Dr. Workie on why Public Debt is so frightening

Business and Management Associate Professor Dr. Menbere Workie is publishing a monthly commentary on economics and finance in HN Komentare, the most readable Economic Newsletter in Slovakia and the Czech Republic. His latest commentary was dealing with the question of why public debt is so frightening:

Why is Public Debt So Frightening?

There is a number of questions related to public debt with focus on its implications for economic growth. In principle, governments have two options to raise additional funds: increasing taxes or increasing public debt by borrowing.  

How does a public debt affect an economy? If a government opts for financing its spending by adding to public debt, in the short run this may stimulate aggregate demand and help to generate short-run economic growth. However, in the long run mounting public debt may have an adverse impact on the economy through various channels. Interest rate is often an increasing function of debt, hence resembling the rule of „eye for eye and tooth for tooth“. Higher interest rate increases the cost of financing for the government itself and contributes to a decline in private investment. This is because higher interest rate increases the cost of financing for the private sector via a crowding-out effect, eventually decreasing economic growth. As someone described it accurately „interest rates on debt grow without rain“.

High public debt, in addition to discouraging private investment, may also discourage private consumption and encourage private savings as the private sector may perceive high public debt today as a signal for higher taxes in the future imposed in order to repay the public debt. This will then slow down economic growth. Unsustainable public debt could also adversely impact an economy through monetary policy if debt is monetized and contributes to rising inflation.  While inflation decreases the real value of public debt, it also decreases real income and consequently consumption and investment.

High public debt may also give rise to the loss of fiscal discipline under the circumstances when a government increases public debt without parallelly increasing taxes and hence keeping the response of the public to the government spending behavior neutral. Nonetheless, this behavior is unlikely to be sustainable in the long run and would require a radical reform in public finance at some point with far-reaching ramifications to the political environment as well as the credibility of the country. In extreme situations, unsustainable public debt would lead to a loss of sovereignty as a debtor country would have to follow the terms and conditions imposed by creditors.

Argentina and Greece are good examples where unsustainable public debt followed by radical reforms in public finance lead to political instability. This said, nonetheless, if public debt is sustainable and a country has higher degree of creditworthiness and public debt does not lead to the aforementioned distortions, it should not be a priori demonized.  It is not the size of public debt but its sustainability in a continuously changing global economic landscape that eventually matters.