Effects of the Public Debt on the Economy

Effects of the Public Debt On the Economy:

The public debt of a country affects its economy in two ways. It has its, ‘revenue effects’ as well as ‘expenditure effects’. In the first place, it’s raising of money through a loan that makes people change their budgets. Though it may not affect the consumption expenditure directly as taxation does, because people use their past or present saving to buy public securities. But, in some cases, they may increase their savings and cut down their current expenditure to buy the loan. Obviously, public debts affect consumption expenditure. This is, therefore, the first effect of public debts.

Secondly, the benefit, conferred upon the people by the expenditure of the money raised through public loans, is another effect of public debt. These benefits may not always be different from the benefit that expenditure of tax income may confer, provided that the same use is made of borrowed money as is made of tax revenue. But except in rare cases, borrowed money is always used in different ways so that of tax revenue. However, the difference is not always very radical. For instance, tax revenue may be used to pay the salaries of teachers, while borrowed money may be utilized for the construction of school buildings. The effects of spending, the proceeds of taxation, and of borrowings are the same. But in some cases, the difference is clear-cut. The borrowed funds are used to finance expenditures of a capital nature, such as for the construction of plants for generating atomic energy, whereas the tax proceeds are used to finance current revenue expenditure, the effects of the former expenditure are different from that of the latter. Let us now discuss the effects of public debt on consumption, production, distribution, and the private sector.

Effects on Consumption:

When people purchase government securities, it is not always necessary that they do it out of past savings. Sometimes people buy these securities out of their present income which they would have otherwise utilized on the consumption of other commodities. Since they get an opportunity of buying government bonds of small amounts, they refrain from consuming something and buy them. Therefore, in this way, consumption is affected in the same way as it is affected by taxes. But, when people buy government securities out of their past savings, it has its specified effects. This does not directly affect the expenditure of the people at present. And, when people buy government securities out of idle savings, the expenditure in the present remains the same. Private investment also remains unaffected in such conditions. If however, it comes from bank deposits, it reduces the money with the bank. The banks have, therefore, less money to lend to private businesses. Hence private investments are affected.

Effects on Production:

If people buy government securities by withdrawing money from industrial concerns, or by selling debentures and shares of industrial concerns, private investment is adversely affected. The net effect on investment will depend upon how the money is used by the government. If the government utilizes this money in public undertakings, the total investment available for production may not be adversely affected, but if the government utilizes it on non-productive works, the total investment may be adversely affected.

If people buy government securities from idle funds, private investments are not affected, but if they buy from bank deposits, private investment may be adversely affected, because the lending capacity of the bank may be reduced due to a reduction in deposits.

The lending capacity of banks is generally elastic. The power of Banks to create loans depends upon their resources and the policy of the Central Bank of the country. When the latter encourages for the creation of credit, the likelihood of the expansion of credit is immense. It can expand credit on the strength, of ad hoc or newly created securities. Thus, government borrowings may not reduce investment in the private sector, provided there are enough funds in the market and provided the government utilizes the borrowed funds for productive purposes. Moreover, the government will utilize the loan proceeds for making payments to contractors for goods and materials purchased and in paying salaries to its employees. This will release purchasing power and increase bank deposits, which can be utilized for making loans to the private sector. Hence, government borrowings from banks may not affect investment in the private sector.

If the government uses the borrowed funds for unproductive purposes, it can only be repaid through additional taxation in the future, and this additional taxation in the future may affect consumption. However, all unproductive loans may not affect consumption. Those utilized for the welfare schemes, increase the efficiency of the workers and that of production. When production increases, the income of the community also increases. And hence, additional taxation may not affect consumption.
If the loans are utilized for productive purposes directly, they increase the income of the community. Hence, consumption is not affected, but it increases. Moreover, the interest along with the principal can be paid out of increased income.

Effects on Distribution:

The purchaser of government securities are mostly the rich people of the community, But the burden of taxes, imposed for finding money for interest payments fall on the poorer classes also. Therefore the tendency of public debt would be to increase the inequalities of incomes. Hence the public debt may not have the desirable effects upon distribution. However, if bondholders and taxpayers are the same, then there will be no distribution of income. Therefore, the inequalities of income will not increase, but it is generally not true. Hence, some redistribution of income will take place as long as the taxpayers and the bondholders belong to different groups, and as explained above, the inequalities of income may increase.

If public debt is utilized to provide more economic welfare to the lower income groups then the inequalities of income will decrease and a more equal distribution of income between different sections of the community would take place, However, if the loan finance created inflation, some of the good effects upon the distribution of income may be neutralized because of rise in prices. Thus, if the loan proceeds are spent on welfare schemes, the effects on distribution are whole-some.

Effects on the Private Sector:

All public expenditure increases the demand for goods because it increases the purchasing power of the people and puts more money into circulation. When this expenditure is financed through taxation, current consumption is not reduced, but when it is financed through borrowing, idle savings are generally utilized and current consumption is not reduced. If the government utilizes the borrowed money in purchasing goods and materials produced in the private sector, the demand for goods in the private sector may increase to the extent that the government spends borrowed funds for this purpose. Again, a portion of the borrowed funds may be utilized on salaries and wages of government officials, who may purchase the goods produced in the private sector. 

Hence the effect of the expenditure of borrowed funds is that the demand for the products of industries in the private sector increases, without adversely affecting the supply. Hence, the effects of public debt are said to be favorable. 

Effects on the Cost of Production:

The cost of production depends upon the prices of raw materials and other factors used in production. The state utilizes the borrowed funds to supply raw materials to the producers at reasonable rates and to provide transport and training facilities. The State may also utilize these funds in promoting industrial research or in giving subsidies to private enterprises. In all those cases, the expenditure of borrowed funds reduces the cost of production. Hence the effects of borrowed funds are said to the favorable.

When borrowed funds are used, the demand for labor and capital is generated. If labor is scarce, wages may rise, the cost of production may increase, and the private industry may have adverse effects. But, if the demand for the product is not adversely affected even with the rise in prices, the private industry may not be adversely affected. In other words, if the proportionate rise in demand due to the expenditure of borrowed funds is higher than the proportionate increase in cost due to scarcity of labor, the industry may not be adversely affected. Moreover, labor is not always scarce. There may be unemployed labor and if the government utilizes this unemployed labor, private industry is not adversely affected in respect of cost of production.

Effects of Public Debt on Investment:

It is generally believed that public borrowing has adverse effects on investment. However, if the government borrows from Commercial Banks or the Central Bank of the country, it will provide extra purchasing power to the community, and therefore, it will not press for any curtailment of funds for investment. But when purchases of securities by banks without an excess of reserves or from individuals are made out of funds meant for business expansion, it results in a decline in investment. It is, however, to be noted that as long as the interest rate is static and government bonds offer special privileges to bondholders over those envisaged in existing securities, the possibility of production in private investment is very slight.

There will be no contractionary effect at all, if the bonds are sold to the Central Banking System, or the Commercial Banks if they have excesses reserves, or to lenders who purchase them out of funds which would otherwise lie idle.

Effect of Public Debt on Resource Allocation and National Income:

Unlike tax finance, there is little effect of public borrowing on resource allocation or the composition of national production. But, when the investment level is reduced, it causes a decrease in the relative output of capital goods as against the total output in periods of full employment. On the contrary, the capital goods on which the government expenditure is incurred find greater incentives for their accelerated production and, thus, there is also a rise in national income. The consequent increase in national income will not only be of high level in proportion to the enlarged investment but will be a multiple of the increment of the investment due to the multiplier effect, thereby creating larger employment prospects.

Effects of Public Debt on Liquidity:

People who buy government securities possess a highly negotiable and highly liquid form of assets that can be converted for any purpose- transactions, precautionary or speculative motive- at any time, and, thus, public debt creates highly liquidated assets.

Besides, in times of inflation, the Central Bank of the country adopts bank rate, open market operations, and other devices which restrict the commercial bank’s “credit creation capacity”. However, this effect is generally nullified because commercial banks can increase the reserves at any time by way of the disposal of bonds.

Further, the existence of large amounts of public debts accounts for an increase in interest obligations of the Government. However, an increase in interest rates has a net expansionary or contractionary effect on the economy which depends on the relative propensity to consume of the taxpayers and bondholders and the effect of the tax upon investment.

Effects of Public Debt on the Working of the Money Market:

The existence of public debt affects the money market in the following manner. If demand for funds from the private sector is on a higher level. The government will have to fix higher interest rates to attract the purchase of its securities, and vice versa. So, when Government borrows from the public, it competes with private investors. Thus. it has to confirm the general pattern of demand, supply, and prices as any other borrower in the market, ultimately, both Government and the private sectors in order to acquire funds in the market, have to draw on the total available supply of investment funds in the market. If the State tries to borrow (especially from Commercial Banks and Central Banks) more than the available supply at the current rate of interest, this may lead to currency expansion.

Effects of Foreign Loans on the Economy:

External borrowing in the economic development of developing countries has made possible the import of high-priority goods (or capital goods) or goods to be used to create and build capacity for accelerating the rate of growth of the economy. It affects both consumption and investment favorably. Again, imports of foreign goods raise the total available supply of commodities, so also the national income, and ultimately help in the betterment of people’s standard of living. Further, these imports, on the one hand, reduce the demand for similar indigenous goods in the present, and on the other, their investment would increase output in the future. Thus, these imports are anti-inflationary, though, this effect may be felt more in the future. Again if the goods and services are imported by the Government and sold to the public, then it reduces currency circulation in the economy. Hence, it enables the state to increase the extent of deficit financing, which can further be used for accelerating the growth and development of the economy.

Foreign capital supplements, the national resources, and makes possible a higher rate of investment than otherwise would be possible. If this higher investment raises the rate of growth of the economy, the increasing external liabilities need not cause any concern. An increase of external indebtedness and debt servicing liabilities, even when large, do not necessarily create difficulties for borrowers. The increase of debt servicing payments has to be measured against the development, which has occurred in the borrower’s economy. The capacity to service the debate is essentially linked to the performance of the economy. The basic condition of debt servicing capacity is the continuing increase in per capita production. It means the capacity to pay debt servicing charges depends upon the continuing increase in per capita production.