Week 19 - Public Debt

Question 1

How do demographics cause problems for government debt?

Answer 1

Currently:
- Birth rates are falling, whilst life expectancy is increasing.
- Baby boomers will soon retire.
This could cause a serious problem for government, as revenues are likely to fall significantly.

Question 2

Why is inflation a problem when measuring public debt?

Answer 2

• If we don’t account for inflation, then the nominal deficit will be higher than the real deficit.
• Thus, when inflation is high countries could have a high nominal deficit, but a real surplus.

Question 3

Why do capital assets pose a problem when measuring public debt?

Answer 3

• Deficit = change in govt. debt.
• A better measure would be to use capital budgeting, where deficit = (change in debt) - (change in assets)
  Problem with cap budgeting? Determining which expenditures are capital expenditures.

Question 4

How do contingent liabilities cause problems when measuring public debt?

Answer 4

Current measure of deficit doesn’t include important (and potentially sizeable) liabilities, such as:

• Future pension payments.
• Contingent liabilities (although how would we quantify these).

Question 5

How does the business cycle cause problems when trying to measure public debt?

Answer 5

• There are some automatic stabilisers (unemployment insurance, income tax system) that cause variations in the debt level.
• This makes it harder to judge fiscal policy stance
• Potential solution: cyclically adjusted budget deficit, that considers would govt revenues and spending would be at the natural rate of unemployment and output.

Question 6

What is Ricardian equivalence?

Answer 6

A view that, even in the short run, a debt-financed tax cut will have no effect on consumption, saving, investment, net exports or real GDP.

Question 7

What is the logic behind Ricardian equivalence?

Answer 7

Consumers are forward-looking and know that a tax cut today will have to be financed by a tax rise in the future. Hence they will save the entire tax break, because they know it will have to be repaid at a later date. Increase in private saving is entirely matched by a fall in public saving.

Question 8

What are the key problems with Ricardian equivalence?

Answer 8

• Myopia: Tax cut simply seen as a windfall, so consumption will increase.
• Borrowing constraints: Tax cut may be a way of consumers consuming more if constraints exist - effectively the government is borrowing for the consumer.
• Future generations: If it is assumed that the debt will be repaid in the distant future, the consumer may not care about repayment - he may be dead by then!

Question 9

What are some other perspectives on government debt?

Answer 9

• Should we limit budget deficits? Eurozone countries’ deficits must be less than 3%. Counter-argument: deficits can be used to stabilise output/employment; smooth taxes; redistribute income.
• Relationship with monetary policy: Huge debts can be financed by printing money (which creates inflation and devalues the repayments). However, this rarely happens, as high inflation has a number of side effects.
• Politics: Current governments may not care about running large deficits, as the burden falls on future generations/governments. Future generations have no say in policy making
• International dimensions: Large debts could result in capital flight. Could also lead to large trade deficits which must be financed.