligations do not have any specific
maturity but may be repayable subject to various
terms and conditions. They are referred to as
floating debt. Examples of this category include
provident fund, small savings, reserve funds and
deposits etc.
Fourth category of government obligations consists
of the permanent or funded debt. Such loans
have a maturity of more than one year at the
time of issue. In practice, their maturity is usually
between three and thirty years. Some of them
may even be non-terminable (or perpetuities) so
that the government is only to pay the interest on
such debt without ever repaying the principle
amount.
Fifthly, obligations owed to foreigners –
governments, institutions, firms and individuals
are called external loans.
Public debt and private debt
Government borrowings have some similarities
with private borrowings. Like a private borrower,
the government may also borrow either for
consumption or for investment purposes. It will
also be paying interest o such borrowings.
But, the dissimilarities between the two are more
fundamental.
i. A private economic unit cannot borrow internally,
that is to say, it can not borrow from itself.
However, the government usually borrows
internally, that is, from its own subjects and from
within the country.
ii. While a private economic unit can repay the
debt either out of its earnings or out of its
accumulated assets or by borrowing from other
sources (thus substituting one debt for other),
such need not be the case with the government.
The government is the creator of the currency
and can pay its debt straight-away by creating
more of it. The fact that it usually does not do so
only reflects its concern for the welfare and
stability of the economy and not the lack of its
power to do so. However, external debt can be
discharged in this manner only if it is repayable in
local currency.
iii. Public borrowings have profound effect on
various dimensions of the economy- distribution,
capital accumulation, economic growth, income
and employment stability, and so on. This way,
public debt is both a source of problems and a
tool of economic management in the hand of the
authorities.
Why public debt?
A government may resort to borrowing because of
some fiscal compulsions, in pursuance of a deliberate
policy or for meeting an emergent need.
1. A government, like any other economic unit, collect
revenue and spends it. And, it is also a fact that its
revenue and expenditure flows may not match each
other during any given time interval. There are bound
to be intervals when it receipts will exceed its
expenditure and vice versa. The deficit and surpluses
will tend to counterbalance each other so that over a
longer time interval there will be a tendency for the
budget to balance.
2. There may be a sudden spurt in government
expenditure. There may be wars, or natural
calamities in which case the government would
be forced to incur much larger expenditure and
may run into a debt.
3. Modern governments do not subscribe to the
philosophy of avoiding a surplus or a deficit
budget for its own sake. Rather they are ready to
use them as a matter of policy. This approach is
sometimes referred to as that of functional
finance – in which the government is ready to
have repeated surplus or deficit budgets for
achieving a variety of objectives including those
of economic growth and stabilization.
4. These days it is widely believed that the
government of an underdeveloped country
should play an active role in the development of
the economy. In this view, budgetary policy is an
important and effective tool in accelerating the
process of capital accumulation and economic
growth. This may be done through borrowing and
investing those funds in various projects. Loans
may even be earmarked for certain project.
Prominent kinds of public debt
Public debt may be internal or external. When it is
owned or held by the subjects of the indebted
government, it is an internally held debt. In this
case, the community owes this debt to some of its
own members. The debt will be external if the
creditors are foreigners and there is a drainage of
national resources in favor of foreign countries
when the debt is serviced.
Loans are called marketable if existing holders can
sell them to others. Non-marketable loans, on
the other hand are those which have been issued
in favor of specified debt holders only and can not
be sold to others.
Government loans may be interest bearing or non-
interest-bearing (i.e., interest free). An interest
bearing loan may carry a fixed coupon, i.e., a fixed
periodic interest entitlement, or coupon may be a
variable one. Alternatively, a loan may be issued at a
discount through bids. Such loans are termed zero-
coupon bonds.
Public loans are also classified into productive and
unproductive ones. A loan is termed productive if it
is used for acquiring income-earning assets or
project(s) for the government or on those heads
which add to the productivity of the economy as a
whole, like education and health service. But in
reality, even fighting a war may not always be an
unproductive act because defense of the country is a
pre-requisite for all productive activities.
Limits of raising public debt
We find that in most countries public debt has
registered a continuous upward trend during the
last decades. As we discuss earlier, some inherent
forces contribute to this trend. But still a question
arises as to whether there are any definite limits
beyond which a government can not raise loans
and add to this outstanding debt obligations. To
answer this question, we shall distinguish
between the will and the capacity of the
government to raise loans both in the short run
and long run.
1. It must be noted at the outset that a modern
government is not expected to borrow for the sake
of it. It is not expected to borrow for indulging in
‘wasteful’ expenditure of any kind. It would borrow
for reasons of either economic compulsions or for
furthering social and economic goals of the society.
On those criteria, it my borrow even for consumption
purposes such as for defense, for education and
health, for meeting natural calamities and for other
welfare objectives. Similarly it may borrow so as to
assist the economy in its growth activities via capital
accumulation and anti-cyclical measures. In other
words, it is expected that the government would
abide by a self-imposed limitation that all
borrowings must be for ‘public purposes’.
2. In some case, there may also be specific legal
restriction on public borrowings.
3. Given the total loanable funds, government
borrowings add to their demand and cause an
upward pressure on interest rates. Thus higher
interest cost can act as a deterrent against the
borrowing programs of the authorities.
4. In the long run, however, total volume of public
debt can increase gradually and in line with the
growth in national income and credit structure.
Therefore, no definite limit may be stated to exist
for the volume of public debt in the long run.
5. A line of thinking pronounced by Gurley and
Shaw and the Radciffe Committee emphasized the
important role of public debt in the economy of a
country. Gurley and Shaw claim that the physical
growth of the economy can not be sustained
without a healthy and strong financial sector.
And this in turn necessitates the growth of public
debt since the latter provides a foundation for the
superstructure of credit in the economy. Similarly,
the Radcliffe Committee emphasized the role of
public debt as a powerful tool in the credit and
monetary regulation of the economy.
6. A fear is expressed that unless restricted by some
means, a government may resort to excessive
borrowing and get into a ‘debt trap’ – that is, a
situation in which it has to borrow a fresh to
service the existing debt. This state of affairs may
eventually raise interest cost to unwieldy high
proportion of its revenue receipts and
expenditure. Such a situation also leads to many
other ill-effects like those on investment,
economic stability and balance of payments.
Public debt and Economic growth
A. Role of public debt to the financial system
Economic growth is accompanied with increasing
monetization of economic activities, i.e., economic
activities generate corresponding financial transactions.
As a result the financial requirements of the economy
increase both in absolute term and in relation to the
national income.
Financial assets may be divided into two parts, viz., ‘inside
money’ and ‘outside money’. Inside money refers to
financial claim against the private sector of the economy
while outside money refers to financial claims against the
government sector. Simultaneously, government
obligations act as an acceptable and sound base for the
private financial assets, that is, financial claims upon the
private sector has highest acceptability when they are
payable in ‘legal tender’ (or official money).
Credit being ultimately an expression of confidence,
its best base can only be the government
obligations. There is no risk of default in their
case and they have a ready marketability. And
these qualities are not found in as much measure
in private debt obligations. Therefore, existence
of government debt becomes a precondition for
the existence of a developed financial system of
the economy.
B. Role of public debt in facilitating saving and
investment
Modern economies are characterized by
'roundabout processes of production’, that is,
their production processes comprise several
stages before products reach final consumers.
Roundabout production adds to the overall
productive capacity of the economy; and, in
general, more the stages, greater is this addition.
Thus, growth-oriented investment involves long
gestation periods and future planning which, in
turn are facilitated by a developed, diversified and
sensitive financial system.
It is noteworthy that the need for growth-oriented
investment is more intense in the case of a less
developed country, particularly in the area of
infrastructure. However, a less developed country
suffers from a weak financial system and
insufficient savings. Accordingly, the government
has to help the economy by raising public
borrowings and investing the same in growth-
oriented projects.
1. In the case of borrowings from the market, if the
public reduces its own consumption and lends its
savings to the government, the result will be a net
increase in the rate of savings. This may happen if
people voluntarily save more under the temptation of
an interest income. However, if loans to government
are given by diverting the savings from private
investment, then there would be no net increase in
saving and investment activity. But public loans can
still help economic growth through reallocation of
resources. Public investment is more likely to be in
the capital goods sector while private investment
tends to concentrate in consumption goods sector
because of its greater profitability.
2. When the authorities borrow from the central
bank of the country, there is an addition to
aggregate money supply in the country. This
causes an addition to demand flows and an
upward pressure on prices. A part of the supplies
is purchased away by the authorities by spending
the newly created money and the market is left
with smaller supplies. In that sense, this process
of forced savings and capital accumulation is not
always a desirable one on account of its harmful
inflationary effects.
 PUBLIC DEBT AND INFLATION
It is claimed that most public borrowings from the
market only divert funds into the hands of the
government. As a result, there is no net addition in
aggregate demand and hence no increased pressures
on prices. This reasoning is quite misleading because it
tries to hide some basic facts.
Firstly, even if public debt does not add to aggregate
demand, it is bound to be inflationary because the
economy's productive resources get diverted from the
production of consumption goods into that of capital
goods. By their very nature, investment goods
industries have longer gestation periods and therefore
during the intervening period, the demand for
consumption goods tends to exceed their supply.
Secondly, borrowings used for war activities, for meeting natural
calamities and for other relief measures are most likely to be
inflationary in their impact because they are basically consumption
oriented.
Thirdly, when a government borrows from the central bank, there
is an addition in money supply which in turn adds to demand and
pushes up prices.
Fourthly, holding of public debt by commercial banks can also
leads to an addition in demand and inflationary pressures. Banks
rate government securities as highly liquid which can be encashed
at any time with minimum risk of capital loss. This assured liquidity
position, therefore, tempts them to increase their loans and
advances and thus add to the inflationary pressures in the market.
However, if public debt is used to bring about an increase in
productivity of the economy leading to an increased supply of
the demanded goods, inflationary forces would be checked to
that extent. In addition, the authorities may resort to price
controls, rationing and other measures to keep prices under
control.
 BURDEN OF DEBT
This dimension of public debt has attracted a lot of
attention in economic literature. The classical
philosophy of laissez-faire assumed that the State
was external to the ‘real’ economy which
comprised only the private sector. Accordingly,
resources transferred to the State were ‘lost' to 'the
economy'. In line with this reasoning, laissez-faire
philosophy was against deficit public budgets,
except under dire necessities. In addition, any
deficit was to be wiped out as soon as possible.
"The national debt used to be regarded as an
aftermath of war, an incubus to be swept away as
quickly as the taxpayer would allow; and the
management of the debt used to consist of a search
for the cheapest way of dealing with a nuisance.”
Furthermore, public debt was often divided into
productive and dead-weight categories. The
general idea was that the government should not
raise loans for consumption activities; at the most it
may do so for the investment activities only. Public
debt should not become a drain upon its budget.
Debts raised during a war etc. were, therefore, very
obnoxious according to this approach.
Assuming that the State was not an integral part of
the “economy’, E. D. Domar claimed that interest
payment on public debt should be taken to
represent a 'burden of debt'. He related the
interest payments to the level of national income
and thus pointed out that as interest on debt as a
proportion of national income rises, a larger
portion of national income will have to be taxed to
pay that interest.
Opponents of public debt claim that it is burdensome
on the basis of some other criteria as well. Those
who make the mistake of equating national economy
with the private sector only, also tend to ignore the
fact that resources are also transferred from the
government to the private sector. Factually speaking,
transfers between the government and the private
sector are transfers within the economy and,
therefore, by themselves, are neither burdensome
nor beneficial.
Burden of public debt takes the form of its spill-over
effects. It may become even 'unsustainable' and the
government may fall into a debt trap', that is, a
situation in which it has to borrow afresh to service its
existing debt.
While internal debt does not cause a direct variation
in aggregate resource availability for the country,
external debt does. At the time of contracting
external loans, the debtor country acquires some real
resources and loses them when that debt is serviced.
Ordinarily, an external debt raised for meeting
consumption needs does not add to the productive
capacity of the borrowing country and results in a net
drainage of resources at the time of its repayment-
more so if the loans are interest bearing. However,
the net outflow will also depend upon the terms of
trade. If the terms of trade have moved in favour of
the debtor country, then to that extent the burden of
the debt is reduced. The debtor country may even
gain in the net.
Judiciously used for investment purposes, foreign
loans are expected to add to the productive
capacity of the borrowing country. In that case,
they need not inflict any net burden on the
borrowing country. This is, however, subject to
the condition that the borrowing country is able
to have an export surplus for servicing the
external debt.
 DEBT BURDEN AND FUTURE GENERATIONS
It is sometimes claimed that debt financing of current
expenditure leads to a burden upon future generations of the
society. Two interrelated questions are involved here.
• Does public debt necessarily imposes a burden or a sacrifice
upon the future generations?
• Is it possible to make the future generations contribute to
the present utilization of resources through debt financing?
As explained below, the classical position is that in debt
financing, the current generation can use only those resources
which are available to it. It cannot draw resources from the
future. Future generations suffer only if the current
generation reduces its saving and capital formation, thereby
retarding the growth of future productive capacity of the
economy. In other words, consumption of currently available
resources, however, may have the spill-over effect of reducing
availability of capital resources for the future generations.
It is claimed that debt financing is more
burdensome for future generations than tax
financing for the following reasons as well. Debt
financing leaves in the hands of the debt owners
bonds and securities which they consider as part
of their wealth. While in the case of taxation, they
believe themselves to be poorer, in the case of
debt financing, they are not likely to do so.
Accordingly, under debt financing, consumption is
not likely to fall. By implication, debt financing can
impose a burden upon future generations, but it
is not a result that must necessarily follows.
This stand has been challenged by several writers
like Buchanan, Bowen, Davis, Kopf, Musgrave,
Modigliani and others. James Buchanan, in his
book Public Principles of Public Debt takes the
position that a burden implies an involuntary
sacrifice.' Holders of public debt, however,
voluntarily opt for it. However, Buchanan is
making the mistake of taking an individualistic
view-point where, for an individual, a tax entails a
loss of resources while a debt does not. But the
economy as a whole suffers a loss of resources in
both debt financing and tax financing.
We have noted above that that if the present generation
provides the resources for debt financing by cutting its
consumption, then savings and capital formation would not
be adversely affected and the future generation would not
be burdened on account of reduced capital stock. Bowen,
Davis and Kopf take the extreme position where the
present generation chooses not to reduce its consumption
at all, but finance entire debt through reduced savings.
Modigliani tries to show that debt financing by the
government necessarily leads to a reduction in capital stock
inherited by the future generations." To elaborate, if the
economy is already at full employment and the government
adds to its own expenditure, then there is bound to be a fall
in either private consumption or investment or both. And
the outcome is the same (though a milder one) even when
the economy is working at a level below full employment.
The foregoing arguments and analysis ignore,
expenditure side of government activities; or
alternatively, it is being assumed that the government
expenditure is necessarily of the consumption type,
such as, in the case of a war. This is mostly an
erroneous assumption. In an underdeveloped
country, especially, public debt is very likely to be
raised with the specific intention of increasing
investment and capital stock. And to a smaller extent,
this holds even for developed countries. It is for this
neglect of the expenditure side of the government's
budget that Mishan calls all those who support the
theory of shift of burden to future generations, the
burden mongers'.12 The net effect of any debt
operation, therefore, need not be burdensome for
the future generations at all.
There is, however, one clear-cut case where the burden
of the debt can be passed on to the future generations.
It is when the debts are raised externally. The current
generation receives the resources (whether for
consumption, or investment, or for destruction in a
war) and the future generations pay back the debt. The
future generations may not feel the burden on account
of increased productivity etc., but the burden of
repayment certainly lies on them.
In conclusion, therefore, we may say that public debt
(for that matter, even taxation) will put a burden on
future generations if two conditions are satisfied:
(i) the present generation does not reduce its savings,
and
(i) the government does not add to the capital stock
and productive capacity of the country.
While arguing this problem, different authors have
made alternative assumptions regarding the
response pattern of the private sector and the
expenditure policy of the government and have
thus reached non-identical conclusions. The
thinking on the possibility of shifting debt burden
to the future generations ignores the economic
implications and ill effects of the debt trap in
which the government may find itself. This is a
manifestation of a real burdent which is worth
avoiding.
 DEBT REDEMPTION
The traditional thinking on this problem has already been
noted. It prescribed a policy of paying off the public debt as
soon as possible (though in practice some governments
defaulted in debt repayment and even repudiated it). Current
thinking, however, places debt retirement in the context of
over-all debt and fiscal policies of the government and favours
repayment of the debt under normal conditions.
One simple way of ending the debt obligations is to repudiate
the debt. But it is unethical on the part of the government to
do so. Such an action erodes credit standing of the
government and creates difficulties for its future borrowing
programmes. It is also disastrous for the financial system as a
whole and more so for those individual creditors who had
invested their life-long savings in government debt or who
were relying upon the interest payments as a regular source
of income.
There are two systematic approaches for retiring
public debt. The first is to create a sinking fund in
which the government regularly puts aside some
money and uses the accumulated fund for
periodic and partial retirement of the debt. The
second approach is that of regularly retiring a
small portion of the debt every year. It is obvious
that for either method of debt retirement, the
government budget must have an over-all surplus.
Alternatively, the government may resort to
printing of additional currency.
Sinking fund approach is followed in several countries.
But this method can succeed in retiring the debt only
if the government has a substantial budgetary saving
every year, uses the saved amount for this purpose
and does not resort to additional borrowings. Interest
earned on the balances should also be credited to the
sinking fund. In olden days, public debt was usually
raised during wars and other emergencies and could
not be paid off quickly. Therefore, sinking fund
technique was considered a sound and practical one.
However, of late, this practice has degenerated into
only a semblance of it. Compared to the total
outstanding debt the amounts credited to the fund are
paltry. Sometimes, even authorized amounts are not
credited to the fund or they are even diverted to other
uses.
The method of paying off a portion of the debt every
year may be effected in two ways. Firstly, the loans
outstanding may have staggered maturity dates. The
public debt in this case can be in the form of serial
bonds. The advantage of this method is that the
repayment obligations are well-spread over time and
do not concentrate the burden in a single year. It may
not, however, be always possible to serialize the
existing bonds without unduly disturbing the
government bonds market. Accordingly, the second
method adopted is that of earmarking a portion of
the budget for debt retirement, purchasing the bonds
in the market and canceling them. The danger with
this method is that it is of a voluntary character.
Under short-term pressures, a government may not
adhere to the practice resulting in 'gap’ years.
When the government does not want to reduce its
outstanding debt obligations, it may "fund the
maturing loans. This means that the existing debt
is converted into a new one of longer maturity.
The holders of maturing debt are given an option
to subscribe to the new debt by surrendering the
older one. In addition, fresh cash subscriptions
may also be accepted. Funding is considered quite
a legitimate alternative to retiring the debt when
the government is not in a position to do so or
does not want to do so for policy reasons. In
India, it is a normal practice to borrow in excess of
maturing loans resulting in a continuous addition
to our public debt.
It is noteworthy that these days, a reduction in
outstanding debt liabilities of a modern government
has become a rare phenomenon. This is because of
several reasons including the following.
• Indispensable role of public debt in being a
foundation of the modem financial system.
• Potential of using public debt for regulating the
financial system.
• Potential of using public debt for accelerating
economic growth, and achieving various socio
economic goals like stabilization.