Download Lecture 1.Principles of Public Debt

Lecture outline
 Musgrave’s model of the Ministry of Fiscal
Affairs
 Classical views on public debt management
 Difference between debt and taxes
 Alternative views on public debt management
Public householding
 Public householding implies the system of managing
revenue and expenditures of the government
 Musgrave, Richard in his “The Theory of Public Finance. A
Study in Public Economy” (McGrow Hill Book Company,
1959) proposes the model of simplified public
householding system
 He explains that budget policy has three main objectives –
resource allocation, income reallocation and
economic stabilization
Ministry of Fiscal Affairs
 Musgrave proposes the concept of Ministry of fiscal affairs
(MFA), which acts to address the issues that market refuses
to deal with
 With the help of taxes, MFA withdraw resources from
private sector to public sector and provides services not
rendered by the former
 According to Musgrave, if MFA or government uses these
resources for consumption then there is no budget deficit
and budget is always balanced (taxes equal
expenditures)
Ministry of Fiscal Affairs
Resource
allocation
Resource
reallocation
Taxes=Expenditures
Taxes=Transfers
Economic
stabilization
deficit or surplus
Taxes- (Expenditures + Transfers)  0
Economic stabilization and business cycle
peak
recession
recovery
trough
Economic stabilisation policy
 Gained importance in 1930s
 Has its budget calculated as follows:
 Sum up panned expenditures and transfers
 Calculate potential output and corresponding aggregate
demand
 Aggregate demand is compared with planned expenditures
and the difference is taken to economic stabilization finances
 Is the only policy in the Musgrave’s model which causes
budget deficits or surpluses. In reality, however, there are
other than stabilization purposes which make governments
run deficits.
Different views on public debt management
 Standard view
 Alternative view
 Both views differ regarding debt burden (lower living
standards) and crowding out effect of public debt
Standard view on public debt management
 The advocates of the standard view on public debt
claim that public debt is harmful to economy.
Standard implies that majority of the economists share
this view.
 Ricardian equivalence sees no effect of public debt on
growth
Classical view on debt
 David Hume claimed that either nation kills public debt or
public debt kills nation. He was skeptical about debt
because to his view the government was unable to resist the
temptation to gain political points through government
expenditures
 In his “Of Public Credit” (Essays Moral, Political and
Literary, Vol. I, New ed.; London, 1882, p. 366. Original
edition published in 1742.) Hume criticized the traditional
opinion which argued that nation does not get poorer
because of debt since people mainly owe to themselves.
Adam Smith on public debt
 Like Hume, Adam Smith had negative views on public debt
too. His ideas were mainly based on the excellence of
private sector over the government.
 In his “An Inquiry into the Nature and Causes of the
Wealth of Nations, 1776” Smith claims that the government
is a bad manager because it takes funds from private sector
and uses them for consumption- often this is called
“crowding out effect”.
 Smith argues that private sector could use these funds for
productive investments and that the government should
always run balanced budget.
Adam Smith on public debt
 But, creditors do not loose anything because
government bonds pay higher interest than
investment
 Also, in the case of internal debt, there is no burden of
interest rate payments since money changes hands
within borders
 Then why is public debt an issue?
Adam Smith on internal public debt
People
Government
Companies
Adam Smith on external public debt
People
Government
Companies
Ricardian view on public debt
 David Ricardo shared the views of Hume and Smith.
He claimed that public debt is one of the worst
disasters. (“On the Principles of Political Economy and
Taxation.” John Murray. 1821. Library of Economics and
Liberty)
 However, Ricardo argued that the removal of public
debt will not be relief. Instead, he pointed to the
importance of savings and cuts in expenditures.
Ricardian equivalence
 For example, assume that the goverment cuts taxes in
order to stimulate demand and covers the budget
deficit by accumulating extra debt
 According to Ricardo, people who enjoy lower taxes are
rational. They know that next year to pay interest on
bonds the government will increase taxes.
 So, these people do not use extra income from tax cut.
Instead they save it to pay future increased taxes!
THEREFORE, TAXES ARE EQUAL TO DEBT!
Difference between debt and taxes
 Assume that government expenditures are constant
and the government has two options to finance these
expenditures: through debt or through taxes
 In the case of debt: bond holders do not finance
government expenditures and their pay-offs in
whatever form; they simply expect their debts to be
paid back with interest
 In the case of taxes: tax payers finance expenditures
and their payoffs
then the question is:
Who pays for the government
expenditures and pay-offs in the case of
public debt?
Alternative views on public debt
 Malthus Thomas Robert did not agree with classical
views on the public debt and suggested that public
debt is a good thing! (An Essay on the Principle of
Population. John Murray. 1826. Library of Economics
and Liberty)
 He put emphases on aggregate demand and claimed
that the worst disaster is lack of demand. To him
demand motivates production and therefore
governments should attract debt to stimulate it.
Alternative views on public debt
 Mill John Stuart in his “Principles of Political Economy”
suggested to divide public debt into good and bad public
debts
 Good public debt- debt made of foreign capital or national
savings available only due to government demand for them
(or savings which would otherwise go to inefficient
investments)
 Bad debt – debt causing crowding out effect as with
classical views. Mill also argues that burden of public debt
will be extended to future generations.
Keynesian approach to public debt
 In his “The General Theory of Employment, Interest
and Money” (Macmillan Cambridge University Press,
1936) John Maynard Keynes put forward the following
principles:
 Say’s law is abandoned: growth is determined by
demand, not supply
 Unemployment is rule, not exception
 To decrease unemployment, the goverment should
provide sustainable demand
 For this, balanced budjet rule can be sacrificied
 However, deficit should be tolerated, not praised.
Summary of classical and alternative views
Question: does public debt mean the transfer of debt
burden to future generations?
 Classical view: yes, at the moment of debt creation, the
burden lays on future generations
 Alternative view: no, public debt does not imply any
transfer of burden in time
Summary of classical and alternative views
Question: is public debt similar to private debt?
 Classical view: yes but private debt is better since it is
more productive
 Alternative view: it is erroneous to make analogy in
every aspect of the matter
Summary of classical and alternative views
Question: is there any difference between internal and
external debts ?
 Classical view: no, since both types decrease national
wealth
 Alternative view: yes, there is significant difference
between them
Thank you for your attention!