Andrey Zahariev DEBT MANAGEMENT

Andrey Zahariev

DEBT MANAGEMENT a distance learning academic course book

© Andrey Zahariev, author, 2003, 2012 © Iglika Angelova, cover design, 2012 © ABAGAR Publishing House, 2012 ISBN 978-954-427-981-3

Andrey Zahariev

DEBT MANAGEMENT

ABAGAR Publishing House Veliko Tarnovo, 2012

Debt Management Second revised and extended edition Assoc. Prof. Andrey Zahariev, PhD – author Prof. Radko Radkov, DSc (Econ.) – reviewer Assoc. Prof. Stoyan Prodanov, PhD – reviewer Vencislav Dikov – translation Rosemary Papworth – proofreading Iglika Angelova – cover design Format: 70/100/16 Quires: 20 This edition is co-financed by the National Scientific Research Fund at the Ministry of Education, Youth and Science of the Republic of Bulgaria within the implementtation of Project INZ01/0116 and managed by Project Manager, Assoc. Prof. Andrey Zahariev, entitled: "Complex Support for Scientific Research and the Transfer of Knowledge in the Fields of Economics, Administration and Management within the Educational and Qualification Programmes of Masters degree and the Educational and Scientific Programmes of Doctor of Philosophy through the Integrated Scientific Centre: Distance Learning and Research Centre" within the "INTEGRATED SCIENTIFIC UNIVERSITY CENTRES” Programme of 2008.

INTRODUCTION

At the beginning of August 2011 the global financial system was shaken to its foundations. The leading rating agency Standard & Poor's cut the credit rating of the United States. Such an act associated with the United States has no precedent in global economic history. This decision not only demonstrated that the leading world power had certain problems, but also that the fundamental concept of the riskless financial asset is obsolete. This decision was apparently reached after sufficient evidence had been sought and found in a single aspect - the U.S. government’s indebtedness. This decision was followed by a series of reductions in the ratings of several European Union member states - especially Greece – which now leads to the conclusion that the global economy faces a systemic problem related to public debt. From a theoretical point of view, the review of the development of financial systems allows us to identify two principal sources of state revenues: taxes and loans.1 Theoretically, the use of loans is expressed as a specific movement of money among the state, companies, banks, financial institutions and households - a movement that is associated with the activities of governments as borrowers of monetary capitals.2 It could be argued that the borrowing of money by governments is an activity which affects all economic agents. This activity has resulted in a new concept of balancing public accounts - the concept of deficit financing. Deficit financing of the state budget is directly related to the genesis of the financial and economic systems. From a theoretical point of view, deficit financing has been studied by the representatives of numerous schools. The extreme viewpoints of deficit financing recommend either its complete avoidance (the Classical School) or its wide-scale utilization (the Keynesian school.) As in many controversial areas of economic knowledge, the various scientific schools defend their positions. As a result, in some countries the political class has embraced the ideas of deficit financing for the state budget, while in other countries it has supported the idea of balanced public accounts.

1

Of course, here we may include the issue of money as a third method. Nowadays, however, its scope may be considered rather limited. 2 ADAMOV, V. Teoriya na finansite (Darzhavni finansi). V. Tarnovo, ABAGAR, 1998, p. 572.

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Debt management

The application of deficit financing of government budgets leads to the accumulation of deficits. Government debt emerges. Government debt (external and/or internal) requires the adoption of new types of solutions related to debt management. The government itself develops as a strategic process of vital importance to governments and economic development.3 This is why we may claim that the precise knowledge of the theoretical foundations, the macroeconomic consequences and the practical examples of the application of deficit financing is the basis for the development of debt management techniques. Analysis of the specific situation regarding the public sector in our country emphasises the topicality of research in the field of deficit financing and debt management. Of course, we have to take into account what has already been done by certain researchers from leading research centres and representatives of specialized debt management institutions – the Ministry of Finance and the Central Bank. Taking the risk of challenging some of the main theoretical arguments "for" and "against" debt financing of budget deficits, this academic course defends the concept of the strategic role of government debt. This role is justified not simply from a purely macroeconomic point of view, but from the perspective of companies and their financial managers. It could be argued that government securities, as a form of securitized debt, are the starting point for the development of various theories and models within the scope of corporate finance management. In fact, the management of the treasury and the management of shareholders’ wealth are directly related. This relationship allows us to complement the research in the public sector and corporate finance, and to develop it further. Considering the above, the object of this academic course is the public sector, and the subjects of this course are the reasons, arguments and consequences of applying the policy of deficit financing for state and local budgets, and related decisions regarding passive and active debt management. Through this academic course the author aims to justify a conceptual framework for the development of government debt management tools through a consistent review of the theoretical foundations, 3

A Direct result of that aspect is the development and adoption of three-year strategies for government debt management, which in Bulgaria covered the periods 20062008, 2009-2011, 2012-2014, etc. These strategic documents include three main sections: first - analysis of the debt, its key indicators and regulative environment; second - defining the risks associated with the size and structure of the debt; and third - the policy objectives and tools for debt management. (For more details see: Government Debt Management Strategy for the period 2006-2008 of the Ministry of Finance of the Republic of Bulgaria, www.minfin.bg/document/961:1 )

Introduction

7

macroeconomic effects, relationship with the shadow economy and empirical evidence for debt financing of budget deficits. The underlying research for this course was carried out in accordance with the following main hypotheses that we intend to validate and verify: Hypothesis One. Deficit financing is a tool for strategically influencing public choice and the political cycle. Hypothesis Two. Budget balancing has a direct impact on the amount of inter-generational redistribution. Hypothesis Three. The determination of the state in the external sector is a function of the cumulative expression of the deficits/surpluses of the individual analytical currency balances. Hypothesis Four. The dynamics within the volume of external deficit financing is a cyclical phenomenon. Hypothesis Five. There is a proportional relationship between the size of the shadow economy and the volume of deficit financing. Hypothesis Six. The accession of Bulgaria to the European Union resulted in the adoption of management techniques and macroeconomic constraints which ensured the maintenance of the deficit and debt within the limits provided for by the Maastricht criteria for EU membership. In order to prove these basic assumptions, we have to widen the scope of the study to include a wide range of theoretical models and empirical evidence for deficits and debt. This certainly supports the efforts of the research centre we represent in order to aid the processes of Bulgarian social, cultural, economic and educational integration into European structures. This current academic course regarding the issues of debt management is a natural extension of the 2003 edition. The course is intended for students undertaking the Master's Degree programme in "Finance". The structure of the course meets the requirements for a distance learning academic textbook, but may also be used by full-time students. Students utilising distance learning to study the Masters Degree programme use web-based technology based at the Distance Learning Centre at the D. A. Tsenov Academy of Economics, and have access to an online module which contains interactive materials, presentations and selfassessment tests consistent with the content of the textbook, and which can be found at http://wdo.uni-svishtov.bg4. In line with the above statements, the main objective of the course is to provide students with knowledge and skills in the field of deficit 4

Note that guest access to the module is restricted.

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Debt management

financing and debt management. The role of the course within the Masters Degree programmes is to develop the competencies of modern financiers, bankers and government administrators in the field of financial analysis and debt management, the assessment of deficit financing and its impact on businesses and other taxpayers, and also to enable them to provide substantiated forecasts about the future state of the economy and its external sector. The course is structured as separate topics which include study questions. It concludes with an end-of-semester case-study examination in "Debt Management" with multivariate input data. Students are provided with several examples of investment analysis of debt instruments in MS Excel format. This approach fully meets the practice established in 2002 by the Department of "Finance and Credit" to provide educational courses in accordance with the current environment of highly developed information and econometric technologies and products.5 For questions and comments related to the curriculum content, hypotheses or opinions expressed in the course, as well as any suggestions for improvement, please contact the author using the following e-mail address: [email protected] COURSE STRUCTURE Chapter І. Introduction to the deficit financing theory 1. The general characteristics of deficit financing 2. Classical concepts of deficit financing Chapter ІІ. The Keynesian theory of deficit financing 1. J. M. Keynes’ research 2. A. Hansen’s contribution 3. A. Lerner’s approach Chapter ІІІ. Modern theories regarding the budget deficit 1. The theories of Tobin and Buchanan 2. The model of burden distribution between overlapping generations 3. The neo-classical concept 4. The Ricardo-Barro theorem

5

For more details see: ADAMOV, V., Holst, J., Zahariev., A. Finansov analiz. V. Tarnovo. ABAGAR, 2002 and 2006.

Introduction

Chapter ІV. Theories regarding the strategic role of government debt 1. The theory of governmental policy in circumstances of time-inconsistent preferences 2. The positive theory of fiscal deficit and government debt 3. The political-economic model of the strategic role of debt Chapter V. The role of the state in the economy 1. Public goods 2. Club goods Chapter VI. Anatomy of the state redistribution function 1. The methodology of state redistribution impact 2. Budget balance and intergenerational redistributions Chapter VII. Instruments for defining the status of the external sector 1. Indices for defining the status of the external sector of the economy 2. International currency balances of payments – a tool for the analysis of deficit and debt 3. Analytical currency balances in terms of product 4. Analytical currency balances in terms of factor 5. Consequences of deficits in analytical currency balances Chapter VIII. Macroeconomic analysis of external deficit financing 1. Reasons for deficit financing through external loans 2. Dimensions of debt dynamics and cycles Chapter IX. The shadow economy and tax evasion 1. The shadow economy and tax evasion – definitions and forms of manifestation 2. Aspects of taxation effects on the shadow economy Chapter Х. Concepts of tax evasion and tax fraud 1. Tax evasion as a criminal activity 2. Models of optimal tax “evasion” 3. Concepts of alternative tax “evasion” and tax fraud Chapter ХІ. Measuring the shadow economy and tools for its counteraction 1. Tools to counteract the shadow economy 2. Methods of measuring the shadow economy Chapter ХІІ. Deficit financing in Bulgaria

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1. The origin and development of the debt crisis in Bulgaria 2. Measuring and evaluating deficits and indebtedness 3. Solutions to the deficit and debt problem Chapter ХІІІ. The contemporary paradigm of debt management 1. General characteristics of debt management 2. Contemporary solutions to the global debt crisis 3. Debt management aims and policies Chapter ХІV. Investment analysis of debt instruments 1. Fundamental investment indicators 2. Specialised indicators for investment analysis of debt instruments

CHAPTER I INTRODUCTION TO DEFICIT FINANCING THEORY

Introduction to the chapter This chapter describes the nature and specific features of deficit financing. By the end of the chapter you will be able to:  use basic terminology;  identify the types of budget deficit;  identify debt financing instruments;  identify governmental debt factors. The chapter includes two subtopics: 1. The general characteristics of deficit financing; 2. Classical concepts of deficit financing.

1. The general characteristics of deficit financing In order to define issues associated with deficit financing we must first consider the issues related to:  governmental debt;  the budget deficit;  debt structure;  the budgeting process;  budget discipline;  the effects of deficit financing. The issues associated with debt financing are among the main discussion points in the organizational process of every budget, and therefore one of the central issues in the field of finance. In its broad sense, the term “deficit” can be defined as an excess of budget expenditures compared with the incomes for a specified period. Its application in both specialized financial theory and practice requires the meaning to be defined with regards to the following three main areas:

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  

budget deficit structure; planned and actual deficit; deficit scope.

The structure of the budget deficit is classified by four levels of consequent inclusion of the main debt-related expenditures, and includes the following basic categories:1 A. Budget imbalance – the mismatch between revenues and expenditures within the budget period. It is the basis for the determination of the budgetary situation having particular importance. Often, its value is positive, i.e. there is a budget surplus, while a deficit is reported after considering the subsequent elements. Examples abound in our budgetary law, which is indicative of the structure of debt accumulated in previous periods. B. Internal budget deficit – calculated by reducing the budget by the amounts due in order to service the internal debt throughout the period (budget year). C. Current budget deficit – calculated by increasing the amount of the internal budget deficit by the expenditures for servicing the external debt over the period. D. Total budget deficit - calculated by increasing the amount of the current budget deficit with all outstanding payments from previous periods.2 Another point of view to consider is when the budget deficit is related to the processes of its adoption and implementation. In this context, the deficit forecasted, planned and approved via State Budget Law is defined as planned deficit. However, the practical implementation of a budget using planned deficit is often particularly difficult because the actual deficit is, more often than not, different from the planned one. The actual result at the end of the budget period is the actual budget deficit. The latter can be larger or smaller, or (for we should not ignore this theoretical

1

The Annual budgetary procedures and the introduction of budget classifications used by the EU lead to some changes in basic terminology. For comparability between the basic research, we use the budget categories introduced and applied by national statistics and the Ministry of Finance, after the reforms in 1989. 2 For more detailed information see: ADAMOV V., Lilova, R., Zahariev, V. Byudzhet i byudzhetna politika. V. Tarnovo, ABAGAR, 1997; SIMEONOV, S., Zaharieva., G.Defitsitno finansirane na byudzheta v: BROWN, C. & Jackson., P. Public Sector Economics (Bulg. transl. ed.). Sofia, FSSA, 1998.

Chapter I. Introduction to Deficit Financing Theory 13

possibility, although this is practically very hard to achieve) equal to the planned deficit.3 It should be borne in mind that governments do not include all activities in the official budget, which is often based on current regulations, such as the redistribution of income and expenses related to social activities that are generally off-budget. However, the official distinction and correct measurement of a government's obligation requires the reporting of all revenues and expenses. According to the U.S. financial practice, the deficit structure is represented through the differentiation of the elements by considering first the amount of the on-budget deficit (which represents only the activities included in the budget), and then the off-budget deficit (which represents only the off-budget activities). The sum of these two elements gives us the aggregate (net) deficit.4 In order to provide more accurate definitions of deficit and debt, we should also consider the following facts:  At a certain point, debt is the sum of the deficits from previous years, reduced by the amount of settled debt;  Debt is the aggregate amount of the excess of expenses over the revenues from previous periods;  Debt is the value of a dynamic variable at a specific moment, while the deficit covers a defined budget period;  Debt resulting from credit transactions has certain obligations for the issuer, expressed mostly in the payment of remuneration in terms of interest and/or discounts on the face value of the debt security. Despite the popular belief that debt is a governmental "problem", we should point out that not only the central government, but also local governments take out loans.5 This generally leads to an overall increase in indebtedness. Of course, the real inflationary effects of the actual reduction of the debt burden to creditors cannot be ignored, and there are certain sufficiently reliable tools for their alleviation. A popular method is debt indexation, without which, lending to the government would be unthinkable during periods of high and varying inflation levels. We should also point out 3

LILOVA, R., Politicheski i ikonomicheski ramki na byudzheta. Svishtov 1992. According to preliminary data from the Ministry of Finance, the budget in 2011 is an exception to the general rule, as the deficit is less than 0.4% of GDP compared to the planned amount. 4 ROSEN, H. Public Finance. New York, 3 ed. 1993. 5 As a result of the process of fiscal decentralization, and with technical assistance from USAID, Bulgaria has adopted and enforced the specialized Municipal Debt Act, promulgated in SG, No. 34 of 19 April 2005.

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that investors tend to shorten the time span and index, even of the most short-term capital market instruments. The basis for debt indexation is of particular importance for the success of a bond issue. Debt management is thus directly related to the actual profitability and burden of the debt respectively, and we must find a reasonable balance between sufficient and essential stimulation of investors on the one hand, and an acceptable burden upon the budget on the other. When we consider public debt, we should take into account both its absolute value and its relation to governmental assets such as administrative buildings, equipment, gold, rights regarding natural resources and other factors. It is believed that the exclusion of tangible assets can be highly misleading when considering debt. In general, the formation of government debt is based on the emergence of budget deficits. Therefore, the size of the budget deficit defines the size and scope of the debt. Debt financing involves the use of various debt instruments. On a global scale, the most common are:6 a) issues of short-, medium- and long-term securities; b) direct loans from Central Banks; c) loans taken through tenders from commercial banks and other banking institutions; d) credit from international financial institutions. The use of any of these instruments is in direct relation to the policy of deficit financing and debt management.

2. Classical concepts of deficit financing Deficit financing is a problem as old as the problems related to the structure and finance of state government. This problem was addressed in Adam Smith’s “The Wealth of Nations”. Smith believes that national debt owes it’s origins to three main factors:7  the willingness of government authorities to spend budgetary funds;  the unpopularity of tax increases as a method for collecting additional state revenue;  the willingness of capitalists to extend loans. 6

SIMEONOV, S., Zaharieva, G. Op. cit., p. 565. FINK, R. and J. High. A Nation in Debt: Economists Debate the Federal Budget Deficit. Maryland. 1997 p. xiv. 7


Smith is explicitly against the use of loans as a method of financing budget deficit. He predicts that, “The progress of the enormous debts which at present oppress, and will in the long-run probably ruin, all the great nations of Europe…” (The Wealth of Nations, p. 753). Based on empirical evidence of deficit financing, he believes that there is a direct relation between the ability of governments to borrow money and their willingness to fight wars. In other words, a budget deficit should be avoided except in situations of war or other extraordinary events. Smith recommends that the main principle of public finance management should be the "prudent owner" principle. The government should be responsible for its financial affairs with the same prudence as the individual regarding their personal financial affairs.8 At a later stage in the development of economics, Karl Marx conjectured that government debt is a derivative of capitalist societies. This derivative is designed to facilitate the exploitation of labour. According to Marx, government loans are an easy and convenient way to raise capital which does not expose the government to the problems and risks that are inevitable if the capital is used for industrial purposes. The use of deficit financing and the formation of government debt leads to four major consequences: first, it creates a class of "lazy annuity holders"; second, it increases the benefits for central bankers in exchange for their agreement to extend loans to the state; third, it stimulates an increase in the tax burden and the collection of taxes for the repayment of government debt; fourth, it motivates industrialists to find new ways of escalating employee exploitation.9 In conclusion, we should point out that the two representatives of the classical school (Smith and Marx) highlight the harmful effects of debt financing – effects which must be limited, and which must not be accepted by governments.

Recommended additional sources: 1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). // Biblioteka „Obrazovanie i nauka”, Svishtov, Tsenov, 2012. 2. LILOVA, R., V. Adamov, Zahariev, V. Byudzhet i byudzhetna politika. V. Tarnovo, ABAGAR, 1997. 3. STIGLITZ, J. Economics of the Public Sector. (Russ. Transl. ed) Moscow, 1997. 4. Municipal Law Act, prom. SG, № 34 of 19 April 2005. 8

SMITH, A. Of Public Debts. in: A Notion in Debt: Economists Debate the Federal Budget Deficit, Maryland, 1987, p. 1. 9 FINK, R., High, J. Op.cit., p. xiv.

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Keywords 1. Budget deficit structure 2. Budget balance 3. Internal budget deficit 4. Current budget deficit 5. Total budget deficit 6. Deficit scope 7. Planned deficit 8. Actual deficit 9. On-budget deficit 10. Off-budget deficit 11. Net (aggregate) deficit 12. Government debt 13. Debt indexing 14. Debt financing

Questions for self-evaluation and discussion 1. Provide the common definition of the term “deficit”. 2. Which are the elements of the budget deficit structure and how are they defined? 3. What is the difference between planned and actual deficit? 4. What is the difference between the terms “debt” and “deficit? 5. What is the U.S. practice in terms of calculating the aggregate deficit? 6. Which debt financing instruments are you familiar with? 7. Which are the main causes for government debt? 8. What arguments did Smith and Marx express, opposing deficit financing?


Chapter summary The issues related to debt financing are among the main discussion points in the organizational process of every budget, and therefore one of the central issues in the field of finance. In its broad sense, the term deficit means an excess of budget expenditures compared to the incomes for a specified period. The successful management of a budget deficit requires knowledge of its structure - the four levels of consequent inclusion of the main debt-related expenditures - and includes the following basic categories: budget balance, internal budget deficit, current budget deficit and total budget deficit. In terms of the processes of the acceptance and implementation of the budget, we can distinguish between planned and actual deficits. The methods used by governments to finance their activities through their official budgets are also important. The U.S government first considers the on-budget deficit (which represents only activities included in the budget), then the off-budget deficit (which represents only off-budget activities) and then defines the amount of the total budget deficit as the sum of these deficits. Various debt financing instruments are used in financial practice: issues of short-, medium- and long-term securities; direct loans from Central Banks; loans taken through tenders from commercial banks and other banking institutions; and credits from international financial institutions. The success of debt management also depends on knowledge of the main factors which influence debt. Smith defined three main factors for growth of government debt. He, himself (and later, other economists as well), was explicitly against loans as a means of financing the budget deficit. Smith recommends that the main principle of public finance management should be the "prudent owner" principle, i.e. that the government should be responsible for its financial affairs using the same prudence as individuals regarding their personal financial affairs. At a later stage, Marx defined government loans as an easy and convenient way of raising capital which does not expose governments to the problems and risks that are inevitable if the capital is used for industrial purposes.

CHAPTER II THE KEYNESIAN THEORY OF DEFICIT FINANCING

Introduction to the chapter This chapter describes the key arguments in favour of deficit financing. By the end of the chapter you will be able to:  discuss Keynes’ key arguments in favour of deficit financing;  discuss the main ideas of Hansen regarding the conditions for the utilization of debt financing;  discuss the burden of debt financing according to Lerner. The chapter covers three topics: 1. The research of J. M. Keynes; 2. The contribution of A. Hansen; 3. The approach of A. Lerner.

1. J. M. Keynes’ research The development of economic thought in the 20th century was greatly influenced by the ideas of J. M. Keynes. These ideas led to the imposition of a policy of active state intervention in the economy. This intervention required the state to utilize various means of financing government spending, which resulted in specific emphasis on deficit financing. Although Keynes himself did not advocate any mandatory recipes for economic development and social welfare, his followers continued the research into state intervention in the economy, and thus established Keynesian theory. This theory refutes the arguments of the classical school to limit the use of deficit financing. Despite the criticism of Keynes’ fundamental ideas in recent decades, it can be argued that

Chapter II. The Keynesian Theory of Deficit Financing 19

Keynesianism still empowers government institutions with beneficial ideas and solutions.1 What Keynes achieved through his research was perhaps the most significant advance in 20th century economic theory. Of course, we should take into account that his "General Theory" emerged in a period where the market was affected by the negative effects of the Great Depression. It is therefore understandable why Keynes set his mind towards harnessing the mechanisms and instruments through which the economy could operate more efficiently. In the "General Theory" he does not provide a direct interpretation of deficit financing problems. At the same time, the analyses regarding the relationship between unemployment and inflation indirectly prove that increased government spending (financed through taxes and/or loans) has a favorable impact on the economy. This increases the volume of capital. The aim is to increase capital, "... until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur, to be harnessed to the service of the community on reasonable terms of reward”.2 According to Keynes, in times of unemployment the task of the government is to borrow money and spend it in the economy. It may be noted that:3 First, the richer the community, the wider the gap is between its actual and its potential production and, therefore, the more obvious and outrageous the defects of the economic system. Second, a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment. Third, a wealthy community will have to discover many ample opportunities for investment, if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. For Keynes, this is why the propensity to consume, the marginal efficiency of capital and interest rate theory are of crucial importance. However, these issues do not remain confined within the limits of national borders. Keynes contended his theory in terms of an open economy where international trade will be "... a willing and unimpeded exchange of goods and services in conditions of mutual advantage". Keynes’ concept found a 1

Or, as M. Mladenov said “… Keynesianism proved to be tough!”. For more details see: Keynes, J. General Theory of Employment, Interest and Money. Sofia, Hr. Botev Publishing House, 1993, p. 447. (in Bulgarian) 2 Keynes, J. Op. cit., p. 435. 3 ibid., p. 43.

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practical application in the late 20th century through the mechanisms of international cooperation between the World Trade Organization and various regional constituencies, including the European Union.

2. A. Hansen’s contribution The studies of A. Hansen are considered one of the most successful attempts to compare the effects of the practical implementation of classical and Keynesian policies in their pure, scientific form. In his research “Fiscal Policy and Business Cycles”4, Hansen departs from the classical school’s principles regarding the use of debt financing of a budget deficit in times of war or natural disasters. Comparing the theoretical concept with the empirical results, Hansen demonstrates that the increased level of lending in times of war stimulates economic growth and the development of credit institutions. For Hansen, unemployment is the equivalent of an emergency and, therefore, the government is justified in using debt as a demand management tool in order to reduce or eliminate unemployment. Specifically, Hansen’s main ideas can be presented in the following way:5 First, the development of credit institutions from the Middle Ages to the present day is the result of increasing social needs. These needs become extreme in times of war. Therefore, the establishment of capital markets and the development of large commercial banks is a method of accumulating the essential capital resources that the government may resort to using in extreme situations. Moreover, the constantly rising standard of living requires the government to spend more money on various infrastructure projects. The scale of these projects often exceeds the capacity of the fiscal system. Therefore, deficit financing is a way to stimulate development and ensure a high standard of living for the whole population. Second, fiscal policy must include the main objective of ensuring full employment for factors of production. Such a policy requires a significant increase in government spending. Some of these expenditures may be financed by increasing progressive taxation rates, others by progressively increasing government debt. The natural limitations of this sort of policy are the instruments used by the Central Bank to control cash flows, by which unutilized funds may be used for the purchase of short-term bonds. The 4

HANSEN, A. Fiscal Policy and Business Cycle N. Y., 1968. The quoted ideas are presented in: HANSEN, A. Fiscal Policy, New and Old; in FINK, R. and J. High. Op. Cit., pp. 52-57. 5


interest accrued on these bonds will be returned to the fund owners as personal income. These, and other ideas of Hansen, resulted in a series of publications launched by other researchers in defense of the policy to stimulate economic development through debt financing of the budget deficit.

3. A. Lerner’s approach A. Lerner (1948) is a prominent proponent of the Keynesian concept of debt. According to him, loans taken by the government should not transfer the debt burden to future generations. To implement the planned expenditure when there is a shortage of funds, the burden must be shouldered by the current generation. Moreover, cuts in consumption must also be present-day. Interest payments are a purely transfer-related problem, i.e. payments are made by some members of society to other members. Lerner’s theory that internal debt is not a burden for future generations dominated economic theory and policy in the 40s and 50s. Subsequent analyses, however, cast doubt on its plausibility. It may be noted that:6 First, Lerner’s thesis that, “…internal debt is a debt we owe to ourselves”, does not answer the question of the specific gravity of its burden to the taxpayer and government creditors. The existence of a large internal debt will inevitably require an increase in the tax burden and therefore will inevitably reduce the level of consumption or taxpayers’ savings. In cases of unexpected inflation, creditors will incur losses because the real value of the repaid loan will be lower than its real value prior to the increase in the level of inflation. As a result, the Pareto optimality (which states that the welfare of some individuals increases at the expense of others) will deteriorate. This is why we should not ignore the assessment of debt burden within one generation. Such an assessment, however, was not taken into account in Lerner’s concept. Second, internal government borrowing, to a certain extent, limits loans extended to the private sector. Thus, it reduces the level of private investment, which leads to loss of benefits for future generations due to lower productivity levels. For Lerner, functional finance is the guiding principle for the implementation of government policy when there is either inflation or 6

SIMEONOV, S., Zaharieva, G. Op. cit., p. 569.

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unemployment, but never for both of them simultaneously. In cases of inflation, the government must raise tax rates and cut spending, while in cases of unemployment, the government should cut taxes and increase spending. In fact, a free-market economy cannot function without having inflation or unemployment. Only the government can balance spending and savings.7 The main notion in Lerner’s concept of functional finance is that the government’s fiscal policy, spending and taxation, the borrowing and repayment of loans, and the issuance of new money and withdrawal of money from circulation must be carried out taking into consideration only their effects on the economy. This approach contradicts the scholasticism, according to which, the government determines its actions in terms of their effect on the economy. On this basis, Lerner formulated two basic rules of functional finance:8  Rule One: total government spending should be maintained at a level that will be sufficient to buy goods produced by all who wish to work, but not enough to increase inflation through a demand level (at current prices) which exceeds the volume of production output;  Rule Two: the government should borrow money only when it is justified that society should have less money and more government bonds due to the effect of debt financing of the budget deficit and vice versa - the government should extend loans (or repay old debts) only if it is justified in increasing the money or reducing the weight of government bonds owned by the public. In response to the arguments against debt financing of budget deficits, Lerner offers four mutually-derivative hypotheses:9  Public debt should not increase;  If public debt increases, the increased interest is not to be paid by increasing the current level of taxation;  If the increased interest is paid by increasing the level of current taxation, these taxes are based only on the portion of benefits obtained from increased government spending and, therefore, are not considered a loss to the public, but simply a transfer from taxpayers to bondholders;  High rates of income tax should not discourage investment, because the appropriate tax deductions for incurred losses will reduce investment capital at risk by the same proportion by which net investment income is reduced. 7

FINK, R. and J. High. Op. Cit., p. xv. LERNER, A. Functional Finance and the Federal Debt; in FINK, R. and J. High. Op. Cit., pp. 59-60. 9 Ibid, pp. 65-66. 8


Recommended additional sources: 1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). // Biblioteka „Obrazovanie i nauka”, Svishtov,Tsenov, 2012. 2. KEYNES, J. The General Theory of Employment, Interest and Money. (Bulg. transl. ed.) Sofia, Hr. Botev, 1993. 3. KANEV, M. et al.. Obshta teoriya na ikonomikata (Makroikonomika). Svishtov, 1995.

Keywords 1. Government spending 2. Capital volume 3. Keynes’ concept of unemployment 4. Hansen’s ideas 5. Fiscal policy objectives 6. Interest payments 7. Lerner’s thesis 8. Functional finance 9. Lerner’s first rule 10.Lerner’s second rule 11.Lerner’s hypotheses in favour of debt financing

Questions for self-evaluation and discussion 1. What is the influence of government spending on the economy, according to Keynes? 2. According to Keynes, how should the government act in cases of unemployment? 3. What arguments did Hansen provide in favour of deficit financing? 4. What is Lerner’s view of the consequences of debt financing? 5. How is Lerner’s theory criticised? 6. Define the essence of Lerner’s rules of functional finance and determine their current feasibility. 7. How would you comment on Lerner’s main hypotheses regarding deficit financing? 8. In the case of the public debt crisis in the period 2011-2012, which of the theories described is “to blame” for national and global debt-related problems?

24 Debt Management


Chapter summary The period of increased state intervention in the management of the economy affected the principles of budget organization and management. During this period, a number of theoretical concepts appeared which refuted the classical school’s arguments for the limited use of deficit financing. One of the most popular theories is that of J. M. Keynes. What Keynes achieved in his research is perhaps the most significant advance in economic theory in the 20th century. Although in his "General Theory" he does not provide a direct interpretation of the problems of deficit financing, the analyses regarding the relationship between unemployment and inflation indirectly prove that increased government spending (financed through taxes and/or loans) has a favourable impact on the economy. For Keynes, the propensity to consume, marginal capital efficiency and interest rate theory were the most important issues. Further research in this field was conducted by A. Hansen. He defined deficit financing as a means to stimulate development and establish a high standard of living for the whole population. Another prominent proponent of the Keynesian concept of debt was A. Lerner (1948), who tackled the problem of transferring the burden of debt to future generations. According to him, in order to carry out planned expenditure when there is a shortage of funds, loans should be taken by the current generation. Consumption must also be cut in the present day, and interest payments are simply transfers from some members of society to other members. Hence, the burden of debt is not shifted from one generation to another. Lerner's ideas have been criticized in terms of the debt burden for taxpayers and state creditors, and the limitations they cause for the private sector. For Lerner, functional finance is the guiding principle for the implementation of government policy when there is either inflation or unemployment, but never for both of them simultaneously. In cases of inflation, the government must raise the tax rates and cut spending, while in cases of unemployment, the government should cut taxes and increase spending.

CHAPTER III MODERN THEORIES REGARDING THE BUDGET DEFICIT

Introduction to the chapter This chapter describes modern interpretations of the budget deficit issue. By the end of the chapter you will be able to:  discuss the various macroeconomic management tools;  discuss the moral aspects of debt financing;  analyse the debt financing burden;  estimate the effects of debt financing on the national economy. The chapter covers four topics: 1. The theories of Tobin and Buchanan; 2. The model of burden distribution between overlapping generations; 3. The neo-classical concept; 4. The Ricardo-Barro theorem.

1. The theories of Tobin and Buchanan The arguments of the classical and Keynesian schools regarding deficit financing of governmental budgets established the historical basis for the development of modern interpretations of this issue. Many of them reject the arguments of both Smith and Keynes by trying to offer a third alternative. This alternative is usually developed within narrow limits of overlap between the classical and Keynesian schools. J. Tobin’s theory of budget deficit assumes that the government has two main macroeconomic management tools - fiscal policy and monetary policy. In a critique of the causes of the 1980-81 recession in the U.S. economy, Tobin claimed that the major recessionary factor was the antiinflationary policy of the Federal Reserve system. He recommended the implementation of a balanced combination of a tight fiscal and a loose monetary policy. Moreover, Tobin recommended an expansion of credit in order to reduce interest rates and stimulate economic recovery which would lead to an increase in fiscal revenue and, possibly, reduce the

Chapter III. Modern theories regarding the budget deficit 27

deficit. Thus Tobin falls into the mainstream of the Keynesian concept of using credit expansion as a factor to stimulate the economy. He claimed that, "...the budget deficit is more a result rather than the cause of higher interest rates and economic depressions caused by these rates."1 Besides research which weighs the arguments "for" and "against" deficit financing, economic development theory contains some concepts which define the above groups of arguments as harmful. According to J. Buchanan (1983), debt financing of public consumption is, "...eating up the national capital.”2 Buchanan believed that citizens’ and politicians’ natural propensity to consume encourages the use of deficit financing. "Voters welcome the receipt of benefits from public spending, but complain about paying taxes. The eligible politicians are trying to meet voters’ expectations”.3 According to Buchanan, what withholds this propensity is regard for national capital, respect that is a product of the cultural evolution. This status quo, however, was altered by Keynes, who can be described as a "revolutionary success", and who brought about the destruction of the Victorian economic model. Despite the economic logic in Keynes’ concept, Buchanan believed that it destroyed the moral barriers that protected national capital, which would be eroded unless these moral barriers were restored. Buchanan recommends that only a constitutionally provided budget balance is the best way to restore these moral barriers.

2. The model of burden distribution between overlapping generations The model of burden distribution between generations resulted from the scientific research of A. Lerner. In this model, the term "generation" includes each citizen of a particular nation, at an age between specified minimum and maximum limits. Since current average life expectancy is now 75 years of age, this model can now be developed based on the assumption of the coexistence of three generations:  the generation of youth;  the generation of middle-aged people, and  the generation of elderly people.

1

For more details see: FINK, R. and J. High. Op. Cit., p. xvi. and TOBIN J. A Keynsian View of the Budget Deficit., California management review, 1984, vol. 26 , no.2 , pp. 7-14. 2 FINK, R. and J. High. Op. Cit., p. xvii. 3 Ibid.

28 Debt Management

The overlapping-generations model includes precisely these three generations. It also demonstrates how the fiscal policy of the state is able to transfer the debt burden from one generation to another. The overlapping-generations model is based on the following assumptions:4  that the population consists of equal numbers of young people, middle-aged people and elderly people;  that the time span of each generation within each of the three categories (young, middle-aged and elderly) is 25 years;  that each member of a certain generation earns a fixed income of $24,000 throughout the 25-year period;  that there are no private savings – each person consumes his or her income in full;  that the situation is repeated at regular intervals. The income generated by each representative of the three generations is shown in Row 1 of Fig. 3-1. Here, we analyze the effect on the three co-existing generations in a situation where the government decides to take an internal loan of $24,000, provided that the budgetary revenue which has been additionally accumulated (by taking the loan) is channelled into the financing of public consumption. We assume that the loan must be paid off in full as a lump sum in 2015. According to this model, only young and middle-aged people will be willing to extend credit to the government. If we assume that the loan is extended proportionally by only the young and middle-aged generation, then each member of these two generations will reduce their consumption by $12,000 for the period between 1990 and 2015. This effect is shown in Row 2. With the funds raised from the loan, the government can provide the same level of consumption for all citizens - everyone gets an extra $8,000 (Row 3). At the maturity of the loan, each generation shifts to the next generational category. A new young generation replaces the elderly generation from Row 1 of the model. The government has to provide $24,000 to pay the face value of the Government Bonds issued 25 years ago. This is accomplished by increasing taxation rates. Thus, each generation bears a new tax burden of $8,000 for each member (Row 4). With the tax revenues of $24,000 collected, the government is able to pay the face value of the Government Bonds issued 25 years ago. In this case, the new elderly and middle-aged generations bear the burden of debt 4

Similar examples can be found in: ROSEN, H. Public Finance, New York, 3 ed. 1993; as well as in: SIMEONOV, St., Zaharieva, G. Defitsitno finansirane na byudzheta, v: BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.), Sofia, FSSA, 1998, pp. 569-572.


financing (Line 5). For the purposes of the model, we assume that the interest rate is zero and that there is no inflation. The overlapping-generations model No. 1.

2.

3.

Period 1990-2015 / generation MiddleYoung aged Elderly

Position Income generated Refusal of current personal consumption and investment in 25year Government Bonds Consumption provided by the government due to the loan …

…

Young 4. 5.

Accumulation of funds for the maturity payment of the 25-year GBs through taxation Payment of the face value of the GBs

$24,000

$24,000

$24,000

-$12,000

-$12,000

Х

+$8,000

+$8,000

+$8,000

… 2015 Middleaged

-$8,000

…

…

Elderly

-$8,000

-$8,000

+$12,000

+$12,000

Figure 3-1 The results of the above model are: a) Due to the loan and related taxation policy, the elderly generation of 1990 has a lifetime consumption level until the end of their lives in 2015 - $8,000 higher than it otherwise would have had. b) The young and middle-aged generations of 1990 did not experience any changes in their consumption levels until 2015. The young generation of 2015 has a lifetime consumption stream that is $8,000 lower than it would have been in the absence of the debt and accompanying fiscal policies. Thus, the government loan of $24,000 results in the transfer of $8,000 from the young generation of 2015, to the elderly generation of 1990. The difference between the present value of taxes and transfers is the net tax paid by every member of this generation. When we compare the net taxes paid by the separate generations, we can see how income is redistributed amongst them. This redistribution is a direct result of the

30 Debt Management

government’s debt policy. Most calculations using this framework suggest that older generations benefit at the expense of younger generations. The main positive result of debate regarding the overlapping generations model is that it focuses our attention on the lasting effects of government fiscal policies which affect the life of a generation and disregard the considerations of the common annual budget cycle. The recommendation is that the size of the deficit, as well as the specific taxation methods, should take into account all effects.

3. The neo-classical concept The generational model shown above does not allow for the fact that economic decisions can be affected by government debt policy, and changes in these decisions can have consequences for whoever bears the burden of the debt. This fact suggests that the taxes levied to pay off the debt affect neither work-related nor savings behaviour when they are imposed. The implication is that, although taxes affect the decisions of economic agents, the real costs are imposed on the economy. More importantly, we have ignored the potentially important effect of debt financing on capital formation. In the neo-classical model of debt financing, when the government initiates a project, whether financed by taxes or borrowing, resources are removed from the private sector. We usually assume that when tax finance is used, most of the resources removed come at the expense of consumption. At the same time, when the government borrows, it competes for funds with individuals and companies who want the money for their own investment projects. Hence, it is generally assumed that debt has the greatest effect on private investment. This is proven by the fact that debt finance leaves future generations with a smaller capital stock (all other conditions being unchanged), and therefore its members are less productive and have smaller real incomes than otherwise would have been the case. In scientific research literature, the mechanism through which the debt burden works is called the reduction of capital formation. Note, however, that one of the things held equal here is public sector capital stock. As suggested earlier, to the extent that the public sector undertakes productive investments with the resources it extracts from the private sector, the total capital stock increases. The assumption that government borrowing (deficit financing) reduces private investment plays a key role in neo-classical analysis. It is sometimes referred to as the crowding out hypothesis. According to this hypothesis, when the public


Public sector production output (annual)

sector draws on the pool of resources available for investment, private investment is crowded out. (See Figure 3-2). In other words, with deficit budget financing, the increase in government spending will move the economy from point a to point b. Within this process the output of production in the private sector (h1 - h2) is pushed to provide resources for the increase (g2 - g1) of the production output in the public sector. It should be emphasized that the crowding-out hypothesis is valid only when all available resources are used. In the opposite situation, when the economy is not operating on the verge of its production capacity (e.g. when the economy is in point c), the crowding-out effect cannot be observed. Crowding-out effect

g2 g1

b Increase of government spending

c

a

Crowding-out of private investments

h2 h1 Private sector production output (annual) Source: Schiller, B. The Economy Today, N.Y, McGraw-Hill, 1994, p.235 (with changes).

Figure 3-2 The crowding-out effect can be avoided via the external financing of the budget deficit. This is due to foreign loans leading to an increase in the production output of the public sector without any reduction in the production from the private sector. In other words, external funding moves

32 Debt Management

the economy (see Figure 3-3) beyond the limit of its production capacity (from point a into point d).

Public sector production output (annual)

External funding and production capacity

b

g2

d a

g1

Additional production output (import) funded with external debt

h2 h1 Private sector production output (annual) Source: Schiller, B. Op. Cit., p. 244.

Figure 3-3 Considering the two options illustrated in Figure 3-2 and Figure 3-3, it is clear that the type of government funding can influence private sector production factors and private spending. Therefore:5  tax-based financing creates a tax burden by reducing the current consumption in favour of raising capital and future generations receive a higher real income and the corresponding consumption level;  vice versa – loan-based financing results in an increase in the current consumption level at the expense of a decrease in capital formation and hence, future real income. In cases of loan-based financing, the members of future generations will be less productive and will have lower real incomes than 5

Brumerrhoff, D. Finanzwissenschaft. Munchen, 1996, p. 388.


they would have had in the case of tax-based financing. Thus, the burden is transferred to future generations and capital formation is reduced.

i

Sector А: Debt-free capital market

9 8 7

6 5

S

4

А

3

D

2

1 0

3000

4000

5000

Real Interest rate (annual percentage)

Real Interest rate (annual percentage)

Debt crowding-out of private capitals Sector B: Capital market with government debt

i 9 8 7

S’

6 5

B

4

S

1500

А

3

D

2

1 0

3000

4000

5000

DC

Volume of capital

Volume of capital

Source: Samuelson, P. and W. Nordhaug, Economics, N.Y., McGraw-Hill, p. 403. (modified)

Figure 3-4 The crowding-out effect illustrated previously is caused by changes in interest rates which are brought about by an increase in the interest rate due to a loan taken by the government. As a result, the cost of capital increases. Along with the rise in interest rates, private investment becomes more expensive and, hence, unattractive (see Figure 3-4). The graphs show the curves for the demand and supply of capital (C). The intersection between the supply curve (S) and the demand curve (D) represents the level of the real interest rate. Sector A above shows the equilibrium price of capital in the absence of government debt, respectively, i = 3%, and C = 4,000 units.6 Sector B shows a situation in which the government has 6

Samuelson, P. and W. Nordhaug, Economics, N.Y., McGraw-Hill, p. 403.

34 Debt Management

adopted a policy of deficit financing for 1,500 units of capital. When the additional debt securities are offered on the capital market, investors include them in their investment portfolios. Consequently, the net supply of capital will be shifted to the left due to the additional demand for the 1,500 units of capital. The equilibrium price on the capital market along supply curve D will shift from point A to point B.7 The new interest rate level will rise from 3% to 4%, as, due to the competition from the government, companies will be discouraged from issuing debt securities and, thus, the overall capital volume will be reduced from 4,000 to 3,500 units of capital. Therefore, the 1,500 units of capital borrowed by the government will result in the crowding-out of 500 capital units in the economy and will reduce its total production output. We should also note the following: due to the international mobility of capitals, the increase in the interest rate will lead to the inflow of foreign capitals. This, in turn, will increase the demand for local currency and the resulting increase in price will result in a relative increase in export prices. Consequently, net exports will be crowded-out (suppressed) in a similar manner to (and, in this case, to a greater extent than) private investments. This relates directly to the analysis of the crowding-out hypothesis. A simple example is the historical relationship between interest rates and budget deficits and their relation to gross domestic product. A positive correlation between the two variables supports the crowding-out hypothesis and vice versa. In fact, things are not that simple, because other factors are also likely to influence interest rates. For example, during a recession, investment declines and thus lowers the interest rate. At the same time, deteriorating business conditions reduce tax revenues and thus increase the deficit. However, these factors may occur in the inverse relationship, which does not provide direct information on the effects of crowding-out. As a consequence, the problem of identifying the separate effects of deficits on interest rates remains unsolved. Despite the ambiguity of the econometric arguments, the theoretical basis for the crowding-out effect is so convincing that most economists believe that a large budget deficit reduces investments. However, the precise degree of the reduction and subsequent decline in the welfare of future generations cannot be estimated with absolute accuracy.8

7

Ibid. Note that the degree of crowding-out is smaller than the degree of attracting foreign investments due to higher interest rates. However, the burden on future generations is almost the same due to the interest payments on external loans. 8


4. The Ricardo-Barro theorem Our discussion so far has ignored the effects of increased tax rates or the issuance of government securities in order to finance government spending.9 This issue was analysed by R. Barro in his classic paper, “Are Government Bonds Net Wealth?” Here, he proves the Ricardian equivalence theorem (named after the nineteenth-century economist David Ricardo), which states that deficit financing of public spending and an increase in tax rates have the same effect on the economy. Under these conditions, assuming that the government reduces the tax revenue by 100 units of capital and also issues government bonds for the same amount to finance its budget deficit, they will be bought by households at the expense of the income available due to tax cuts. If households feel richer as holders of government bonds, they will reduce their savings and increase their consumption. From this, the Keynesian thesis can be derived regarding the stimulating effect of deficit budget financing on aggregate demand and economic activity. According to Barro, the above assumption ignores the effect of the future tax burden. Each rational economic agent is aware that when the government finances a deficit by issuing government bonds, it will raise taxes in the future in order to pay the interest on them and their face value. Therefore, through deficit financing the government only postpones the increase in taxes. What is the rational response of households in terms of debt financing of government spending? To prepare for the future payment of higher taxes, households save part of their income and purchase government bonds. Therefore, the total amount of savings remains the same in level as it was before the reduction of taxes and the issuance of government securities. This means, however, that the level of consumption also remains the same, and private investment is not crowded out because the interest rate does not change. This is because the supply of money is unchanged (since the total savings do not change) and government bonds are purchased with the money left over from tax cuts. From the analysis above, Barro concludes that budget deficit financing does not affect economic activity. Therefore, deficit financing does not create a burden for future generations. Barro also applies the theorem to the generational model. He believes that parents are rational in the long run. They realise that, in conditions of budget deficit, their 9

This section is based on the interpretation of this problem in: SIMEONOV, S., Zaharieva, G. Defitsitno finansirane na byudzheta, in: BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.) Sofia, FSSA, 1998, pp. 574-576.

36 Debt Management

successors will have to pay the interest and principal on the government bonds issued by paying higher taxes. This will reduce their consumption and level of prosperity. Parents are worried about such a fate befalling their children and grandchildren. What can they do to prevent this scenario? A rational solution is to increase their wealth and to bequeath it to their children. Parents invest the surpluses in income due to the reduced taxes in different assets. In the broader sense, these assets can be in various forms of wealth (corporate shares, real estate, bank deposits, jewellery, etc.). Barro perceives government bonds specifically as liquid wealth. Due to the wealth inherited from their parents, the heirs will pay higher future taxes without reducing their consumption. For example, let us assume that parents have bequeathed a house to their children. In this case, the children won’t have to save in order to purchase a house and therefore will have greater disposable income. However, after they pay higher taxes, they will have the same disposable income as their parents used to have. When parents bequeath their government bonds to their children, the latter will obtain additional income in the form of interest and principal. This will be used by the children to pay the higher taxes in order to repay the loan borrowed during their parent’s lifetime. However, the level of consumption will not fall, i.e. it will remain the same as before the imposition of higher taxes. Therefore, deficit financing actually does not change anything. The parents’ generation retains its level of consumption. At the same time, it bequeaths some of its wealth (as government bonds or other assets) to their children. The income from this wealth is used to pay higher taxes to repay the debt accumulated in previous years. In effect, then, the rational behaviour of parents eliminates the future burden on their children caused by debt financing of the budget. Therefore, the general conclusion is that fiscal policy regarding the budget deficit is unnecessary and useless.

Recommended additional sources: 1. ADAMOV, V. Teoriya na finansite (Darzhavni finansi). Svishtov, 2012. 2. SIMEONOV, S., Zaharieva, G. Defitsitno finansirane na byudzheta, in: BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.) Sofia, FSSA, 1998. 3. ROSEN, H. Public Finance. New York, 3 ed. 1993.


Keywords 1. Macroeconomic management tools 2. The views of J. Tobin 3. Credit expansion 4. Fiscal revenue 5. Ricardo’s moral considerations regarding his research 6. “Eating up” national capital 7. Generations 8. Overlapping generations model 9. Assumptions regarding the overlapping generations model 10.Generational accounting 11.Current tax value 12.Transfers 13.Net tax 14.Care amongst generations 15.The neo-classical debt pressure model 16.Effects on private investment 17.The crowding-out hypothesis 18.The crowding-out effect 19.Shifting of the economy 20.Full utilization of the resources available 21.External financing and production capacity 22.Private supply of factors 23.Tax and credit financing 24.The equilibrium price of the capital market 25.Dependence between the interest rate and budget deficit 26.The Ricardian equivalence theorem 27.Government bonds 28.Reaction of rational households 29.Burdens for future generations 30.The views of R. Barro 31.Parental transfer of wealth 32.The rational behaviour of parents

Questions for self-evaluation and discussion 1. Which are the main macroeconomic management tools according to J. Tobin’s theory? 2. How, according to Tobin, could the deficit be reduced?

38 Debt Management

3. What, according to J. Buchanan, encourages the use of deficit financing? 4. How would you discuss the model of burden distribution among overlapping generations? Does it have any disadvantages and what are they? 5. Is the hypothesis that the young generation bears the burden of debt valid? Provide arguments to support your opinion. 6. What are the effects of government loans according to the neo-classical concept? 7. Explain the mechanism or the relationship between external financing and production capacity. 8. Define the Ricardian equivalence theorem and state your own opinion regarding this. 9. Do you agree with Barro’s opinion that deficit financing does not create a burden for future generations? Provide arguments to support your opinion.


Chapter summary The arguments of the classical and Keynesian schools regarding deficit financing of the government’s budget established the historical basis for the development of modern interpretations of this issue. According to J. Tobin, the budget deficit is more as a result of, rather than the cause of, higher interest rates and the resultant economic depression. It is a consequence of the misuse of the two main macroeconomic management tools by the government: fiscal policy and monetary policy. Economic literature also discusses the moral aspect of this issue. This was studied by J. Buchanan, according to whom debt financing of public consumption is, "...eating up the national capital." Buchanan believes that citizens’ and politicians’ natural propensity to consume encourages the use of deficit financing. Voters welcome the receipt of benefits from public spending, but complain about paying taxes. Eligible politicians are trying to meet voters’ expectations. What withholds this propensity is regard for national capital. According to Buchanan, the economic logic in Keynes’ concept destroys the moral barriers that protect the national capital, which will be eroded unless these moral barriers are restored. Besides the moral aspect, modern theories also tackle the problem of transferring the burden of deficit financing amongst generations. A. Lerner’s model attempts to compare the benefits and burdens of state fiscal policy for different generations in the long term. The neo-classical view of deficit financing ignores the effect of tax increases, or the issuance of government bonds to finance government spending. This effect is analysed by R. Barro, who proved the Ricardian equivalence theorem which states that deficit financing of government spending and tax increases have the same effect on economic activity. He reached the conclusion that deficit financing does not affect economic activity and also does not create burdens for future generations.

CHAPTER IV THEORIES REGARDING THE STRATEGIC ROLE OF GOVERNMENT DEBT

Introduction to the chapter This chapter presents contemporary research into the relationship between government decisions and public debt. By the end of the chapter you will be able to:  analyse the applications of deficit financing as a tool for strategic influence over the political cycle;  interpret the main characteristics and hypotheses of modern budget deficit theories. The chapter includes three subtopics: 1. The theory of governmental policy in circumstances of time-inconsistent preferences; 2. The positive theory of fiscal deficit and government debt; 3. The political-economic model of the strategic role of debt.

1. The theory of governmental policy in circumstances of time-inconsistent preferences The emergence of theories regarding the strategic role of debt is a modern answer by researchers within the context of public choice theory. Unlike earlier theories, where fiscal inefficiency is usually explained by the political conflict between various forces operating at the same moment in time, they assume a single-factor dependency by the fiscal policy of a single political ideology at a certain period of time. This single-factor dependency is interpreted as the right of governments to set fiscal policy without taking into account the opinion of other political forces. For this purpose, researchers examined the fiscal behavior of governments with different ideological preferences in a competitive political environment. This would mean that political decisions would be consistent with the political

Chapter IV. Theories Regarding the Strategic Role of Public Debt 41

cycle and the will of voters. In other words, regardless of the government’s political ideology, the preferences of voters will actually determine whether it should resort to deficit financing or not. Therefore, we must take into account that the preferences of voters could lead to the use of debt as a strategic instrument.1 Scientific literature discerns two main strategic aspects of debt:  Each fiscal decision has long-term consequences. Debt is a typical example of governmental decisions with long-term consequences as the servicing and repayment of it affects future governments. In other words, by leaving a legacy of debt, the indebted government determines the behavior of successive governments as well.  The indebted government (and the respective political party) can use debt to improve its image in the eyes of voters, therefore improving its chances to win at the next elections. This denotes a strategic influence on voters’ attitudes. Of course, the specific actions of the indebted government will depend on the ideological preferences of its electorate. This means that every political party has ideological constraints regarding the type of strategic instruments it would use and the way in which they should be used. Such an approach can be seen to be based on the "political divergence hypothesis." An alternative view is stated in the "political convergence hypothesis." According to this hypothesis, given a certain distribution pattern of voters’ preferences and expectations, and a certain economic structure in a bipartisan system, both parties will have as their primary goal the creation of an election platform that meets the expectations of the average voter. In other words, their primary objective will be to remain in power by fulfilling the expectations of the average (resp. mass) voter. However, the political convergence hypothesis conflicts with the ideological resistance of political forces. This is due to governmental policy being optimal only for certain conditions and for a specific period of time. This policy should change according to changes in conditions. However, these changes may conflict with ideological restraints and the political force may lose its identity. Under these conditions, the decisions of the indebted government can:  pre-define the policies for successive governments according to the preceding government’s policy;  change the attitudes of voters. 1

De WOLFF, J. The Political Economy of Fiscal Decisions. N. Y., Physika-Verlag, 1998, p. 28.

42 Debt Management

A comprehensive review of the publications regarding the issue of the strategic role of debt has allowed us to consider in more detail: a) the theory of governmental policy in circumstances of timeinconsistent preferences, developed by T. Person and L. Svensson in 19892, b) the positive theory of fiscal deficit and government debt, developed by A. Alesina and G. Tabellini in 19903, c) the political-economic model of the strategic role of debt, developed by P. Aghion and P. Bolton in 19904. The above works are new developments in deficit financing theory. They complement research on the philosophy of deficit financing. The basic assumption of the theory of governmental policy in circumstances of time-inconsistent preferences is a simplified bipartisan political model in which two political parties (having left- and right-wing orientation) alternate in office, differ in their levels of public consumption and are uncertain of electoral attitudes. Person and Svensson apply the model to a small open economy assuming that the interest rate is zero. During different periods the country is ruled by governments that can increase taxes in order to provide sufficient resources in order to finance the production of public goods. Part (or all) of the fiscal revenues from the first period can be transferred to the second period, where they can be used to supply public goods. Taxes are assumed to have a distortive effect, which means that they induce a deadweight loss to society. The government generates public benefits beyond those that are generated in the production of public goods. The presence of a deadweight loss, however, means a reduction in the benefits generated by the government. In order to present the main points in Person and Svensson’s study, let us consider the following example of a situation in which public consumption is affected only in the second period:

2

The theory is presented as the author’s interpretation of the original ideas described in: PERSON, T. and L. Svensson. Why a Stubborn Conservative would run a Deficit: Policy with Time-Inconsistent Preferences. Quarterly Journal of Economics, 1989, May, pp. 325-345. 3 The theory is presented as the author’s interpretation of the original ideas described in: ALESINA, A. and G. Tabellini. A Positive Theory of Fiscal Deficits and Government Debt. Review of Economic Studies, 1990, vol. 57, pp. 403-414. 4 The theory is presented as the author’s interpretation of the original ideas described in: AGHION, P. and P. Bolton. Government Domestic Debt and the Risk of Default: A Political-Economic Model of the Strategic Role of Debt, in: Public Debt Management: Theory and Practice, ed. by R. Dornbush and M. Draghi, Cambridge, pp. 315345.


First, periodic limitation requires that all consumption tax revenues from the first period should be transferred to the second period. This creates significant problems in terms of time-inconsistent preferences. If either party is in power in both periods, this party will have to form a budget in period one (for both periods), which will include the collection of tax revenues in the first period and their expenditure during the second period (with the expenditure in the second period exactly equal to the tax revenue from the first period). To optimize the effects of the budget on the economy, the government would construct a budget to equalize the marginal cost of tax distortion in relation to the marginal benefit from the production of public goods. At the beginning of the second period, the government may revise this budget. Second, in choosing the optimal ex-post budget which will have certain tax revenues transferred from the first period, the government will try to equalize the marginal benefits of public goods with the marginal cost of tax distortion (thus all costs from the first period will be depreciated). The ex-post budget will differ from the ex-ante budget, not by the marginal benefits (which will be the same), but by the cost of tax distortion. An alternative situation will occur when the government opts for a timeconsistent budget. Thus, in determining the taxes in the first period, the government will take into account the fact that the budget during the second period will depend on the fiscal decisions from the first period, in order to avoid subsequent budget updates. Third, the time-consistency problem arises when the government in office during the second period is different from the one which was in office during the first period. Initially, Person and Svensson analysed a case of fiscal behaviour by a conservative government, who would rather reduce government spending in the knowledge that, in the second period, they will be replaced by a government that relies on increased budget spending. Under these conditions, the conservative government would opt for a low level of public goods in the second period, and would have to increase some taxes in the first period to ensure that the resulting revenues are transferred to the second period. On the other hand, knowing that during the second period the office will be held by a liberal government, the conservative government would prefer to allocate less budget revenue for the second period. This is why the liberal government in the second period will be forced to increase taxes in order to ensure the higher level of public goods envisaged. Thus, with lower taxes in the first period, the conservative government would reduce the expansion of the provision of public goods planned by the liberal government. However, it is clear that the behaviour of the conservative government in the first period causes an

44 Debt Management

increase of tax distortion – tax rates are too low in the first period and too high during the second period. Fourth, the exact amount of reduction caused by the conservative government depends on the level of the importance of public goods compared to the reduction in the government’s usefulness due to tax distortions. If the government is more persistent than necessary, the reduction in its usefulness as a result of too many public goods will be relatively high compared to the reduction of its usefulness caused by tax distortion. Thus, the conservative government will achieve a higher level of restriction regarding the activities of the liberal government by accumulating less money in the state budget. On the other hand, if the conservative government is more flexible, the level of taxes in the first period will be modified more easily and smoothly to the level projected by the liberal government for the second period. This means that the conservative government will determine its fiscal policy based on the anticipated changes during the term of office of the liberal government. The main reason for this behaviour is that the level of tax distortion is lower than the level in the previous situation. Both situations do not assume the use of debt financing to ensure the provision of public goods. In fact, the conservative government restricts the success of the liberal government only by limiting the increase of tax rates to a greater extent than the economy can endure. Fifth, the theory of Person and Svensson has new areas of application when we include borrowing as a factor which may limit the success of the liberal government in the second period. This means that loans taken during the first period will have to be paid by the government during the second period. One weakness in the Person and Svensson’s theory is the fact that both authors do not analyse a situation in which the resources accumulated via the budget during the first period (from taxes and loans) are used for the production of public goods in the second period. This means that:  if the conservative government transfers the entire amount to the second period, the liberal government can use the accumulated resources directly to repay the debt. In this case, the constraining effect will not be achieved (because the interest rate model has assumed a zero interest rate);  if the conservative government distributes the money among the consumers in the first period, the tax (respectively the tax distortion) will be significantly greater during the second period. The main finding of Person and Svensson’s study can be defined as follows: any conservative government can complete their mandate by


imposing lower-than-optimal taxes if they are to be replaced in office by a liberal government who intend to increase government spending. This would result in governments choosing time-inconsistent preferences. To prove their theoretical concept, Person and Svensson analysed the effects of the Reagan government’s first fiscal policy, where the main strategic objective was to reduce tax rates during their term of office in order to reduce the spending of subsequent governments. Another example is the privatisation policy adopted by the Thatcher government in the UK. In general, Person and Svensson’s theory instigated further research into the analysis of the strategic role of government debt.

2. The positive theory of fiscal deficit and government debt The positive theory of fiscal deficit and government debt developed by Alesina and Tabellini was influenced by New Keynesian ideas at a time when conservative governments in the leading economies were being replaced by liberal governments. The theory’s assumptions are comparable to the initial assumptions in Person and Svensson’s model. Like them, the authors consider an economy with two political parties having different preferences regarding the desired composition of government spending between two public goods (e.g. defence and welfare). In this case, unlike Person and Svensson’s model, the volume of the provision of these goods does not vary. The two parties have ideological differences and represent the interests of different constituencies. The government in office provides both public goods via a specific composition. The goods provided may be financed through tax revenues (the proportional taxation of labour incomes) or by issuing government bonds. Since this is a closed-type of economy, the interest rate is determined entirely by the influence of internal conditions and factors. Alesina and Tabellini developed their model using a temporally indefinite, two-period horizon. The mechanism of electing a government is not peremptorily defined and the parties alternate in office according to an externally defined pattern regarding the probability of being elected. There is a constant populace of individuals who work, consume and save. They are born at the beginning of the first period and have the same time horizon (two periods or an infinite time horizon). They are identical in all respects except in their preferences regarding the composition of the two public goods supplied by the government. The utility function for these individuals can be expressed as:

46 Debt Management

(4-1) where:

U  U (ct )  V ( xt )  h( gt )  (1   )h( f t ) ,

c

is private consumption; x is leisure time; g is public good one (e.g. defence); f is public good two (e.g. welfare);  is the coefficient of the individual preference regarding the composition of the two public goods ([0;1]); t is the time period. The overall utility for the period is a discounted sum of the utilities derived throughout the period. Alesina and Tabellini use a model of random distribution of preferences to define the uncertainty regarding future policy. At any moment each consumer is endowed with one unit of time that may be used for either labour or leisure. One unit of labour is transformed into one unit of public goods. Labour income taxation affects the level of consumers’ supply of labour and hence the level of individual consumption. Since consumers are identical in every aspect but for their preference regarding the composition of the two public goods, we can assume that all consumers will choose the same levels of consumption and leisure under the same fiscal policy. In their analysis, Alesina and Tabellini point out that: First, the government remains in office during all periods and maximises the weighted average of the utility of all voters. The optimal solution would be to balance the budget for every period. However, in this situation the government in office would define the supply level and the composition of the public goods, as well as the alternative method of financing their supply (loans or taxes), according to its objective for maximising the long-term utility of its electorate (in terms of an average, representative voter). Under these conditions, the government conforms to the likelihood of being replaced in office by another government supported by another political force. To simplify the analysis, the authors assume that the preferences of the two parties regarding the supply of public goods vary dramatically: only one good will be supplied in any period – the first party will supply only good g (e.g. wealth, =1) while the second party will supply only good f (e.g. defence, =0). Second, the analysis of the two-period model requires reverse induction. Under these conditions, the government in office during the second period will have to impose a level of taxation and also a level of supply and composition of the public goods which will be in compliance with the debt inherited from the previous government, because, during this period, the debt has to be repaid. Thus, the government in office during the


first period, being aware of the consequences of deficit financing for the government in office during the second period, will determine the tax rates, the budget deficit and the level and composition of public goods supplied during the first period. Due to the simplification of the characteristics of the two political parties, the situation during the second period will be perfectly symmetrical: at a certain volume of inherited debt, during the second period both parties would choose the same tax rates and level of supply of public goods regardless of their different preferences regarding the composition of the supplied goods. Third, long-term decisions made by the government in office during the first period depend on the probability of its re-election. The problem of optimising fiscal policy and deficit financing is solved according to the marginal cost of the inherited debt (which depends on the probability of reelection) and the marginal utility of generated public debt to be bequeathed to the next government in office (which depends on the possibility of supplying larger volumes of the preferred public good). Therefore, the lower the probability of re-election, the higher will be the preferred optimal level of deficit financing. Consequently, policy choices for the next government in office will be constrained proportionally to the size of the inherited debt and the corresponding reduction of government spending for provision of public goods. The main conclusion which can be derived from Alesina and Tabellini’s theory is that public debt plays a strategic role in determining the restraints of the fiscal policy of future governments.

3. The political-economic model of the strategic role of debt The theories mentioned above regarding the strategic role of deficit financing and public debt related only to the influence that a certain government may have on the decisions of the subsequent government. They did not consider the possible effects of a government on voters’ behaviour. A study conducted by P. Aghion and P. Bolton in 1990 fills this gap by developing a political-economic model of the strategic role of debt, which demonstrates how the over-accumulation of debt can have a strategic influence on voter’s behaviour and attitudes. The model considers a closed economy in which two political powers are trying to win elections in two successive periods. Elections are held at the beginning of each period. The government provides a public good during either period. In period one the government can choose

48 Debt Management

between proportional income tax5 and issuing government bonds to be sold to other economic agents (deficit financing). The interest rate is determined by internal factors in the economy. During the second period, only taxes are available to finance both debt repayments and expenditure on the public good. The rate of transformation between the private and the public good is equal to one, i.e. one unit of private good produces one unit of public good. Aghion and Bolton’s analysis covers two scenarios: a) that the government does not default on outstanding public debt in period two; b) that the government decides when and how much of the inherited debt they will repay. The consumers live throughout both periods. Within each period they earn a fixed amount of income according to a given normal histogram of income distribution. Therefore, consumers are heterogeneous in terms of their incomes. The public good is supplied to each consumer at equal rates. Under these conditions the utility function for a consumer who consumes a private ( c ) and a public ( g ) good throughout the two periods is represented as: (4-2) U c1, c2 , g1, g 2   log c1  g1    log c2  g 2  , where:  is the discount factor. This utility function is rather specific since the private and public goods are completely interchangeable. Consumers choose the volume of consumption in both periods and also the amount of savings in the first period in light of the budgetary constraints in each period and in order to maximize the utility function above. Between the two periods the two parties compete with each other to win the elections. The left-wing party represents primarily the interests of those individuals whose income is below the average in the economy. The right-wing party represents primarily the interests of those whose income is above the average. The electorate vote for the party that guarantees them a higher value with regards to the utility function in the second period. The party which receives at least fifty percent of the votes is elected. Initially, Aghion and Bolton assumed a model having no default on the debt. Their analysis starts with a comparison of the optimal fiscal policy for the two periods from the point of view of a left-wing and a right-wing

5

Hence we have a distortive effect of income taxation.


“dictator”.6 After that, they analysed a situation having alternating governments. The equilibrium in their model (like those in Alesina and Tabellini’s analysis) is solved using the method of backward induction. Thus, the optimal fiscal policy in the first period is determined by the known amount of inherited debt. The first government decides on the optimal amount of debt and the level of supply of public goods for this period. In Aghion and Bolton’s model the key fiscal policy decisions are taken by the Minister of Finance who bears the political responsibility to his party for the success of its term in office and electoral victory. Under these conditions it may be noted that: First, at a certain volume of mature debt, the Minister of Finance will be indifferent with regards to the high level of expenditure on public goods. This indifference is in terms of:  a policy for determining a level of tax rates during the second period 2 in order to ensure revenue which would cover only debt servicing expenditure and not the finance for the provision of the public good 

g 2 ; and a policy of higher tax rates during the second period in order to provide the resources for the supply of the public good.

The reason for this indifference is clear. Since private and public goods are completely interchangeable and the average consumer gets an exact equivalent of public good in exchange for his private good, the feasible utility level will be the same for any composition of consumption of private and public goods. Such a relation, however, is valid only for the average consumer - those with average incomes. Consumers with lower incomes will generate less fiscal revenues than the value of the public good they receive. For consumers with higher than average incomes, this proportion will be the inverse. Similar results can also be obtained for the first period. Without the distorting effect of taxes, and with two completely interchangeable goods, the Minister of Finance will be indifferent not only to the choice between the composition of debt and taxation financing the provision of public goods, but also between the probable volume of debt. Aghion and Bolton define this situation as Ricardian super indeterminacy. The authors point out that the indeterminacy is in terms not only of the composition of the expenditure for financing the provision of public goods (as in the Ricardian equivalence theorem), but also of the feasible level of government spending. For the average consumer a greater

6

For Aghion and Bolton the term “dictator” means a party which has a government in office in both periods.

50 Debt Management

present day public debt motivates agents to save more in order to pay the future increase in income taxes in the second period. Second, fiscal decisions during the second period will vary according to the political affiliation of the government in office. A right-wing government would choose to cease the provision of public goods during the second period and the tax rate will correspond to the minimum level required to repay the debt. A left-wing government will try to maximize the provision of public goods and will therefore set a tax rate  2  1 and provide the maximum possible volume of public goods once the debt is repaid. During the first period, a right-wing government will try to minimise expenditure – it will stop the provision of public goods and, hence, will not have the grounds to collect taxes or issue bonds. As a result, consumers will not save. A left-wing government, on the other hand, will maximize the level of government spending, impose the maximum tax rate 1  1 and issue bonds for a specific maximum value (the value of the discounted aggregate income during the second period). However, this leads to a confusing situation – bonds will not be purchased because the whole income of consumers will be transferred to the budget as tax revenues.7 In order to avoid such controversy, Aghion and Bolton additionally assume that   [0 ; 1], the criterion being an efficient income tax. At this stage of the analysis we may summarize that:  a country with a right-wing “dictator” may be described as a country having a zero level of state interference in the economy8; during both periods in such an economy, no public goods will be provided and no public debt will be incurred; consumers will dispose of all their income and will be able to spend it on purchasing private goods;  a country with a left-wing “dictator” may be described as a country having total state interference in the economy. During both periods, taxation will claim all income and only public goods will be consumed.9 Third, the alternation of the government in office results in changes in the fiscal policy. Aghion and Bolton analysed the optimal fiscal policy in two situations – first, when a left-wing government is replaced by a right-wing 7

The model will be even more confusing if we assume that consumption can have a negative value. 8 i.e. the classical ideal of a laissez-faire world. 9 This description strongly resembles the imagined communist society (author’s note).


government (LR), and vice versa (LR). Following the inverse induction method, the analysis started with the second period. The results were identical to those described above: for a given level of inherited debt, a right-wing government will not provide any public goods and will impose the lowest possible tax rate that would allow them to repay the debt; a left-wing government, on the other hand, will maximise budget revenues (1), repay the debt and use the remaining budget revenue for the provision of public goods. Which party will win the elections depends on the distribution of incomes – as we have already mentioned, consumers (i.e. the voters) are heterogeneous in terms of their incomes. The voters with average incomes will be indifferent – all voters with incomes below the average will be worse off, and this is why they will vote for a left-wing party; all voters with incomes above the average will be better off and will therefore vote for a right-wing party. In this situation, the outcome of the elections depends on the direction of the income distribution asymmetry. If the median voter is worse off than the average voter, the elections will be won by the left-wing party and vice versa – if the median voter is better off than the average one, the elections will be won by the right-wing party. Therefore the outcome of the elections is a function of the position of the median voter. Fourth, if the left-wing party is in power in the first period in an economy where the income distribution is such as to ensure victory for the right-wing party, the left-wing party would prefer a maximum level of public spending whilst in office. Things get much worse when we take into account that the right-wing successor will have radically different preferences - a minimum level of supply of public goods. In this case, the left-wing party will impose tax rates of 1  1 in an attempt to constrain the policy choices of the succeeding right-wing government by taking a substantial loan, thus reducing the disposable incomes during the second period. During the first period this will provide poorer consumers with greater benefits compared to the benefits for the average consumer, because their disposable income does not allow them to purchase any quantity of the public good provided. Moreover, this will have a redistributive effect during the second period, as the richer consumers will bear a relatively higher tax burden to service the debt. Fifth, if a right-wing government is in office during the first period and it is obvious that it will not be re-elected plus it will be succeeded by a left-wing government, the former will not collect any taxes because it is aware that the latter will collect all incomes as taxes and is therefore indifferent to the actual volume of debt. For example, if a right-wing government bequeaths a substantial debt to the succeeding left-wing government, the latter will have to cut its spending because its priority will be to repay the debt. In fact, the large debt results in a higher level of

52 Debt Management

savings by rational consumers since they will try to avoid future losses of income due to the imposition of higher tax rates. Under these conditions, it can be argued that the debt cannot have a strategic impact on the outcome of the election. In their analysis, Aghion and Bolton further examined the likelihood of default on a part of, or the full amount of, the debt during the second period. Their first assumption related to the behaviour of the Minister of Finance once again, who is indifferent to the alternatives:  repaying the debt, and  defaulting. If the Minister of Finance defaults during the second period, this will result in lower taxes and, respectively, a higher income for the average user. If the Minister does not want to default and repays the debt, consumers will recover their bond holdings from the first period, which will also automatically increase their income. The average consumer benefits in both cases. Sixth, if both the left- and the right-wing governments choose to default, the initial equilibrium will change. As already noted, the structure of the utility function induces a preference for the party left with the highest possible level of public expenditure. Thus, by defaulting on the outstanding debt payments, a left-wing government will ensure the achievement of the above preference. In fact, a government like this redistributes income in favour of poorer voters. Since savings are a function for increasing income, wealthy consumers are assumed to recover a much greater amount than the poorer, who will recoup smaller volumes of savings. They will be better off at a higher level of provision of public goods. What is surprising here is that a right-wing party will choose to default on the debt as well. As we already noted, the right-wing will increase tax rates during the second period only to repay the inherited debt, and will not attempt to provide any public goods. If the right-wing government defaults on a part of, or the full amount of, the debt, this will maximise the benefits for voters who support the party. This can easily be proved via mathematical means. A right-wing government will impose a zero tax rate during the second period and a complete moratorium (on principal and interests) on the debt. In these circumstances, Aghion and Bolton take into account that consumers with incomes above the average will pay more in taxes to finance debt repayment than the value of their bond holdings. In other words, for every dollar of savings return, the rich will have to pay more than a dollar as income tax. Seventh, costless default on the debt leads to the impossibility of establishing a rational-expectations political equilibrium where government expenditures are financed through debt. This is logical, because no one will


agree to lend to the government if they anticipate a default on the debt. In fact, the initial assumptions and limitations of the model (a non-distortional effect of taxation, rate of transformation between the private good and the public good of “one”, etc.) result in one where small changes in the parameters yield non-linear changes in the results. Any modifications to the initial assumptions and limitations also results in changes in the results. At this stage of their model’s development, Aghion and Bolton changed the rate of transformation by assuming that it takes more than one unit of private good to produce one unit of public good. In these circumstances, the provision of public goods becomes more expensive. This changes the results of the model, and now the right-wing government will have to resort to deficit financing as an instrument of strategic influence on voters’ attitudes in order to be re-elected. Eighth, the new logic of the model results in a change of income distribution. This establishes a new middle class which would prefer repayment of the debt during the second period. Moreover, the size of the middle class is a function of the volume of the debt accumulated. Thus, due to the modification of the model, we can analyse the behaviour of a marginal (indifferent) consumer. For a substitution rate of one, marginal consumers will be those with average incomes. These average consumers were indifferent to both alternatives in the second period due to the fact that one unit of private good could be exchanged for exactly one unit of public good. When the rate of substitution changes, average-income consumers will change their behaviour as well: if all their incomes are taxed away, the volume of public goods they will get in return is smaller than the volume they would be able to purchase with their disposable income. This is why the average consumer will be better off with a right-wing government. The new marginal consumer is poorer than the averageincome consumer (see Figure 4-1).10

10

The figure is based on: De VOLFF, Op. Cit., p. 42 (with modifications).

54 Debt Management

Optimal default policy Middle-class voters Marginal income

0

2=1 Maximum volume of public good Default

Affluent voters Average income

1

2=annuity

2=0

Zero volume of public good

Zero volume of public good

Without default

Without default

Preferred policy during the 2nd period

Poor voters

Figure 4-1 The group of voters with incomes between the marginal and average level form a new political class of voters – the middle class. They differ from affluent voters in one thing only – they tend to tolerate the taxation of income. The new marginal voter may change their behaviour depending on the amount of debt to be repaid. Therefore, their voting attitudes can be influenced using public debt as a strategic instrument:  the smaller the amount of debt, the closer the marginal and the average voters will be;  a small amount of debt means a lower level of savings during the first period (a limited issue of government bonds) and, therefore, a lower level of repayment expenditure during the second period;  a higher level of consumption of public goods during the first period which results in electoral support for the left-wing party. Hence, the conclusion that debt as a strategic instrument can be used to influence the behaviour and size of the middle class, and therefore the outcome of the elections. In defence of the right-wing government’s policy, Aghion and Bolton prove that such a government will issue bonds for electoral purposes only. Intuition suggests that the existence of a majority of voters who hold a significant proportion of the income saved in government bonds will reduce their support for the left-wing party, which is likely to default.


Recommended additional sources: 1. ADAMOV, V. Milinov, V. Teoriya na finansite (metodichesko rakovodstvo). V. Tarnovo. ABAGAR, 2002. 2. ALESINA, A. and Tabellini, G. A Positive Theory of Fiscal Deficits and Government Debt. // Review of Economic Studies, 1990, vol. 57. 3. BOLL, S. Intergenerationale Umverteilungswirkungen der Fiskalpolitik in der BRD. Frankfurt, 1994. 4. De WOLFF, J. The Political Economy of Fiscal Decisions. N. Y., Physika-Verlag, 1998.

Keywords 1. 2. 3. 4.

Strategic aspects of debt The political divergence hypothesis The political convergence hypothesis Basic assumptions of the theory of governmental policy in conditions of time-inconsistent preferences 5. Distortionary effect of taxation 6. Periodic restriction of consumption 7. Time-inconsistency of preferences 8. Optimal ex-post budget 9. Fiscal behaviour of conservative governments 10.Behaviour of liberal governments 11.Reduction of government’s utility 12.Weaknesses in Svensson and Person’s theory 13.The result of Svensson and Person’s research 14.Basic assumptions regarding the positive theory of fiscal deficit and government debt 15.Utility function 16.The mechanism of political elections 17.Maximisation of voters’ long-term utility 18.Reverse induction method 19.Optimisation of fiscal policy and debt financing 20.Basic assumptions regarding the political-economic model of the strategic role of debt 21.Heterogeneity of consumers 22.Inter-periodic utility function 23.Left-wing party 24.Right-wing party

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25.Expenditure for the provision of public goods 26.Conditions for indifference regarding the expenditure for the provision of public goods 27.Ricardian super indeterminacy 28.Behaviour of average-income consumers 29.Behaviour of right-wing governments 30.Propositions in Aghion and Bolton’s theory 31.Indifferent voter 32.Right-wing successor in office 33.Protection against future loss of income 34.Consequences of debt aging 35.Consequences of debt default 36.Middle class 37.Marginal consumer 38.Average-income voter

Questions for self-evaluation and discussion 1. What is new in the theories regarding the strategic role of public debt? 2. What is the feasibility level of the “political divergence hypothesis” and the “political convergence hypothesis” in the existing political and economic conditions of Bulgaria? 3. What are the basic assumptions of governmental policy theory in conditions of time-inconsistent preferences? 4. What are the key elements in, and the main results from, Svensson and Person’s research? 5. Comment on the validity of the functional dependencies in Alesina and Tabellini’s theory (equation 4-1). 6. What are the weaknesses in Svensson and Person’s theory? 7. What are the differences between the positive theory of fiscal deficit and government debt, and Svensson and Person’s theory? 8. What are the basic assumptions of the political-economic model of the strategic role of debt and how does it differ from the first two theories? 9. What are the main situations and the key elements in Aghion and Bolton’s analysis? Do you agree with them?


Chapter summary Modern public debt theory includes the use of debt as a strategic instrument to influence voters’ decisions on the one hand, and to improve the image of the government in office on the other. Governmental actions also depend on the ideological preferences of its electorate. They can be based on two main hypotheses: the “political divergence hypothesis” and the “political convergence hypothesis”. An in-depth knowledge of debt financing philosophy requires that we should consider: а) Governmental policy theory in conditions of time-inconsistent preferences, b) The positive theory of fiscal deficit and government debt, and c) The political-economic model of the strategic role of debt. The theory of governmental policy in conditions of time-inconsistent preferences was developed by Person and Svensson. It assumes a simplified two-period model in which the two political parties (having left and right orientation) alternate in office, differ in their levels of public consumption and are uncertain regarding electoral attitudes. The positive theory of fiscal deficit and government debt developed by Alesina and Tabellini is influenced by New Keynesian ideas. Its basic assumptions are similar to those of Person and Svensson. The government in office provides a particular composition of two public goods. The supply of public goods can be financed either from tax revenue or from the issue of government bonds. It is a closed-type economy and therefore the interest rate is determined entirely by internal factors and conditions. Aghion and Bolton coined the terms “middle class” and “marginal consumer”. The size of the middle class is a function of the volume of the debt accumulated. The marginal consumer is worse-off than the averageincome consumer. The marginal voter may change their behaviour depending on the amount of debt to be repaid. The authors prove that a right-wing government will issue bonds for electoral purposes only.

CHAPTER V THE ROLE OF THE STATE IN THE ECONOMY

Introduction to the chapter This chapter describes the types of public goods and the role of the state in the process of their production and supply. At the end of the chapter you will be able to:  identify the various types of public goods;  use the instruments for control of production of such goods;  discuss the advantages and the specific features of club goods. The chapter includes two subtopics: 1. Public goods; 2. Club goods.

1. Public goods Apart from purely public goods such as national defense, which are non-rivalrous and cannot comply with the principle of excludability (otherwise their compliance to this principle would be too expensive) and the purely private goods, which are rivalrous and excludable, there are also mixed types of goods. These goods are neither purely public nor purely private. Brown and Jackson (1992, 1998) classify them into two groups according to the following criteria:1  Consumption rivalry;  Possibility for application of the excludability principle. 1. The first group includes goods consumed collectively and are at the same time subject of overconsumption. These goods are provided by private companies or by the public sector. They are supplied by means of the market, of the state budget and are financed with either sales incomes (e.g. fees charged for the use of 1

For more details see: BROWN, C. and P. Jackson. Public Sector Economics. 4th ed., BLACKWELL, 1994.

Chapter V. The role of the state in the economy 59

a service) or tax revenues. Examples for such goods are public parks, public swimming pools, etc. In other words these goods are rivalrous and non-excludable (i.e. the excludability principle cannot rationally be applied). 2. The second group includes goods which are non-rivalrous and excludable. These are the so-called “goods with external effects”. They are produced by private companies, distributed by means of the market with subsidies or adjustment fees and financed with sales incomes. Examples for such goods are schools, private swimming pools, cable TV, etc. More generally, mixed goods are goods with personalised benefit (i.e. the individuals benefit from the goods) that can also be beneficial for the society as a whole. Consider education: the state is interested in its citizens to be better-educated and better-qualified and therefore participate in the production and provision of this good. On the other hand, individuals receive personal benefits from the consumption of that good. Under the conditions of equilibrium and perfect rivalry, where the optimal quantity of each type of good is produced, the conditions for marginal costs are identical to the equations for purely private and public goods. This means that the marginal cost for the joint good is equal to the amount that all individuals are willing to pay for the benefit of private and public goods consumption. Fees must be charged for the consumption of private values of the mixed goods, because: 1. No groups of individuals should be privileged in the consumption of a good paid for by the whole society; 2. The demand corresponding to such fees provides an index for the desired level of investment and monetary expenditures for the provision of such goods. 3. When the cost of providing additional capacity are proved to result from those who demand the good, the consumption fees serve as a rationalisation tool to limit the demand for this particular good. This stimulates the demand for alternative goods as well as to channel supply in areas that best meet the economic needs of each buyer. In other words, if the government acts as a distributor or a supplier of private goods, its aim is to compete with the freemarket providers, i.e. goods and services must be produced only if consumers are willing to pay the price asked for them. Where this is not done, the provision will be very expensive, i.e. there is no effective constraint on the demand for these goods. (Of course

60 Debt management

there may be reserves. Without consumption fees and some clear demand indicators, the government may not be willing to provide expensive goods or services for which consumers are willing to pay in full). The supply of public goods further raises the question of the private spending to finance public funds. According to Keynes “… government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.”2 Government itself is one of the most important public goods: a capable and efficient government benefits all. A good government has the two main characteristics of public goods:  everyone benefits from it;  it would be difficult and unnecessary to exclude any individual from it. The analysis of the efficient provision of public goods assumes that any redistribution carried out by the government in connection with the equitable distribution of income is achieved through the method of lump sum taxes. Such taxes do not distort the relative prices and therefore are neutral in terms of the efficient allocation of resources. These taxes are not used in practice. This means that the current tax system is associated with the so-called deadweight loss, i.e. the price paid by the taxpayer to obtain one unit of income through taxation is usually greater than one unit. This imperfection in the tax system means that when purely public goods are financed using the distorting taxes method, the Pareto optimality condition derived by Samuelson should be modified to: EMRSi + E (private spending on public funds) = MRT This means that private spending on public funds includes the price system distortions caused by the tax, the cost of the state to collect taxes and the costs incurred by the taxpayer to determine and pay the tax. This rule can be applied in the analysis of public benefits and costs, where the costs will include the costs of government. If these costs are included in the analysis, we shall see that the effective size of the public sector will be smaller than that defined with the traditional analysis of Samuelson, who has ignored these costs.

2

ROSEN, H. Op. cit.


2. Club goods The analysis of the non-pure public goods led to the development of the club theory. According to this theory, the club is an association of people who collectively consume a good which none of them could consume individually. Thus they aim to exploit the economy of scale – to share the costs with the other club members or to satisfy the need for interpersonal communication. The size of the club plays an important role. Each additional member reduces the average cost of the club good. Another question is to what extent the size of the club can increase without sacrificing the quality of services or benefits that members receive. Basically the problem of the excessive large number of club members may be solved by introducing a membership fee or restriction. Examples of such club goods are swimming pools, language courses etc. Typical here is that those who are not members of the club may be excluded from the benefit of good. The main feature of such goods is that those who are not members of the club can be excluded from the consumption of the goods. The classical club model of Buchanan included the following propositions:  the club can exclude the non-members of the club at no cost;  there is no discrimination among the club members as all benefits and costs are shared equitably. Buchanan’s club is a voluntary association and his analysis is focused on the development of a representative individual club member denoted as I, the consumption of the i-th individual of of private goods - yi, the non-pure public good X and the size of the club - s. Thus the individual’s utility function can be expressed as: max Ui (yi, X, s). The analytical problems are related to determining the:  optimal conditions for the club good;  the volume of good that can be provided;  the optimal size of the club. From the point of view of the debt management concept, the club theory generates valid solutions at municipal level, where the decisions regard the deficit financing of the local budget.

62 Debt management

Recommended additional sources: 1. BROWN, C. and Jackson, P. Public Sector Economics. (Bulg. transl. ed.) Sofia, RSSA, 1998 (ed. G. Manliev). 2. STIGLITZ, J. Economics of the Public Sector . (Bulg. transl. ed.). Sofia, Stopanstvo, 1996. 3. ZAHARIEV, A. Fiskalna detsentralizatsiya i finansovo upravlenie na obshtinite v Balgariya. Tsenov, // Biblioteka „Obrazovanie i nauka”, book. 13, Svishtov, 2012.

Keywords 1. Mixed goods 2. Excludability principle 3. Consumption rivalry 4. Pure public goods 5. Pure private goods 6. Equilibrium conditions 7. Marginal costs for mixed goods 8. Private spending financing public funds 9. Good government 10.Lump-sum taxes 11.Club goods 12.Club 13.Club size 14.Buchanan’s classical model 15.Analytical problems related to provision of public goods 16.Optimal conditions for provision of club goods

Questions for self-evaluation and discussion 1. What are the differences between mixed and the pure goods? 2. Describe the main types of mixed goods. 3. Describe the main reasons for imposing fees for the consumption of goods. 4. What is the role of the state in the process of the production and supply of public goods? 5. What methods for the efficient supply of public goods are you aware of and what is the level of their efficiency?


6. Comment on the main idea of Buchanan’s classical club model and define the level of its feasibility today? 7. What are the main problems related to club goods?

64 Debt management

Chapter summary Pure public goods are those goods which are non-rivalrous and either cannot comply with the principle of excludability or their compliance would be too expensive. Unlike the pure public goods, the pure private goods are rivalrous and excludable in terms of their consumption. Apart from the pure goods, there are also mixed types of goods that are neither purely public nor purely private. They can be classified into two groups according to the above criteria. The first group includes goods consumed collectively and are at the same time subject of overconsumption. These goods are provided by private companies or by the public sector, are supplied by means of the market of the state budget and are financed with either sales incomes (e.g. fees charged for the use of a service) or tax revenues. The second group includes goods which are non-rivalrous and excludable. Therefore mixed goods are goods with personalised benefits (i.e. the individuals benefit from the good) that can also be beneficial for the society as a whole. Under the conditions of equilibrium and perfect rivalry, where the optimal quantity of each type of good is produced, the conditions for marginal costs are identical to the equations for pure private and public goods. This means that the marginal cost for the joint good is equal to the amount that all individuals are willing to pay for the benefit of private and public goods consumption. We should not disregard the issue of financing the provision of goods. Individual consumers must be charged fees for the consumption of private values of the mixed goods. It is believed that if the government acts as a distributor or a supplier of private goods, its aim will be to compete with the free-market providers, i.e. goods and services must be produced only if consumers are willing to pay the price asked for them. Otherwise there will be no effective constraint on the demand for these goods. The supply of public goods further raises the question of the private spending to finance public funds. Government itself is one of the most important public goods. A good government has the two main characteristics of public goods: everyone benefits from it and it is difficult and unnecessary to exclude any individual from it. The analysis of the efficient provision of public goods assumes that any redistribution carried out by the government in connection with the equitable distribution of income is achieved through the method of lump sum taxes. Such taxes do not distort the relative prices and therefore are neutral in terms of the efficient allocation of resources. These taxes are not used in practice. This means that the current tax system is associated with


the so-called deadweight loss, i.e. the price paid by the taxpayer to obtain one unit of income through taxation is usually greater than one unit. The analysis of the non-pure public goods led to the development of the club theory. The club is an association of people who collectively consume a good which none of them could consume individually. Thus they aim to exploit the economy of scale – to share the costs with the other club members or to satisfy the need for interpersonal communication. The size of the club plays an important role - each additional member reduces the average cost of the club good or reduces the quality of the services or benefits that members receive. Basically the problem of an excessively large number of club members may be solved by the introduction of a membership fee or another restriction. According to Buchanan’s classical club model, the club can exclude the non-members of the club at no cost and there is no discrimination among the club members as all benefits and costs are shared equitably.

CHAPTER VI ANATOMY OF THE STATE REDISTRIBUTION FUNCTION

Introduction to the chapter This chapter describes the problems related to the intergenerational effects of the governmental financial policy. At the end of the chapter you will be able to:  analyse the effects of governmental decisions in the field of deficit financing;  discuss the relationships and dependencies between the budget balance and the volume of intergenerational distribution. The chapter includes two subtopics: 1. The methodology of state redistribution impact; 2. Budget balance and intergenerational distributions.

1. The methodology of state redistribution impact The intervention of the state on the economy is a process, the knowledge of which is a prerequisite for sound decision-making in the field of deficit financing and debt management. As a form of financing the budget deficit, public debt raises some questions as to the nature and extent of the intergenerational impact of governmental financial policies. For this purpose a two-generation model based on the neoclassical growth model is used. The starting point for such research is to analyse the general economic importance of the state tax and its transfer policy in terms of its impact on macroeconomic stability and economic growth. The common redistribution method of global transfer, results in a minimum macroeconomic capital base as well as a low overall level of social welfare (even in long-term equilibrium). In fact, a redistributive policy that leads to major economic consequences, such as the state budget balance, is difficult to describe with a single variable. For this purpose, we should look for another option which would allow a more objective evaluation of the effects of the government’s intergenerational redistribution. The theoretical

Chapter VI. Anatomy of the state redistribution function 67

basis for such a measure is the fiscal balance rule, which provides clear criteria for the implementation of an unbiased but efficient financial policy by the state. Research into the general-economic effects of the intergenerational distribution led to the following results:1 First, the economic activity within the generation’s model of a representative individual is characterised with individual distribution of their income at the time of its acquisition among the current consumption flows, and, by means of his savings – among future ones as well. Under these conditions, the labour supply of an individual household will depend on the wage level (i.e. the income of an economic agent at a certain time t amounts to wt.) His consumption at a young and an old age is denoted 1

2

1

respectively with c t and c t 1 and his savings at a young age with s t . The personal savings of the individual generate interest at the current interest rate rt 1 in such a way that his liquid assets and income from interest are available to cover his current consumption spending. The adopted redistribution policy provides for a uniform tax rate (z) for all economic agents and a common transfer in favour of retired agents. For each period the population growth is n. Throughout the lifetime of each young individual the state collects from taxes at the tax rate of z and transfers the whole amount to the old generation in the same period. Thus each retired economic agent receives a transferred amount of 1 n z . Therefore the budget constraints for the young and the old generation are respectively: (6-1)

w t  c1t  s1t  z

(6-2)

s1t 1  rt 1   z1  n   c 2t 1

The equations above are converted to yield the intergenerational budget constraint equation:

c1t

(6-3)

c 2t 1 r n z1  n    wt  z   w t  z t 1 1  rt 1 1  rt 1 1  rt 1

Therefore the aggregate expression of the value of consumption spending should be equal to the net income. This is actually an expression of the net salary after the deductions for the net transfers paid by the state throughout the life cycle. Notwithstanding the planned transfer payments to 1

The equations are adopted from: BOLL, S. Intergenerationale Umverteilungswirkungen der Fiskalpolitik in der BRD, Frankfurt, 1994.

68 Debt management

the old generation, the economic agents are taxed as the interest is foregone due to reductions in income capacity not paid. There is a parallel decrease in the taxation of the individual agents because as the population grows the transfer amounts per capita increase more than the per capita payment transfers for each generation. If the rate of population growth is lower than the interest rate, then the accrued interest on the contributions within this redistribution model will not be enough to compensate for foregone interest income of the payers of social security contributions. Therefore, the net value of the net payments of each employee to the state budget will be positive, and will accordingly decrease his purchasing power. In the opposite situation rt 1  n , population growth will contribute to the effect that the implemented policy of redistribution will actually not burden any generation. These correlations do not actually concern the retired generation at the time of the introduction of such a policy, as it receives the same transfers without having to pay any contributions. Thus, in all cases, this generation takes advantage of all social benefits. The consumption of this age group will comply with the budget constraint (6-2) and use the total amount of the transfer 1 n z above the initially planned level.







This

1

2



Second, each household maximises its utility function u t  c t , c t 1 function is based on the Cobb Douglas methodology:

  c 

u t  c1t



2 1 t 1

for (0i. If >I, then the deficit of resources cannot be sustained indefinitely because this would mean that the ratio D/X would have to increase indefinitely. If exports grow at a rate lower than the interest rate, an increasingly large part of export incomes must be set aside for debt servicing if we do not want the ratio D/X to increase indefinitely. This condition must be determined by creditors’ confidence regarding the expected behaviour of i over time, their uncertainty about the effectiveness of policies and perceptions about "over-indebtedness". If i

Andrey Zahariev DEBT MANAGEMENT

Andrey Zahariev DEBT MANAGEMENT

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