Economics Handout

Public Debt

“Blessed are the young, for they shall inherit the national debt”. Herbert Hoover.
This quote sums up the situation we now face in Jamaica and many other small territories.

The national debt, also called the public debt, is the total value of the government’s
indebtedness at a moment in time. It is as a result of previous deficits. These two concepts are
closely related because the government accumulates debt by running deficits or reduces its debt
by running surpluses:
Deficit = G + Transfers – Taxes.

The relationship between budget deficits and national debt can be explained in the stock and
flow of the national debt. If the government continues to borrow to finance its budget deficits
(flow) it adds to the total national debt of the country (stock). This is represented in the diagram
below:

Flow of the debt

The Debt
Stock
Net Budget
Gov’t revenue + Deficit
Government expenses -

The Outstanding Public Debt as of 05 Feb 2012 at 04:17:13 AM GMT is:

$15,360,444,452,159.85. The estimated population of the United States is 312,166,946
so each citizen's share of this debt is $49,205.86. Currently the national debt of Jamaica is over
$1.6 trillion. Check out the Jamaica Debt problem for the last two decades at
http://dmu.mof.gov.jm/public/1980_2010TotCalDebt.pdf

The national debt can also be propelled the government’s fiscal indiscipline. Persistent budget
deficits, unnecessary spending, project overruns and corruption have cost this country dearly.
These actions have increased the flow of the debt and by extension the stock of national debt.

Domestic vs. External Debt

● Internal debt
This is the part of the total debt in a country that is owed to lenders within the country. In
other words, it is money that the government borrows from its citizens. If the national debt
consists entirely of borrowings within the country, the government is simply moving money
around from one group to another. To pay off the people it owes interest to, it borrows from
another group. When they have to be paid back, it borrows from another group. The money
however, remains within the economy. Therefore, the wealth of the economy as a whole is
not changed. This is not the case though with external debt.

1
● External debt
This is the portion of a country's debt that was borrowed (loans and bonds) from foreign lenders including
commercial banks, citizens of other countries, governments or international financial institutions. These
loans, including interest, are usually repaid in the currency in which the loan was made. In order to earn
the needed currency, the borrowing country may sell and export goods to the lender's country.
A debt crisis can occur if a country with a weak economy is not able to repay external debt due
to the inability to produce and sell goods and make a profitable return. The International
Monetary Fund (IMF) is one of the agencies that keep track of the country's external debt.

The causes of the national debt

● To counter the adverse effects of external economic shocks and natural disasters
● Governments try to maintain the level of public sector consumption even though revenue is
falling or the economy is stagnant
● To speed up the economic growth and development process

The Effects of National Debt on the Economy (The Burden of National Debt)

Here we are exploring some genuine problems that may arise when the government spends more
than it generates through taxation, that is, when it runs budget deficits.

1) Inflation - Deficit spending under some circumstances is inflationary. Why? Because when
government spending pushes up AD, firms may be reluctant or unable to produce higher
quantities of their products that consumes are demanding at the going prices. Prices will
therefore have to rise. Let us examine this situation graphically:

Ex

Real output
Initially, the country is at point A. Output is 7 billion and the price index is 100. The
economy is also operating at full employment, because the AD and AS curves intersect
precisely at potential GDP. Now with the government running a deficit, an increase in
government expenditure will shift AD upwards to AD1. Equilibrium shifts from point A to
B, thereby raising the equilibrium price level to 106 or 6%. This represents inflation, note
that point B indicates an inflationary gap (revisit your notes). In fact inflation will persist
until the AS shifts far enough upward to the left so that it passes through point C, at which
the inflationary gap disappears. In the long run then, deficit spending will have raised the
price level by 12%.
Thus the cries that budget deficits are inflationary are true. However, it is dependent on
several factors:
🟂 The slope of the AS curve – the steeper the AS, the more the inflation will be.

2
 🟂 The degree of resource utilization – Deficit spending is more inflationary in a fully
employed economy than in an economy with lots of slack (unused capacity).

2) Can lead to an increase in Money Supply – The central bank is said to monetise the deficit
when it purchases the bonds that the government issues. If the central bank takes no
countervailing actions, an expansionary fiscal policy that increases the budget deficit will
raise real GDP and prices, thereby shifting the demand curve for money outward and driving
up interest rates. If the central bank does not want interest rates to rise, it can purchase more
government debt. But when this is done the money supply will increase. This can be shown
graphically:

Qty
If the central bank takes no action then interest rates will rise from A to B. To prevent this
rise, they would engage in expansionary monetary policies that shift the supply curve for
money outward to the right. The interest rate will now become C, rather than B. This
monetising, done to reduce interest rates will cause a further rise in AD, shifting it to perhaps
AD2. Thus, the price level will rise even more. But is this anything to worry about? Many
economists and business leaders are concerned about the long-run dangers of monetisation
when deficits are large and chronic. This reason is simple: When budget deficits are
extremely large, even a small percentage of monetisation can lead to substantial increases in
the money supply – a cause for rapid inflation growth for many countries.

3) Interest Rates and Crowding Out - In brief, large budget deficits discourage investment and
therefore retard the growth of our nation’s capital stock. We have just seen that budget
deficits tend to raise interest rates unless the central bank engages in substantial monetisation.
However, the rate of interest is a major determinant of investment spending. Therefore if we
spend less on I today, we will have a smaller capital stock tomorrow i.e. we inherit less plant
and equipment and thus future generations will be burdened by a lower productive capacity -
a smaller potential GDP. In other words, a large deficit may retard economic growth.
According to most economists, a large national debt may burden future generations.
Crowding out may also occur. Crowding out occurs when deficit spending by the
government forces private investment spending to contract.
Conversely, an increase in G (by raising real GDP), may induce increase in private
investment spending. Deficit spending in times of economic slack quickens the pace of
economic activity. As the economy expands, businesses find it both necessary and profitable
to add to their capacity so as to meet the greater consumer demands. This induces
investment. The strength of this move by firms depends on how much additional real GDP is

3
 stimulated by government spending and how sensitive investment spending is to the
improved profit opportunities that accompany rapid growth.

4) Higher taxes will be necessary to make these payments. The burden of debt service falls
heavily on wage and salary earners who cannot escape income taxes, deducted at source.
This leads to an increase in income inequality

5) There may be cuts in employment as the government reduces workforce if the public sector
has a significant amount of its revenue goes into the servicing of the country’s debt.1 This
occurred in Jamaica during the late 80’s and early 90’s. Many workers were made redundant
as a substantial amount of the government’s (up to 60%) went toward servicing national debt.
The private sector also eliminated jobs because there was a fall in AD. Firms faced with
falling sales cut their workforce t compensate for the losses.

6) International debt servicing may also result in foreign exchange shortages, which will serve
to constrain production for an import dependent country as Jamaica. The shortage may
promote the black market, which can undermine the formal economy. In addition, residents
may lose confidence in their domestic currency. This may cause speculation and panic as
individuals seek to get rid of the ‘worthless currency,’ and this will result in a massive
depreciation of the domestic currency if supply is not increased to match demand (e.g. in the
early part of 2003). This will further compound the situation.

7) Forgone investment and output – one of the opportunity costs of debt servicing is the forgone
investment that the government could have made with the money. This new investment
could help to increase output thus providing jobs and if the output is exported, providing
needed foreign currency.

Measuring the National Debt

1. Debt Service Ratio

Debt servicing is the cost of meeting interest payments and regular contractual repayments of
principals on a loan along with any administration charges borne by the borrower.

Debt service ratio is the ratio of debt servicing payments made by or due from a country to that
country’s export earnings. It is calculate as:

Principal + Interest x 100

Exports
The ratio is considered to be a key indicator of a country’s debt burden.

1
Total debt servicing in Jamaica is projected at $210,000.8mn or 59% of the budget in 06/07. This compares to
$224,507.5mn or 65% for FY 2005/06.

4
2. Debt to GDP ratio
This is a measure of a country's federal debt in relation to its gross domestic product (GDP).
By comparing what a country owes to what it produces, the debt-to-GDP ratio indicates the
country's ability to pay back its debt. This measure gives an idea of the ability of a country
to make future payments on its debt. If a country were unable to pay its debt, it would
default, which could cause a panic in the domestic and international markets. The higher the
debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of
default. This is calculated as:
National Debt x 100
GDP

The responsibility for debt repayment

In most cases the responsibility of the debt repayment rest on the future generation. One
government may borrow heavily but then may not be around when the payments are to be made.

Management of the national debt

a. Internal and external borrowing – since internal borrowing results in just a switching around
of wealth locally, the government can borrow internally rather than from external sources
which may come with conditionality.

b. Taxation – one way of reducing the national debt is by increasing government revenue. This
is accomplished through an increase in taxation. Higher government revenue will reduce the
government borrowings, thus reducing the flow of debt. With enough revenue, the
government can also repay some of its debt without additional borrowings

c. Debt restructuring: Debt restructuring is the reorganization of the debt stock and/or its terms.
It may involve any of the following:
i. Debt rescheduling - this is the formal deferment of debt service payments and the
application of new and extended maturities to the deferred amount.
ii. Debt refinancing – this is refers to the contracting of a new loan to repay or prepay an
existing loan or group of loans. This loan is usually on better terms (interest and
maturities) than the existing loans
iii. debt swapping – typically involve exchange at a discount of external debt in foreign
currency for a non-debt obligation in domestic currency, for example, equity in an
enterprise
iv. debt exchanges – this is where a sovereign debtor makes an offer to exchange his
existing bonds for new instruments that reflect terms of a debt restructuring

d. Debt forgiveness (debt relief) – this is the writing off of a portion of one or more loans to a
financially troubled firm or country by its lenders. It is the act of excusing heavily indebted
countries from all or part of their unsustainable debts. The world bank and IMF consider a
country’s debt to be unsustainable if:
● The size of the country’s external debt exceeds the value of its exports by a ratio of
150%

5
 ● The ratio of the country’s debt-to-government revenue is above 250%

e. Debt retirement – the act of repaying the debt. This may be accomplished by recalling
treasury bills and bonds that have been issued and returning the principal to those who have
purchased the debt

f. Foster growth in the economy hence generating revenue – instead of increasing taxation, the
government can make the economy investor friendly to generate investment and by extension
revenues from taxation. Growing the economy means that more persons will be employed
and businesses will benefit from better profits.

g. Divest loss making entities – many countries, such as Jamaica, have had to watch the
insufficient revenue they collect from taxpayer bleeding out through loss making entities. To
stop the flow of the country’s resources, the government should divest these entities e.g. Air
Jamaica and the Sugar Company of Jamaica