Download Lecture 1.Principles of Public Debt

Lecture outline
 Healthy finances vs. functional finances
 Impact of deficit on inflation
 Reasons for financing government expenditures
through public debt
 Healthy finances vs. healthy economy
Rules of healthy finances
 1st rule - budget should be balanced
 2nd rule - retain surpluses of budget to cover against
rapid increases in debt
 3rd rule – short run fluctuations in expenditures
should be covered through debt, long term
expenditures- through taxes
 4th rule – income sources should be grouped according
to types of expenditures- current and capital
Rules of healthy finances
 Some economists suggest that the short term extraordinary
expenses of the government (e.g. natural disasters) should
be covered through government debt (3rd rule)
 However, although short term, consumer expenditures
should not covered through debt since current benefit from
debt is received only by current generation while its burden
is spread across future generations
 Replacing entire debt financing with taxes is also not good
idea because in this case the government will have less
investment projects
Rules of healthy finances
 Every public debt should have amortization schedule.
 For example, the government may built a new road and
finance it through debt. It will start paying principal of the
debt after people start to use this road. In other words,
bonds are paid back after investment brings profit to the
society and government
 In this way, capital expenditures are finance through debt,
not taxes. In other words, expectation of future payoffs
justifies the transfer of expenditures to the future (4th rule)
Rules of healthy finances
 Classical school suggests that at times of economic crisis it is
better to print money to cover deficit. The cost of printing money
is insignificant and therefore the government use seigniorage to
finance its expenditures
 Advantage of seigniorage is that it does not create fiscal burden,
but it leads to high rate of inflation
 Even so, the proponents of seigniorage claim that this inflation
can be addressed by the issue of government bonds and selling
them to non banking sector. This would decrease liquidity on the
market and decrease inflation rate. Interestingly, the cash
collected will not go budget, but to Central Bank. Obviously,
costs of anti inflationary debt issue are born by future
generations.
Functional finances
 Alternative school (e.g. Keynesians) was skeptical about
permanent budget deficit
 They proposed the following principles of “functional
finances”
1.
2.
3.
Taxes should be collected and used in order to maintain
growth of production at full employment and zero inflation
( not for extra income)
Debt should be attracted and paid only to change the ratio
of cash to bonds in hands of population (not for paying debt
or attracting extra funds)
Issue and withdraw money to link previous two principles
Functional finances
 First principle eliminates the possibility of inflation
 Second principle avoids crowding out effect
 A. Lerner (“The Burden of the National Debt.” In Income,
Employment, and Public Policy, New York, W.W.Norton and Company,
1948) claimed that deficit and debt may increase with any current and
future losses to economy.
 He argued that following the principles of functional finances
automatically leads to balanced budget in the long run.
 Budget expenditures and revenues should enable creating GDP at full
employment at given price level. In this context, debt or money
emission is not good or bad things, it is just the instrument of
achieving full employment and stable price level.
Healthy finances vs. functional finances
 Health finances differ from functional finances regarding only
one objective: balanced budget
 Healthy finances method focus on balanced budget as target,
while in the functional finances, balanced budget is seen as an
instrument of achieving targets.
 It would be odd to have balanced budget when economy is
experiencing deep recession
 While the government can print money to finance its budget
deficit, it uses taxes to affect behavior businesses and it uses debt
to manage banking reserves and interest rate
Impact of deficit on inflation
 In their research, Luis Catao and Marco Terrones
(“Fiscal Deficit and Inflation: A New Look at the
Emerging Market Evidence,” IMF Working Paper, May
2001) found that:
 In the long run, deficit proportionally affects inflation
 Only global inflation and high oil prices may affect
inflation independent of deficit
Impact of deficit on inflation
 Fiscal theory claims that price level is determined by
budget constraints of the government:
𝑑𝑒𝑏𝑡 𝑖𝑛 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑡𝑒𝑟𝑚𝑠
𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 =
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑎𝑙 𝑠𝑢𝑟𝑝𝑙𝑢𝑠
rearranging we get
𝑑𝑒𝑏𝑡 𝑖𝑛 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑡𝑒𝑟𝑚𝑠
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑎𝑙 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 =
𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
Impact of deficit on inflation
 It follows that to keep nominal debt increasing while
price level is fixed, the government should increase
present value of future budget surpluses
 Similarly, given the constant present value of future
real surplus the growth of debt should be
accompanied by increasing level of prices in order for
the government to maintain its fiscal sustainability.
Reasons for financing government expenditures
through public debt
 According to what we have covered above, in the long run
the impact of debt on economy is not positive- it is either
negative or neutral (Ricardian equivalence)
 Nevertheless, in practice, ministry of finance practitioners
prefer to use public debt in order to cover budget deficit
 The followings are ways to cover budget deficit:
 Cut expenditures
 Collect more taxes
 Keep taxes and expenditures constant and seek resources
elsewhere
Fiscal conservatism
 In theory, taxes should be:
 Fair (proportional to income)
 Predetermined, not discretionary
 Convenient to pay
 Cost efficient (in collection)
 In theory, the government should limit its intervention to
taxes which math the above criteria
 In practice, however, the government not only taxes
economy, but also attracts debt, prints money and possess
large amount of assets.
Fiscal conservatism
 Economists consider taxes to be the primary source of
income followed by debt and money emission.
 Emission of money can happen through two ways-
direct loan to the government by the Central bank or
hidden emission through purchasing government
bonds on the primary market
 Money emission is considered as the last instrument
when nothing else works.
Fiscal conservatism
 Other ways of covering budget deficit:
 Budget loans attracted from different levels of budgets
of budget system
 Revenues received after selling the government
properties
 Using government reserves surpluses
 Foreign debt provided by private and public
organizations abroad
 Nevertheless, public debt and money emission are the
most popular ways to cover the deficit
Healthy finances in practice
 Between 1919-1938 the Great Britain had budget
surplus almost every year (Ritschl, Albrecht,
“Sustainability of High Public Debt: What the
Historical Record Shows”, 1996). This meant that it
followed 1st rule of healthy finances. So did the US
during this period.
 On the contrary, Germany did not follow rules of
healthy finances and managed to decrease its public
debt to GDP ratios through defaulting on debts due.
Only in 2011 Germany could achieve balanced budget.
Health finances vs. healthy economy
 Healthy finances and healthy economy are not the same
thing. This is seen clearly at time of economic recession. 1st
rule of health finances (balanced budget) worsens
economic recession
 Also, 1st rule of health finances significantly limits the
ability of the government to invest and hence help future
generations to enjoy payoffs of investment.
 As a result, the government loses interest in long term
investment initiatives. This is especially true when deficit is
decreased.
Health finances vs. healthy economy
 Above discussion regarding 1st rule of healthy finances is relevant
to the 2nd rule too (budget surplus to pay debts).
 Classical school of economists saw 2nd rule of healthy finances as
the only way to pay back debt. They argued that surplus should
be large enough to cover all current liabilities of the government.
 For this reason, in early 1800s the governments of the UK and the
US launched retained funds aimed at meeting debt obligations
in the future. However, ironically these funds were then used to
attract new debts for political reasons.
 Nowadays some countries still use retained funds: Canadian
extraordinary fund, Italian retained fund, Norway oil fund and
Russian Stabilization fund
Health finances vs. healthy economy
 The government should transfer to the retained fund
the predetermined by law funds
 However, the government should incur significant
costs associated with maintenance of these funds
 Also there is a big temptation for policy makers to use
the fund to finance social projects.
 The existence of the fund makes it necessary to
generate significant surpluses and collect more taxes
Excessive tax burden
 3rd rule of healthy finances allows the government to attract funds on
voluntary basis because unlike paying taxes, buying bonds is voluntary
action.
 3rd rule of healthy finances is especially important at times of recession
or wars. During this period, increasing taxes is not welcomed by the
electorate. So the government uses bonds instead and transferring
fiscal burden to future generations.
 For example, after 2001 terrorist attacks, the US government issues so
called Patriot Bonds.
 However, debt financed budget deficit may turn to significant tax
burden to future generations. Some economists suggest to smooth this
burden by spreading evenly tax rates over generations. This would
eliminate necessity of changing tax rates chaotically.
Debt vs. tax
 There may be need to change taxes significantly in the
short run due to following reasons:
 Automatic stabilizers
 Changes in economic environment
 Short term unpredictable shocks
 Economists suggest to cover deficit caused by these short
term fluctuations through debt because increasing taxes
temporarily harms economy due to dead weight loss and
“rule of square”
 However, if shocks are not temporary, the government
cannot attract debt and will have to increase tax rates
Thank you for your attention!