How does public debt make our money worth less?

PUBLIC debt is defined as how much a country owes to lenders.

It can be categorised as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Another common division of government debt is by duration until repayment is due. Short-term debt is generally considered to be for one year or less, long-term is for more than 10 years. Medium-term debt falls in between these two boundaries.

A broader definition of public debt may consider all government liabilities, including future pension payments and payments for goods and services which the government has contracted but not yet paid. Regardless of how the public debt is defined, it is simply the accumulation of annual budget deficits. It is the result of years of government leaders spending more than they take in via tax revenues.

By contrast, the annual “government deficit” refers to the difference between government revenue and expenditure in a single year. And there is a difference between public and external debt. Let us not get confused. In the case of external debt, it is the amount owed to foreign investors by both the government and the private sector.

Public debt affects external debt. When interest rates go up on the public debt, they will also rise for all private debts. That is one reason businesses pressure their governments to keep public debt within a reasonable range.

When is public debt good?

Public debt is a good way for countries to get the extra funds needed to invest in their economic growth. It is expected to yield positive returns to the economy when used correctly. It will help improve the standard of living in a country.

That is because it allows the government to build new roads and bridges, improve education and job training, and provide pensions. This will spur the peoples’ confidence and raise current spending more instead of saving for retirement. This spending by the people of the country will further boost economic growth though greater business activities, capital expansion and job creation.

Bad side of public debt

Governments tend to take on too much debt because the benefits make them popular with voters. Therefore, investors usually measure the level of risk by comparing debt to a country’s total economic output, known as gross domestic product. The debt-to-GDP ratio gives an indication of how likely the country can pay off its debt.

Investors usually are less concerned until the debt-to-GDP ratio reaches a critical level. When it appears the debt is approaching a critical level, investors will start demanding for a higher interest rate. They want more return for the higher risk.

This is because, if the country keeps spending, the risk of being downgraded by the international rating agencies becomes stronger in view of the growing risk of the country likely to default on its debt.

When interest rates rise, it will become more expensive for a country to refinance its existing debt. In time, more income has to go towards debt repayment. It will strain the money the government has and will add pressure on government expenses. This is when the government will start juggling between development and operating expenditure.

Should the public debt continue to increase with more emphasis on operating expenditure than to the development expenditure, it will be like driving with the emergency brakes on.

When this happens, investors will drive up interest rates in return for a greater risk of default. That will make the components of economic expansion such as housing, business growth, and auto loans more expensive.

To avoid this burden, the government will have to be careful to find that sweet spot of public debt. It must be large enough to drive economic growth and yet small enough to keep interest rates low.

Probably this is what the Malaysian government is trying to do with the RM1 trillion public debt.

Should the people be concerned as to how much the national debt is?

A government is able to add the national debt in various ways such as deficit spending, quantitative easing and stimulus measures. Each time the government does that, it has to create money or credit. It will add pressure on inflation. Rising prices is what many believe is the definition of inflation. Possibilities for those rising prices can be hidden or postponed or made to look disassociated.

Also, the public debt is like a tax on us all because it makes everything more expensive so that the government can spend money it does not have. Furthermore, it can be viewed as a regressive tax in the sense that it impacts the poor more than the rich.

Aside from the ups and downs of the economy, it makes energy, groceries and housing more expensive because it makes our money worth less.

How does it make our money worth less?

Let us use a simple example. Assume there is a boat, and it is wrecked in the middle of the ocean on an uncharted island. A chest that contains gold coins was salvaged from the sunken boat. In the initial period, those who salvaged the chest of gold coins could enjoy it. However, the gold coins were worthless to these people as they could not buy anything on this uncharted island.

As time went by, this island started creating economic activities and needed a medium of exchange. So these people used the gold coins. The goods and services were measured based on the number of gold coins, now that the gold coins have found its way into the economic activities.

Assume that one of the individuals on this island found another chest of gold coins from the capsized boat. The additional gold coins increased the supply of gold coins. Now, the individual becomes richer and is able to buy more things without really working anymore. Eventually, all the additional gold coins that the individual has, found its way into the island’s economy and is equal to the total value of all goods and services.

But now the prices of goods and services in the island has increased by say 50%. That is what happens when the government issues extra money and credit.

How much is too much?

Based on a basic framework, if a government could choose either having high or low debt today, with all else being equal, the country should select the latter. After all, when debt is high, the government will impose unpleasant taxes to fund spending on debt-interest payments such as goods and services tax (GST) or other taxes. These taxes can act as a drag on the economy.

What happens if the government is faced with a high debt? Is it better to practise austerity and pay it down, or take advantage of low interest rates to invest? Much will depend on the amount of “fiscal space” the government has. It is actually the gap between a country’s debt-to-GDP ratio and its “upper limit”.

If it surpasses the upper limit, the country will have to adopt austerity measures or prudent measures to avoid a default.

This could be what the Malaysian government has embarked on – prudent measures since the public debt-to-GDP is at 80.3%. In order to reduce the debt, the authorities have cancelled some of the mega projects under the government guarantee, and at the same time reduce the operating expenditure while providing incentives to boost household spending.

By instituting prudent spending and letting the economic growth take its course of action, in the long run, it should improve the public debt-to-GDP ratio, provided the economic growth outpaces the public debt growth.

But my analysis is a simplified one. Under normal circumstances, there are more concerns on the growth dynamics in the long run compared to the effects of borrowing on growth in the short run which may often be more relevant to the question of the time electoral mandates have on the government.

So a government, in planning to fix the public debt issue, will need to take a more reasoned look, rather than rushing to fix it, and that is what our government is doing.

Anthony Dass is AmBank Group chief economist.

Source :-MSN

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