The demand and supply side of Public debt
Abstract
This paper analyses the supply and demand side of public debt in both domestic and global markets. It discusses the government debt in terms of private and severing borrowing to fill the budget deficit and this affect demand in financial markets. It also includes a review of various factors influencing the domestic demand for public debt and various related to such debts. An analysis of Greek crisis is done to explore where it related to supply and demand in domestic and global market. The paper concludes the trade deficit prompts an increase in public debt.
Introduction
In a mixed economy, the government spending, borrowing and raising of revenue – which informs the operations of public sector, plays an important role. The government spends its funds in various ways, including the supply of goods and services not provided by the private sectors, spending to improve the macro-economy through supply-side enhancements, for income redistribution and to increase the aggregate demand in the economy. The government expenditure involving deficit finance refers to a policy where the spending is increased without a corresponding increase in taxes or reduction of taxes without reduction in the spending[1]. The government is forced to raise the level of borrowing so as to sustain the policy, and this involves borrowing from the private sector through issuance of government bonds. In the financial market where the government borrowing takes place, the demand and supply laws also applies. The demand law holds that an increase in rate of return will lead to low quantity demanded. An increase in the rate of return or a favorable rate of return offered by the government will increase the demand for the government bonds in the market[2]. This means that more firms or individuals will be willing to buy the bonds and this provides the amount required by the governments. The deficits in the budget have some effects on the economy of a country. The classical deficit theory holds that the budget can lead to increased current expenditure by the government, which is offset by a reduction in investment. IF there is an increase in expenditure, there is reduction in savings which in turn makes the interest rates to increase and this then leads to a reduction in the investment.
Sovereign Debt
The effects of increased government debt due to deficits can present problems to the emerging markets, mostly because they are vulnerable to market volatility. The investors in government bonds pull sudden stops whereby they stop purchasing government bonds or begin selling the ones they hold. In the recent years, it has become apparent that even the market for government bonds in the advanced economies can also face investors’ outflows and related runs. In addition, some countries traditionally considered safe haven have seen historic drop in borrowing costs as they continue to face increasing inflows from foreign investors[3]. These countries exposure to public borrowing costs and refinancing risks is determined by those holding the government bonds, which represent the government debt demand side. Other aspects in the global economy like financial crisis affect the public debt especially the sovereign debt[4]. Amidst such risks, the foreign investors’ share in the public debt for majority of the developed economy has continued to increase especially outside the euro area. The cumulative share of the sovereign debt in an advanced economy was more than double in 2004 – 2011 periods from US $ 5 T to about US$ 12 T[5]. The major driving force was foreign nonbanks and central banks purchase of government bond. In the same period, ownership of the debt by foreign banks was basically constant at about US $ 2 T. Due to this, among many nations, foreign banks ownership of public debt reduced[6]. During the whole 2004-2011 period, the foreign investors share average of public sovereign debt rose to 62 percent from 50 percent for those low-spread area economies and for investors from developed economies, it increased to 31 percent from 20 percent[7]. For the traditional haven nations, the share of the sovereign public debt increased to 21 from 14 percent. At the end of 2009, the total foreign share of countries in euro areas mostly stopped increasing but later reduced to 35 percent from 60 percent at the time the area was experiencing debt turmoil[8].
Factors influencing domestic demand for public debt
During the 2007-2008 financial crisis, the share of domestic holding of public debt begun to increase in majority of the developed economies as a part of assets from banking sector and in nominal terms. Such an increase is mostly seen in euro area where the debt held by local banks rose to around 20 percent from about 15 percent of overall GDP[9]. The rising demand for the government debt from domestic investors especially banks is worldwide phenomena and this seems to suggest that common aspects are the likely cause. While quantifying the relative significance of every aspect is difficult, the role they play after the financial crises seems to be quite important. These include the global recession, deleveraging of banks, more financial regulations and increasing home bias for the loan. The low economic activity due to financial crisis in 2008 and resulting weak growth in private sector especially in developed economies led to reduction of demand for loans offered by banks and hence, the banks started to accumulate government debt[10]. The deleveraging of banks in the developed economies after the crisis possibly made banks to focus their investment towards government debt so as to minimize risks related to their assets. Such a motivation is brought about by the fact that debts issued by local debts are subjected to Zero Regulatory Risk-weights[11]. The local banks possibly raised their demand for public debt due to efforts to enforce various regulatory changes in whereby stricter liquidity and capital standards and increased need for collateral are required[12]. As aforementioned, there seems to be a more bias for local banks, specifically those in euro area. The increasing demand for the public debt among the local investors can be related to market uncertainty given that investment in government bonds attracts lower risks than in other areas.
Issues with Public Debt
Many economists hold on to their idea that a bit of government debt can be important and at the same time not affect the economy negatively, but such ideas change once there is a rise in debt levels. An increased rise in the government debt can cause problems to the economy since the repayment has to be done. This involves paying the interests on the bonds from the government budget. The interest rates levels have been reducing since 1980s and have reached low since 2008[13]. With low interest rates, the government can operate a budget deficit since its inexpensive especially if the expenditure is on investments that will have more multiplier effect. For instance, in case of infrastructure spending where the multiplier is 2, 200 billion spent would lead to creation of 400 billon as overall economic activity[14]. The gain from such will probably be large than cost of repaying the debt due to low rate of interest and this leads to positive net gain. Concerns arise when there are concerns by bond holders about the government’s ability to repay the debt. The likely effect is an increase in interest rates in the market as they seen a huge risk and can either result in reselling the bonds or seek for higher rates of interests which can justify the risk of holding such bond[15]. Such an issue is common among countries that are considerably less wealthy in comparison to countries with advanced economies. In case of financial crises, countries whose global GDP share is small have little ability to solve their debt problems. They are not even able to convince bond holders that they are able to continue repaying the interest on debts while debt level rises during this recession[16].
Countries can repay their debt in two ways, which consists of debt monetization or tax revenues. An increase in taxes with an aim of meeting the requirements to service the debt may hurt a country’s GDP since taxes can lead to investment and consumption reduction. The only safe way is to pay the debt when the budget has a surplus or is balanced and even in such a situation, the repayment of the whole debt can take long[17]. In addition, cutting back government expenditure which is also required to have a balanced budget may lead to further depressing of the economy. Such a problem has affected the Greece and led to great political conflict. Monetization of the debt basically means printing more money. In monetizing the debt, treasury bonds would be sold, which would then be bought by Federal Reserve and interest on such debt would be repaid by the Treasury department[18]. In this case, the Federal Reserve would give back the interest paid on debt to Treasury after deducting expenses and in this money, more money is printed for repaying off the debt. This process may increase the threat inflation since it lead to higher supply of money in the economy. However, some economists argue that increasing inflation with a small percentage can have positive impact on the economy since in an economy experiencing depression or recession, the deflation threat (reducing prices which may cause further business activity depression) can be countered by use of inflationary forces[19]. The debt monetization option can only apply to the counties than can control the debt denomination currency. In countries like Argentina and Greece whose debt was in dollars and Euros respectively such an option was not available[20].
The Case of Greek Crises – Supply and Demand
The unfolding of 2008 financial crises brought about a striking rise in public debt in various advanced economies. The market crisis involving US mortgage loan in 2007 transformed into a sovereign debt problem especially in the euro zone[21]. The large increment in public debt could be related to governments’ efforts to minimize private debt level whose accumulation over the years preceding the crisis was quite great. Various issues can be observed from the crises: substantial increment in debt crisis in euro zone during some periods and high reduction of private debt in other periods; private debt increased during economic booms at high rates; during the entire period, private debt increased considerably than public debt; the private debt increased at an yearly average of about 35 percent among euro zone countries[22]. In Greek , a rise in public expenditure in years preceding the 2008 crisis brought about increased need for borrowing and hence, high accumulation of public debt. The level of the debt amounted to € 298.5 billion, while the ratio of debt to GDP continued rising, which was also increased by EU rescue package of € 110 billion and was then projected to go beyond 150 percent by 2020[23]. The problems in increased public debt can be related to reduction in consumption and productive activities in the market which meant that even taxation could not take care of the expanding government expenditure. In addition, Greek has an economy whose structure is distorted such that economic activities are concentrated in few individuals and this lead to price inflexibilities[24]. The wage cuts and fiscal strictness adopted by the country lead to a dangerous reduction in demand, leading to recession and increased unemployment. The restructuring of sovereign debt in 2012 failed to solve the huge public debt in the country. This shows that large amount of debt was an effect rather than a cause of the crises. The problem can be related to both demand and supply; supply issues have persisted since the country joined EU in early 1980s; the demand issues were a result of financial strictness and reduction in wages which reduced the rate of consumption[25]. The fiscal austerity adopted brought about more negative multipliers and a great reduction in the economy’s output. While internal depreciation helped the exports to some level, the wage cut that initially caused this together with unstable prices caused large fall in domestic demand. Even the adopted structural reforms failed to solve the situation because its scale was limited[26]. The falling exports lead to high trade deficit in the country which eventually translated into increased public debt. In addition, the reduction in productivity and wage costs resulted from great reduction in aggregate demand and even investment. In the Euro area, the formation of fixed capital in 2014 was almost 19 % of overall GDP, and this was a bit lower than levels observed before the crisis[27]. However, in Greek, the formation of fixed capital fell from over 20 % in periods before the crisis to almost 16.3 % during 2009 period and in 2014, it fell to 8 %. The construction of residential houses made up the largest portion of the decline[28]. In addition, the nature of Greek economy is such that it is not as open as others in the euro zone and is vulnerable to many frictions in comparison to countries like Portugal and Ireland. In an economy like Greek, fall in prices does not occur and aggregate demand fall due to wage decrease bring about aggregate activity contraction and hence, unemployment. There reductions in wages were indicated by the larger increase in profit margin instead of being reflected by prices’ reductions[29].
In terms of public debt, the risks posed by economic hard ships due to fall in aggregate demand and country’s investment indicated a maturity profile that is not convincing. The government could not convince the bond holders than with prevailing status of the economy it would repay the loans. This made the investors to seek for higher rates of interests so as to lend additional funds to Greek. With the onset of the credit crunch, the public debt continued increasing especially driven by the ability and willingness of the government to implement fiscal structures that would help the situation[30]. The discussion helps in highlighting various important points. The high borrowing by the Greece government from abroad with an aim of funding deficits in current account and government budgets left it with high level of external public debt. The economic structure of the country was vulnerable to various frictions, which is seen in reduced aggregate demand, productive activity and level of exports. The holders of the bonds demanded high interest on the debt given the kind of risks they were exposed to and this further worsened the situation. In addition, the level of Greece external debt and budget deficit way above the normal rules established by Economic and Monetary Union of EU, so that there was that the expected 3 percent and 60 percent of GDP respectively was not observed[31]. In addition, the high government expenditures and with not corresponding strength in government revenues lead to the crisis. In a period of years, there was an increase in central government spending of 87 percent; revenue growth was only 31 percent which lead to the aforesaid deficit[32]. The various structural policies in the country are also so rigid that they lower its international competitiveness – in terms of wags and reduced productivity – ad the major factor[33]. The reduced growth in exports in comparison to other countries increased trade deficit. The borrowed funds were mostly directed to current expenditures and little was used in improvement of productive investments for generation of future growth, competitiveness and creation of new resources that would be used in the repayment of debt.
Conclusion
The above discussion shows how the accumulation of trade deficit can lead to crisis in public finances. In an ideal case a country is having no trade deficit and government expenditure is covered by taxes, while exports values equal exports value. However, the world economy is vulnerable to internal and external factors that affect aggregate demand, productivity and international competitiveness of a country. In case there is recession among other countries, the demand for exports from the country will fall significantly. In case the imports demand remains constant, a trade deficit would develop since exports are lower than imports. The increasing trade balance will affect the demand in the country which will lead to reduced output and unemployment. To prevent such a scenario, the government borrows more money with an aim of making up for the lost exports and this leads to debt accumulation. The trade deficit can therefore, lead to budget deficit which is then financed through borrowing.
References
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Gennaioli, N., Martin, A., & Rossi, S. (2014). Sovereign default, domestic banks, and financial institutions. The Journal of Finance, 69(2), 819-866.
Herndon, Thomas, Michael Ash, and Robert Pollin. "Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff." Cambridge journal of economics 38, no. 2 (2014): 257-279.
Karagöz, K. (2013). Determinants of tax revenue: does sectorial composition matter?. Journal of Finance, Accounting and Management, 4(2), 50.
Perry, Nathan .Debt and Deficits: Economic and Political Issues. Tufts University. 2014
Vlamis, Prodromos, and P. Kouretas Georgios. "The Greek crisis: Causes and implications."
Vlamis, Prodromos, and P. Kouretas Georgios. "The Greek crisis: Causes and implications." Panoeconomicus, Vol 57, Iss 4, Pp 391-404 (2010) no. 4 (2010): 391
YANNIS M., IOANNIDES, and PISSARIDES CHRISTOPHER A. "Is the Greek Crisis One of Supply or Demand?." Brookings Papers On Economic Activity (2015): 349. JSTOR Journals, EBSCOhost
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