National Debt

Nowadays, it does not take one to be an economist to understand the notion of a national debt. It comes as the result of one’s own experience after a national debt has affected one personally. A national debt causes many financial, economic and social problems, and, therefore, it is considered to be a source of great danger for a country and its people. In situations of economic crisis, countries with a large national debt may face dire financial future. The most common explanation for getting into debt is that countries spend more money than they make, a situation referred to by some as “financial irresponsibility” (Billitteri, Clemmitt & Katel, 2008, p. 938). Governments usually try to liquidate their obligations by raising tax level and cutting programmes in order to save budget money, or very often resort to extra borrowing.

The economy of each country is characterized by certain features that can define the state of its economic wellbeing. A lot of research is conducted to collect data on the status of a national economy and sum of government debt correspondingly. Official data is “often adjusted to reflect three economic variables, such as the price level, interest rates, and business cycle” (Elmendorf, 1998, p. 6). The real value of a debt is, for many purposes, more important than the nominal value (Elmendorf, 1998).

The status of national economies is defined according to the achievement of economic objectives, which can be either long-term, e.g. sustainable development, or short-term, e.g. stabilization in response to economic shocks. Determining the current state of an economy is an important task for policy makers; and, therefore, certain indicators are used for these purposes. The major indicators include national income, output and spending (Higson, 2011). They are thoroughly measured and analyzed to help determine whether an economy is prospering or falling into recession. Economic development is examined by determining the existing indexes of development (e.g., “Human Development Index” (Higson, 2011, p. 5)). Various factors are taken into account during this process, including the level of people’s education, social activity, health condition, life expectancy, etc. Prices are constantly monitored, as their stability is a feature of a stable economy and, at the same time, its significant objective. Other important indicators used to determine economic development include levels of investment and savings. Levels of poverty, unemployment rates, average salaries, and distribution of income are put under close scrutiny when determining a country’s economic state. There are also a lot of indicators connected with trade and exportation, such as export balance, purchasing power of a national currency, as well as a country’s competitiveness on the international trade market.

Apart from the above indicators, there are other ways of determining a country’s economic wellbeing, such as the real and nominal Gross Domestic Product (GDP).

The nominal GDP is the sum total of the value of goods and services measured by using constant set of prices, while the real GDP is the sum total of the value of goods and services measured by using a constant set of prices. (Agarwal, 2011, p. 1.8)

The real GDP is the best measure of a country’s economy wellbeing, as it is not influenced by price instability. The nominal GDP, on the contrary, does not show the exact ability of an economy to satisfy the demands of a country’s households and government. The real GDP “shows the changes in expenditure as a result of changes in the quantities of goods and services produced, keeping prices constant” (Agarwal, 2011, p. 1.8). As the amount of the mentioned goods and services reflects the ability of a country’s economy to satisfy the needs of people, the real GDP is considered the best measure of economic wellbeing.

The abovementioned indicators and measures are significant, but the key indicator of a national economy’s wellbeing is its level of indebtedness, and particularly the Public Sector Net Debt indicator, which is used as the main criteria of productive government performance and efficiency (Higson, 2011).

A national debt is the result of financial borrowings of a state made to cover a budget deficit. A government debt equals to the sum of deficits of previous years after deducting budget surpluses. It consists of the debt of a central government, regional and local authorities, as well as debts of all state-owned corporations in proportion to the state share in capital stock of the latter.

It is important to distinguish between external and internal debt. External debt means that a country has borrowed money abroad to cover the balance of payments deficit. Internal debt is what a state has borrowed to cover the balance of payments deficit. The part that a state borrows abroad will thus be included both in a state and foreign debt. Movement of payment balance determines a total external debt. A national debt is determined by the dynamics of a budget deficit. A budget should have a positive surplus for a national debt to be reduced.

When assessing the value of a national debt, one should take into account the amount of assets, which may be rather significant for “any overall accounting of the government's financial situation” (Elmendorf, 1998, p. 7). According to Elmendorf (1998), the largest explicit government assets and liabilities are “debt held by the public (excluding the Federal Reserve) and expected pension liabilities for federal military and civilian employees” (p. 7).

Elmendorf (1998) considers wars to be the biggest influential factor for a government debt increase. As an example, he analyses the state of the USA economics before and after period of wars, i.e. “the War of 1812, the Civil War, World War I, and World War II” (Elmendorf, 1998, p. 4)), and comes to the conclusion that all wars “produced noticeable upswings in federal indebtedness” (Elmendorf, 1998, p. 4). Recently, almost all countries of the world have had one more significant reason for having a national debt, i.e. economic recession. During recession, prices of assets and equities become much lower, which leads to a decrease in national income from corporate tax. Moreover, widespread unemployment causes individual income tax to fall, which, in fact, constitutes the largest component of national revenue (Austin & Levit, 2012).

The first and easiest way to solve the problem of a government debt is to print more money; however, it does not eliminate the root cause of the problem. When more cash is available, demand for services and goods naturally rises, thus causing high prices and inevitable inflation. A large national debt interest may cause a lot of negative effects. Firstly, an increase in tax rates could break the effect of economic incentives for production development, reduce investors’ interest in new ventures, as well as increase social tension in the society. Secondly, the existence of a debt involves the transfer of a domestic product abroad (in case of payment of interest). Also, the growth of external debt reduces a country's international image. One more effect is when a government borrows from the assets market to refinance or pay interest on a national debt; this will inevitably lead to an increase in the rate of assets interest. Rising interest rates result in a reduction of assets costs and reduced private investment, while future generations may inherit an economy with a poor production capacity and all the negative consequences that come with it.

Elmendorf (1998) analyses the effects that national debt causes to a country’s economy by taking into account conventional, alternative, and positive points of view. He divides all the effects into “short-run” and “long-run” ( p. 12). Among the shot-run ones he names “increased demand for output” (p. 12) and “increasing aggregate demand” (p.15). A debt affects a national economy in  the long run by causing “reduced national saving” (p. 13) and “reducing the capital stock” (p. 15). Other effects include:

-  “high inflation and  interest rates”;

-  “deadweight loss of the taxes needed to service a debt”;

-  alteration of “ the political process that determines fiscal policy”;

-  reduction of “the fiscal flexibility of the government”;

-  “danger of diminished political independence or international leadership” (pp. 15-18).

The presence of a federal debt requires maintenance, i.e. payment of current interest. The cost of government debt maintenance is determined by interest rate, which in turn is influenced by the total demand and supply of monetary resources. Economic consequences of a debt can be as follows:

-  The need to maintain a debt, which means a substantial reduction of consumption opportunities for a country’s people;

-  To a certain extent, a debt leads to the exclusion of private assets, which may limit further growth of a country’s economy;

-  Raising taxes to pay off a growing national debt serves as a disincentive to economic activity;

-  Redistribution of income in favor of government bondholders.

Deficit financing in financial markets reduces investment and causes some private sector projects to remain underfunded. Here, a high alternative cost comes out, both of the borrowings and the whole process of debt maintenance (Billitteri, Clemmitt & Katel, 2008).

There also exists a problem of the ratio of the public and private sectors’ size. Increased government spending results in the growth of the public sector and reduces the crowding out of the private sector. Moreover, if increased government spending does not involve increased public investment, then future generations will suffer due to reduction of investment.

Dr. Bryan Taylor (n.d.), Chief Economist at Global Financial Data, analyses the debt situation of twelve countries by using previously unavailable data concerning debt and Gross Domestic Product numbers covering the whole century. According to him, it is not taxes a government collects, but rather expenditures that constitute the true cost of its economy. A government can either collect taxes today, or issue promissory notes, such as currency or bonds, to pay for its purchases in the future. When a government increases money supply, it can cause inflation; and if it bonds, it can “crowd out” the private sector (Taylor, n.d., p. 2). The government runs a deficit because it is unable or unwilling to collect a sufficient amount of taxes within any given year to cover its expenditures. Taylor (n.d.) lists the following ways of eliminating or reducing a national debt:

-  Run surpluses and pay off a debt, or reduce a debt by running surpluses. Here, the cost of a debt is imposed directly on taxpayers, while fixed income investors incur no loss;

-  Run a deficit that is less than the growth of the nominal GDP. Thus, even if you continue to run a deficit, the debt/GDP ratio shrinks. A government may have to run a surplus before paying the interest in order to achieve this. The lower the interest rate is, the easier this is to do;

-  Inflate your way out of a debt. If the inflation rate is high enough, the nominal GDP can grow faster than the deficit, thus reducing the debt/GDP ratio;

-  Outright default. This can be done through a currency reform, if a major part of a government debt is held domestically (Germany, 1948), devaluation, if a debt is held by foreigners but in the local currency, or a default on foreign currency bonds. Here, the entire cost is born by bondholders to the benefit of taxpayers, but it becomes difficult to issue new bonds (Taylor, n.d., p. 3-5).

As with a government debt, the private sector has been known to become highly indebted, which can make the real economy suffer. But what should be done about it? Current efforts focus on raising the cost of credit and making funding less readily available to would-be borrowers. It would probably help if direct government subsidies and preferential treatment a debt receives were reduced. At the end of the day, the only way out is to increase saving (Cecchetti, Mohanty & Zampolli, 2011, p. 22).

When analyzing the problem of a national debt, one should first pay attention to its quality. The need to borrow may be due to various reasons, such as the lack of financial resources in a budget caused by emergency circumstances, e.g. wars and local conflicts, acts of terrorism, technological disasters, large-scale natural disasters, etc., or insufficiency of the reserve fund.

A national debt may be a consequence of a country’s economic policy. The idea of borrowing to fund various socio-economic tasks is not an uncommon one. Almost all countries have resorted to external sources of funding. The overwhelming number of them have scarce budgets, and, therefore, lack their own resources for internal investment, socio-economic reforms, and meeting external debt liabilities. A chronic deficit of current accounts is typical of many countries.

Currently, many economies are characterized by large national external and internal debts. No nation can do without borrowing financial resources from the financial markets through internal government borrowing. Internal borrowing acts as an effective tool of overcoming limitations of tax revenue and conducting a successful monetary policy.