Transcript Lecture 1.Principles of Public Debt

Lecture outline
 Golden rule of public finance
 Case of the Great Britain
 Single budgeting vs. double budgeting
 Seignorage
 Refinancing
Golden rule of public finance
 There are two main classical argument in favor of debt:
 Debt burden is transferred to future generations
 Taxes are paid by those who benefit from
 These two points suggest that future generations finance
current budget expenditures to the extent that these
expenditures are useful for them.
 Out of budget expenditures only capital expenditures
provide benefit for the future generations
Golden rule of public finance
 There are two main classical argument in favor of debt:
 Debt burden is transferred to future generations
 Taxes are paid by those who benefit from
 These two points suggest that future generations finance current
budget expenditures to the extent that these expenditures are
useful for them.
 Out of budget expenditures only capital expenditures provide
benefit for the future generations. Therefore, according to
Musgrave capital expenditures should be financed through
public debt(Musgrave, Richard. The Theory of Public Finance. A
Study in Public Economy, McGrow Hill Book Company, 1959)
Golden rule of public finance
 According to Musgrave:
 It is unfair that the current generation finances the
construction of railway which will by exploited by the
future generation
 Although future generation cannot pay now, it is
possible to borrow from them. Debt can be used to
allocate burden of capital investments across
generations. Current loans mean future taxes and
therefore involve future generation into financing of
current investments.
 Net value of the government does not change.
Golden rule of public finance
 Golden rule of the government finances – to borrow in
order to invest
 Its central message is to finance current expenditures
by taxes and capital expenditures by debt
 However, for the Golden rule to work the government
should have its budget with a little surplus. In this case
debt will go to finance investments and budget deficit
does not exist.
The case of the Great Britain
 Great Britain practices double budgeting – current and
capital expenditures
 In the late 90s the government of the Great Britain
admitted that it could not follow the Golden Rule of public
finance. In particular, the current expenditures exceeded
current revenues by 1 percent of GDP, which meant unfair
burden transferred to future generations
 This was also true from the point of investments which
were below international level even after privatization
process.
The case of the Great Britain
 Since 1997 the government follows these guidelines in
its capital expenditures:
 Golden rule is followed in context of business cycle. For
example, if at the certain phase of business cycle there is
need to cut expenditures, they will be cut from current
expenditures
 Creation of Fund of Britain helps to double the share of
government investments in GDP from 0.5% to 1%. It
also helps at time of recession
 Budgeting and accounting maintain the golden rule of
public finance. This creates the incentives for using the
assets effectively
Double budget of the Great Britain in 2006-2007
(bln. pounds)
Current budget
Current revenues
520
Current expenditures
502
Amortization
17
Net
1
Capital budget
Investments
50
Minus revenue from selling actives
-4
Minus amortization
-17
Equals: net investment
29
Net borrowing
29
Net public debt at the end of the year
489
The case of the Great Britain
 In the medium term the government aims at maintaining
healthy public finance and fair distribution of tax burden
over generations
 In the short run, the government will focus on the
monetary policy and let automatic stabilizers to smooth
business cycle fluctuations
 To achieve this, the government should follow Golden rule
of public finance-to borrow in order to invest, not to cover
current expenditures and rule of sustainable investmentsratio of net debt to GDP does not exceed 40% over one
business cycle
Single budgeting vs. double budgeting
 Single budgeting is a simple method of controlling
operations of the government bodies
 However, the focus on current financial flows may lead
to reduced real price of government expenditures. The
pay offs of investment projects are underestimated. It
allows frauds in fiscal management.
 It seems that double budgeting helps to avoid all these
issues, but the governments do not hurry to adopt it.
Single budgeting vs. double budgeting
 Problems of implementing double budgeting:
 It is difficult to separate current expenditures from
capital expenditures
 Net wealth of the government (actives minus passives)
cannot serve as a measure of society’s efficiency
 Double budgeting does not allow to implement
performance based budgeting
 Budget process becomes complicated
Debt vs. printing money
 Printing money is done by the Central Bank. It issues money to
finance the government budget deficit-this is called “seignorage”
 However, to limit irresponsible seignorage practices, normally
central bank is not allowed to finance deficit directly or even
through buying bonds from the government. Instead it buys
government bonds from commercial banks, which buys them
from primary market. As a result, money supply increases and
puts pressure on the inflation rate.
 Seignorage allows the government to cover deficit without
redistributing money from private sector to the government
sector.
Seignorage in Canada
 On the balance sheet account of the Bank of Canada, the issued
banknotes are shown as liability and they are balanced by
government bonds on the assets side.
 Seignorage is difference between interest payment on bonds and
cost of issuing banknotes.
 For example, what is seignorage from issuing 20 dollar
banknote? If corresponding bond pays 5 percent per annum and
costs of issuing 20 dollar banknote is 4 cents, then seignorage=
20*0.05-0.04= 0.96 per 20 dollar banknote.
 In recent years Bank of Canada issued 35 billion dollars and
purchased government bonds. These bonds paid 2,2 billion
dollars per annum. Bank spent 130 million to issue banknotes
and other operational expenses.
Side effect of seignorage
 If the government used seignorage to finance its budget
deficit, then the tax burden and debt related issues will not
exist. Indeed, printing money at low cost and selling them
to commercial banks at face value would be easier and
faster than collecting taxes and attracting debt.
 However, according to quantity theory of money, in the
long run, increasing money supply by 1 percent causes
inflation rate to increase by 1 percentage points.
MV  PY
where, M-money supply, V- velocity of circulation, P- price
level, Y-income
Side effect of seignorage
 If printing money causes inflation, then it can considered as
indirect tax on money holders. This is cheaper than taxing
economy directly.
 Inflation decreases wealth of money holders. It also decreases
wealth of bond holders. Therefore, inflation decreases nominal
debt of the government by cutting purchasing power of
borrowed funds.
 For example, assume that the investor buys 3 year bond of the
government bond in 1977. The bond pays 7 percent annually and
real interest rate equals 3 percent. Therefore, the investor’s
expectation of the rate of inflation is 4 percent. Otherwise, he
would not buy the bond. But in 1977-1980 inflation rate was 8
percent. As a result, the investor lost 8-7 =1 percent. So, this is
gain for taxpayers and the government.
Complete financial market
 Complete financial market- the market which provides risk-free
assets (e.g. government bonds) If the market is incomplete, then
the government depends on only central bank credits or
international debt.
 Complete financial market allows to place government bonds
easily and with less costs.
 Central Bank also needs complete financial market. Using
government bonds CB controls reserves of banking system and
changes money supply.
 Government bonds are risk free assets and are used in REPO
operations of commercial banks.
Refinancing
 Difference between private and public debt is that individuals try
to return the debt in their lifetime. However, in the case of the
government, lifetime is not limited. This allows the government
to attract new debt to cover the old one. This is called
refinancing.
 Refinancing was favorite tool of policymakers since 1930s.
However, by 1980s things turned to be worse than seemed. The
growth of debt exceeded GDP growth.
 Nowadays in many countries it is impossible to achieve balanced
budget. Consequently, the modern view on debt is not to balance
the government budget, but to keep deficit and debt within the
limits defined by the tax potential of the government.
Refinancing
 Primary deficit- excess of non-interest expenditures over
non-interest revenues.
 Total deficit- excess of all expenditures over all revenues
 The main debt does not include interest payments, but the
total debt does:
Main debt= ∑Primary deficit + initial main debt
Total debt= ∑ Total deficit+ initial total debt
Refinancing
 Borrowed or attracted funds are spent to pay for three
types of expenditures: to pay debt due, to pay interest
and to cover budget deficit.
 Paying debt due is refinancing main debt.
 Paying debt due and interest is refinancing total debt
 Refinancing main debt does not depend on budget
outcome and does not count towards nominal debt
that will be accumulated by the start of the next year.
Refinancing
 Does it means that refinancing can delay the payment
of debt forever? No. Eventually the government will
have to increase taxes.
 One instance when the government has to increase
taxes is when GDP growth rate is less that interest rate
on debt already attracted. For example, assume that
GDP growth is 2 percent and consequently savings
increase up to 2 percent. Interest on bond is 5 percent,
which means at debt to GDP ratio close to one, further
refinancing will be impossible.
Thank you for your attention!