Vol 4 Issue 5 by Juliana Foo

DEBT FREE DEBTFLATION AUSTERITY

VOLUME 4

ISSUE 5

THE DEBT ISSUE

THE CHAINS OF DEBT MICRODEBT DEBTFLATION OR INDEBTED?

ECONOMICS BROUGHT ALIVE!

38 REGULARS 03 From the Editor’s Pod 24 Essays Re-Modelled

Check out our essays on budget deficit—a common starting sign of a more long-term problem of debt, as well as a microeconomic essay on banks— the conduit for this whole concern over debt. Reinforce your understanding on the debt problem by putting content you have read to essays written by top students and re-vamped by our teachers to improve your own essay writing skills.

Editor-In-Chief

Juliana Foo juliana@mindlevereducation.com

Design Director Mark Jason Vargas

Contributing Writers Juliana Foo Jaclyn Wee Tricia Wong

Printer KHL Printing Co Pte Ltd Insights Magazine is published by MindLever Education Centre Pte. Ltd. All rights reserved. No part of this magazine may be reproduced without the written permission of MindLever Education Centre Pte. Ltd.MICA 128/08/2010

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THE DEBT ISSUE

32 FEATURES On the Cover

18 Counting and Assessing Debt

A problem isn’t a real problem until it’s been studied and examined. Data and statistics are useful, but we have to use them with caution. Though data sets can be used to tell one story, they can sometimes tell different stories if used correctly. Such is the situation when we try to understand the world’s debt problem. Is it really that bad? Are there economies that seem to be in a bad debt situation but could have a rosier outlook through the numbers? Learn the skill of interpreting data with care.

04 Microdebt

Though sounding similar to the term MicroFinancing—a program targeted at offering loans to the poor to get a better life—we look at the topic of borrowing and debt from the bottom up through the perspective of the entities that take out the loans, firms. Why do they take out loans, which firms tend to take on more debt, and what happens when loans can’t be repaid? Are there exit paths similar to those available to countries on a macro level? We’ll look at the problem of debt from a bottom-up approach!

10 10 Debt-Free

A word that brings smiles to many, but a word that seems highly elusive in today’s world, where debt seems to be the norm. Is being free from debt a dream that can’t be reached or can it really be attained? If so, how can it be done? What about past economies that have been paralyzed by debt? What was the final remedy, and can these cures be used to solve today’s debt problems?

32 Chains of Debt

Debt clearly has its costs, but are the costs of debt really so dear that all countries will begin a downward spiral once debt is accumulated? We look at the relationship of debt on the economic growth of a country and learn how debt, if allowed to fester, works like a leech, sucking away the GDP of the country in debt and sparking a domino effect among other faltering economies.

38 Debtflation or In-Debted?

Debt has a direct outcome on economic growth, but what about on inflation or general price levels? Is there a clear relationship between debt and inflation, or the other way around? We take a different perspective to the debt problem by focusing on aspects other than growth.

Downloadable mindmaps & review worksheets available from http://insights.mindlevereducation.com

FROM THE EDITOR’S POD

e are living in a time whereby the past is catching up with us. Past eras of profligacy and unchecked spending are starting to weigh down on the present. Well, the good thing about a debt problem is that it seems as if countries that have allowed such excessive spending to take place are paying a high price for allowing such a debt amount to add up. The countries that are the source of the debt problems are seeing a situation that has been allowed to brew and then manifest its full negative consequences in the past few years. Those countries are

counting the costs of past excesses and are associated with debt, we’ll present them to experiencing prolonged unemployment you in this issue on debt. and sluggish growth like never before. The We count the costs on the economies price of wanton profligacy? of those with debt in the two articles: “The The cost, however, isn’t confined to Chains of Debt” (pg. 32) and “Debtflation the countries with debt. Given the close or In-Debted” (pg. 38). We also want to integration of countries in this age understand just how bad the situation of globalization and given that these really is—on an absolute scale and also economies together make up a huge on a relative comparison level between portion of global GDP, their problems countries. We also look at how realistic it is become a shared world problem. Debt to think that a country can be debt-free in in today’s era turns into a global crisis, “Counting and Assessing Debt” (pg. 18). affecting all nations. The damage is done In the article “Debt Free” (pg. 10), we and the world is now looking at how to look at the present day problem of debt contain the problem with the least damage relative to past debt crises to gain a better to the world economy. understanding of the severity of today’s Being able to witness such a grand debt crisis. Finally, we take a microscale economics problem of a debt crisis perspective look at debt by looking at firms, could be a once-in-a-lifetime experience. borrowing, and debt in “MicroDebt” (pg. 4). Let’s just hope we don’t bear too much of Your Editor-In-Chief, the economic pain from the potentially Juliana Foo damaging economic costs if such a problem does get out of hand. For all the negative headlines and negative outlook THE DEBT ISSUE

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hen examining the issue of debt, we often take a macroeconomic perspective to the problem, looking at measurements such as the debt to GDP ratio (the amount of interest a country needs to pay for loans). While looking at the macroeconomics perspective gives important clues on an economy-wide basis, failing to understand the problem from a microeconomics perspectives (from the individual firm level) will compromise our understanding of the problem. That is what this article hopes to cover—the lesser known aspects of debt, loans, and borrowing at firm level compared across industries. As we look to understand the act of taking on loans by firms, we cannot ignore the centerpiece in all these activities—the banks that accept deposits and dish out loans. It was in the not-so-distant past (2008) that we saw

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microdebt big banks in developed countries facing a crisis never felt before. Was it related to the loans given out by those banks to firms? Let’s see! Firms are producers that undertake the risk and effort to organize different types of factors of production in different combinations to offer goods and services in return for profits. Different firms take on different levels of risk as they foray into different types of industries. Some industries will require more financial capital while other less, so the corresponding level of risk will differ. How are firms spreading these risks? What are the mechanisms available for firms to leverage what they have and increase the risks?

COSTS IMPLICIT AND EXPLICIT

Land, labour, and capital are the essential factors of production deployed by a producer to produce different types

of output. Land refers to resources provided by Mother Nature itself— unspoiled minerals. Capital refers to manmade resources, such as machinery that aids in the production of goods and services. Labour works with the resources of land and capital to generate output based on the direction of the enterprise. In the process of acquiring land, labour, and capital, financial ability to purchase these factors of production will be required. But where does the financial capital for all these come from? In setting up a firm, upfront costs cannot be avoided and the financial capital can be from a producer’s own savings, in which using it entails an implicit cost to be added to the cost of production. An entrepreneur using $100,000 of his own savings to finance the acquisition of the various factors of production will miss the chance of putting that $100,000 in a bank to earn interest. The interest earnings forgone

KEY POINTS OF QUERY Why do firms seek loans? Do firms in certain industries tend to borrow more? Do large firms or small firms require more borrowing? What happens when firms take on too much debt?

are then implicit costs to the firm to be added to the total costs of production. Otherwise, a firm will need to borrow its startup financial capital from a bank. The interest charged for borrowing money will become an explicit cost to the firm. In the real world, other avenues of raising the financial capital include getting investors to plough in money, known as venture capital or seed funding. This applies to small and medium sized firms as raising financial through more complex means such as selling shares of the company through listing on stock exchanges is not an easy option. Besides needing to raise financial THE DEBT ISSUE

SKILLS capital when first establishing a business, loans are also required for various needs, such as maintaining inventory, expansion of business, purchase of new machinery, research and development programs, or marketing projects.

TENDENCY TO BORROW BY INDUSTRY

When understanding the nature of business loans, we need to realize that firms have varying natures. The tendency to borrow varies widely across the industry in which a firm does business as well as the size of the firm. Does a large firm require more loans or does a small firm require more? Looking first at the industry’s nature and the need for loans, we would expect the need for loans to rise with the capital intensity of the firm. A firm requiring a huge amount to build facilities and to purchase machinery would require a bigger amount of financial capital and a need for loans, since the ability to have that initial pool of a few million dollars would be rare. Industries such as construction and capital intensive manufacturing require large amounts of loans for the purchase of specialized construction equipment. Transport companies such as shipping and airline companies would also need loans to purchase costly ships and aircraft. With this understanding, let us look at Figure 1 to see if this concurs with what

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has been explained. Even though, from Figure 1, certain industries see a greater need for loans due to the need for expensive machinery and technology (such as building and construction), the amount of loans shown in Figure 1 is not simply a function of a firm’s demand for loans, but also an outcome of supply of loans. The supply of loans given to any particular sector can be controlled through government intervention. Governments can encourage the disbursement of loans to priority sectors or curb loans to non-productive areas, such as when companies borrow money to channel into real estate speculation. The Chinese government, at the start of 2010, had to set curbs on banks giving out loans to sectors already having overcapacity. Due to a stimulus package

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rolled out in 2008 (Qiaoyi, 2010), many infrastructure projects were rolled out, and in competing with rivals, many steel, chemical, and cement Firms driven by an optimistic outlook may overestimate the returns from investment and since the cost of borrowing was low – this made projections on investment projects even more profitable.

factories were overzealous with their expansion plans, taking on loans to further expand capacity even though there was idle capacity. When supply capacity increases without corresponding increases in demand, greater problems await. Loans in China had to be redirected towards the automobile industry, where capacity was running at nearly full levels.

EVEN THOUGH, FROM FIGURE 1, CERTAIN INDUSTRIES SEE A GREATER NEED FOR LOANS DUE TO THE NEED FOR EXPENSIVE MACHINERY AND TECHNOLOGY (SUCH AS BUILDING AND CONSTRUCTION), THE AMOUNT OF LOANS SHOWN IN FIGURE 1 IS NOT SIMPLY A FUNCTION OF A FIRM’S DEMAND FOR LOANS, BUT ALSO AN OUTCOME OF SUPPLY OF LOANS.

FIGURE 1 BANK LOANS AND ADVANCES TO NON-BANK CUSTOMERS BY INDUSTRY (AT END OF PERIOD)

Governments also often set directives on loans to be given out to priority sectors that are identified as key industries for growth, such as green industries. Where loans get disbursed is also determined by where banks are willing to make loans. Banks with an aim of increasing the returns from money lent out will extend loans to sectors where the risk of default is low and to growth sectors where corresponding demand for loans will be high.

OVERZEALOUSNESS WRONG DECISIONS

It’s generally a good thing when loans are channeled to productive uses, such as the building of new plants and discovering new technology, compared to non-productive loans for purchase of real estate in a bid to cash in on rising housing prices. However, trends that appear to be good on the surface can in fact be detrimental to the economy. Too many loans taken by firms in an overzealousness of increasing plant sizes can be a time bomb waiting to explode and have detrimental effects on the wider economy.

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Source: Monetary Authority of Singapore

When firms are already sitting with idle capacity, with factories running at half the optimal capacity, firms can easily meet any sudden rise in demand by upping production levels without facing any constraints. The supply of its goods will still be fairly price elastic. Why then do firms still look to expand in the face of idle capacity? Sometimes it boils down to over-optimistic outlook of the economy. Expecting demand for a product to rise dramatically, firms invest in multi–million dollar plants, yet demand can never ever rise to those levels. Sometimes it’s driven by the need to lower long-term production costs. Firms may want to upgrade production techniques and invest in a new facility. The deal with production facilities is also that there are minimum levels that make sense. It’s basically economies of scale, whereby the cost difference of building a smaller and relatively larger plant size is not too large. Firms can easily get Banks, in minimizing their losses, will take any capital goods or inventories to sell off and recover whatever value of loan outstanding from these assets.

swayed into opting for bigger plants. This is especially true when the cost of borrowing is low and the cost difference of interest repayments to the bank of a larger loan is not significantly larger for a bigger plant. With so many factors favoring a larger plant and in the heat of keeping up with competitors, firms want to take on expansion despite current underutilization of resources. If projections go through and demand rises, the firm with the foresight to take on expansion will have the final laugh. Yet if the projections fail, firms face the cost of miscalculation, a high cost of servicing loans and a low level of output will raise the per unit fixed costs of production. The larger than needed manufacturing plants also need servicing and maintenance, which adds to the firm’s operational costs. If the firm’s revenue cannot cover its cost of production and its loan repayments, it finds itself indebted and banks seeing this situation may force the firm to shut down, as the banks want to reduce risk and get back as much of the loan as early as possible. THE DEBT ISSUE

SKILLS A firm can always try to get rid of its expanded plant, but bear in mind that there are also high costs of exit. Firms need to sell off and may engage professional help in finding the right buyer, which involves cost as well. If the problem of overzealousness is confined to only a few firms, the negative impact can be restricted to individual firms. The problem is that such overzealousness often takes place within firms of an industry as intense competition drives the need to keep ahead and overrates the benefits of expansion. If firms within an industry all take on extra capacity, the industry will be plagued by the problem of high debt and high default if the expected industry boom does not materialize. The industry will then see a sudden increase in supply, The increase in capacity and sudden increase in output produced will cause a slump in prices. Given the sudden increase in industry output, prices will plummet, causing revenues to fall tremendously.

with demand failing to keep up, leading to excess supply and prices going into freefall, driving down profits and forcing firms to exit in the long run. Firms taking on excessive loans are the start of a brewing of the boom-and-bust cycle seen in many industries, such as cotton, e-commerce, and steel.

TENDENCY TO BORROW BY FIRM SIZE

Besides the type of industries and their need for loans, another way to look at

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the nature of firms and loans is the size of firms. Which types of firms have a greater tendency to borrow? Large firms or small firms? Banks favor lending to bigger firms since they are perceived to be financially sounder and the risk of large firms defaulting on their loans will be low. Whereas medium and smaller firms are not as established and can easily run into negative profits when new competitors arise, lending to such firms is considered riskier. In fact, larger firms are perceived as better clients that enjoy lower cost of borrowing as the amounts of loans are larger, the profits to banks from a big loan are higher. This tendency for loans to be given to large firms has led to medium and small firms experiencing difficulty getting loans when they in fact have a greater need for them. Why? With less surplus profits from years of operation, these firms have less to fall back on or lack the financial capital needed to undertake expansion or the marketing needed for them to stay ahead. So smaller firms, though having a greater need for loans, have less access to loans.

This lack of loans is addressed by governments seeking to give aid to smaller firms to encourage more entrepreneurship and to increase the level of competition in the domestic economy by making loans accessible to smaller firms and keeping them alive. Programs offering “soft loans” offer preferential or even interest-free loans for specified purposes, up to a given limit. In Canada, for instance, firms with annual revenues of less than $5m qualify for such loans. A government policy to render assistance to small firms becomes even more important during a recession. As seen in Figure 2, the amount of loans given out by banks falls in a post-recession period. In the shaded bars, indicating times of recession in the US, the dollar value of loans fell correspondingly. Supply of loans evaporates in a recession as income levels fall and absolute savings amounts fall, even though the marginal propensity to save increases. Likewise, shrinking profits means firms have less surplus to offer up as supply of loans. On top of that, demand for loans increases during a recession as firms with negative profits depend on loans to stay afloat. Profitable businesses may face cash flow problems, as expenses are to be paid out first and it takes longer to collect revenues owed to them. Again, this problem is especially acute for smaller firms with little to fall back on. Governments come to the aid of small firms by extending loans, as in almost every country the SMEs make up the bulk of employment in a country.

These days, we have seen recessions bring down not only small companies, but also big firms, from big global banks to giant airlines. THE DEBT ISSUE

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BANKS FAVOR LENDING TO BIGGER FIRMS SINCE THEY ARE PERCEIVED TO BE FINANCIALLY SOUNDER AND THE RISK OF LARGE FIRMS DEFAULTING ON THEIR LOANS WILL BE LOW.

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Certain industries have been so mammoth in their need for loans and industry performance in terms of profitability has dipped so much that meager banks are unable to offer the type of financial assistance that such firms in the industry needs that they have received loans directly from governments. Collectively as an industry, each firm in the industry has been unable to keep afloat as every firm has been riddled with negative profits, quarter after quarter. Such was the case for the US automobile industry as US$25 billion worth of loans to the auto industry was seen as a much-needed lifeline from the government. More recently, the airline industries across the world, regardless of nationality, have also sunk into deep trouble as profits dived and remained

negative. From Air India to British Airways, the industry has performed terribly and has put out calls for government bailout or aid. Besides being singled out for special assistance from the government, industries have also been given special access to loans as these industries have been identified as growth industries. In 2011, China introduced policies to curb loans given out for the purchase of houses and to prevent excessive liquidity in the system. To ensure that such a policy would not hurt the need for loans in productive areas such as in the growth of firms, the Industrial and Commercial Bank of China announced that it would double the amount of loans given to China’s key strategic industries, such as high end manufacturing, the service industry, and the green sector (Xiang, 2011).

FIGURE 2 BUSINESS CYCLE AND SUPPLY OF LOANS

RISK APPETITE

When it comes to the motive for firms to take on loans, the nature of an industry and the nature of a business in terms of cash flow play a role in helping us understand the tendency to take on those loans. Yet there is also the inexplicable aspect of the risk appetite of firms, ruled by what Keynes termed the “animal spirit”. Some firms have an aversion towards taking on more loans. Prudent firms fear borrowing and can be hesitant about expansion plans. Conversely, firms that are overzealous take on too much and end up riddled with debt. Banks thus have an crucial role in giving out loans to the “right businesses”. It’s a task that is not simple, since banks give out loans with imperfect information, such as whether the management of the firm is making the right decisions, cutting costs, etc. Despite being an uphill task of issuing loans to the right firms, giving out loans is an important lubricant to a healthy, growing economy. It is not good for an economy to have excessive idle funds lying around instead of being allocated to firms that are in need of such funds. BIBLIOGRAPHY Qiaoyi, L. (2010, January 06). Global Times . Retrieved July 10, 2012 , from Global Times : http://www.globaltimes.cn/business/chinaeconomy/2010-01/496498.html Xiang, L. (2011, March 7). China Daily. Retrieved July 9, 2012, from China Daily: http://www.chinadaily.com.cn/ china/2011npc/2011-03/07/content_12125848. htm

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magine if a government has plans KEY POINTS OF QUERY to expand the current rail network, What determines interest rates in an economy? but there is insufficient tax revenue Why do countries facing debt face different levels of crisis? in a single year to finance the How can a country work towards reducing debt? entire project in one go. Or if an When is a debt crisis more severe in terms of its negative consequences? entrepreneur wants to set up a new restaurant but does not have enough In this article, we will look at the THE ECONOMICS OF LOANS: capital to purchase the furniture and microeconomic theory of loans—what DEMAND, SUPPLY, AND THE cooking equipment. Or if a student influences demand, supply, and the INTEREST RATE without the financial means to pay “price” of loans. Of course, theory is Loans are no different from any other college tuition fees but believes his obsolete without application so we will good or service in the economy. They future job will earn him enough to do so. put the theory to the test in analyzing are affected by demand and supply, and The usefulness of loans in an economy case studies of Japan and the Eurozone a “price” that borrowers have to pay in permeates every level of society, whether sovereign debt crisis. We will then take order to get access to loans. They closely it is a government issuing new bonds it a step further and question whether resemble services—the provision of or you borrowing ten dollars from your it matters who the lenders are. Is a loans is essentially a service provided by friend because you forgot your wallet. sovereign debt crisis easier to solve than lenders to borrowers. Lenders provide a Loans play an important role in ensuring a domestic debt crisis, or is the euro just certain amount of funds to offset upfront a smooth functioning of an economy and an anomaly? These are questions that will fixed costs, such as the purchase of are often described as the lubricant that be answered by the end of this article, so production machinery, in exchange for a keeps the gears of an economy turning. without further ado, let us begin. token fee—the interest rate.

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Though this theory is not a syllabus requirement, it is still good to have a basic understanding of it, as it serves as an extension of the basic demand and supply model used in the goods market.

Here, you can look at the interest rate as the marginal cost of borrowing, as a higher interest rate would mean higher debt-servicing costs, or the marginal benefit of lending, as a lender would have higher returns when the interest rate is higher—much like the role of prices in the goods market. Hence, much of the microeconomic theory that has been covered under demand and supply of goods applies to loans as well. We call this the Theory of Loanable Funds, where we analyze how the volume of loans and their interest rates are determined in an economy. THE DEBT ISSUE

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by lenders. These include the affect demand and supply (Figure 2). We supply of credit by banks, credit are unable to cover each of them in detail, SS SUPPLY OF CREDIT card companies, investment but take some time to question and banks, and also includes “indirect understand the effects of these factors lenders”, such as the purchasers and see if you can come up with a few of interest-bearing financial more. assets like government and With this model, we can now attempt corporate bonds. Here, a higher to understand the situations in the interest rate is likely to cause financial markets around the world the supply of credit to increase, and why certain countries have such DD as lenders now earn more from high investments while others have DEMAND FOR CREDIT REAL SS supplying loans, and the higher skyrocketing interest rates. But first, here Volume INTEREST SUPPLY OF CREDIT of Loans RATE rate of return is more likely to are a few limitations and warnings about exceed any opportunity cost of the Theory of Loanable Funds. The two major QUALITY determinants of the FACTORSthe lenders. Similar to demand, a change FACTORS AFFECTING AFFECTING QUALITY OF CREDIT DEMANDED total volume of Loanable Funds in theOF CREDITinSUPPLIED interest rate would lead to a movement A COMMON INTEREST RATE Real interest rate rate economy and the interest rate are the Real interest along the supply curve, while a change in The sheer range of interest-bearing FACTORS AFFECTING DEMAND FOR CREDIT Funds. FACTORSother AFFECTING SUPPLY OF CREDIT Demand and Supply of Loanable factors would result in a shift of the financial assets in an economy means The demand curve, indicated as DD supply curve (Figure 1). that there is no single interest rate that in the diagram, is downward sloping Putting demand and supply together, encompasses all loans. Corporate bonds and represents the demand for credit we can see how the two factors interplay tend to have higher interest rates than DD by borrowers. This encompasses all in allowing the loan market to function. DEMAND government bonds due to the risk of FOR CREDIT aspects of borrowing in the market, such When the government runs a budget default, and student loans might be Volume of Loans as consumer borrowing (credit card deficit and is forced to issue government offered at lower interest rates than other loans, house mortgages, student loans, FIGURE 2 FACTORS AFFECTING DEMAND FOR AND SUPPLY OF LOANS etc.), corporate borrowing (corporate FACTORS AFFECTING QUALITY FACTORS AFFECTING QUALITY bonds, etc.) and government borrowing OF CREDIT DEMANDED OF CREDIT SUPPLIED (government bonds, treasury bills, notes, Real interest rate Real interest rate etc.). Note: Private equities and the secondary FACTORS AFFECTING DEMAND FOR CREDIT FACTORS AFFECTING SUPPLY OF CREDIT dealings of previously issued bonds, be they corporate or government, do not constitute a change in demand or supply of loans. The former is essentially a purchase of a stock or an asset in a company and there is no “debt” that has been incurred. The latter is merely a bonds, the government is demanding consumer loans due to governmental change in ownership of the loans with credit while the purchasers of the bond policies attempting to encourage further no change in the principle amount to be are supplying credit. When a credit education. As such, the single interest repaid. card company issues a credit card to a rate predicted by the Loanable Funds The inverse relationship between the consumer, the consumer is demanding model is more a proxy for the average interest rate and the volume of loans credit whenever he uses the card and the interest rate in the whole economy and demanded is logical, as the higher company is supplying credit. not a direct representation. However, the interest rate, the higher the cost The interest rate comes into play to the model remains useful in predicting of borrowing and fewer individuals ensure that the market is at equilibrium, potential shifts in the interest rate or and firms would demand loans. Each with the volume of loans demanded volume of loans. individual or firm may also choose to and supplied being equal. If the quantity take a smaller loan. For example, you of loanable funds demanded exceeds REAL, NOT NOMINAL RATES would be creating a demand for loans the quantity supplied, borrowers For the purpose of this article, the use when you approach the bank to take would bid up the interest rate in order of the term interest rate refers to the on a student loan to pay your college to attain loans, and in the process inflation-adjusted real interest rate and tuition, but if the interest rates are high, increase the quantity of credit supplied not the nominal interest rate. While you might reconsider and decide to find while decreasing the volume of credit contracts and loan agreements are often a job instead. A change in interest rate, demanded by borrowers until equilibrium signed in terms of nominal interest therefore, leads to a movement along was attained. rates, the decision-making process of the demand curve. Only changes in other Changes in interest rates and the creditors and borrowers are controlled factors would result in a shift of the overall volume of loans for a country are only by the real interest rate. To a lender, demand curve (Figure 1). explained through movements in the for example, earning a nominal interest The supply curve, shown as SS in the demand and supply of loans. We have rate of 5% on a loan would actually be diagram, represents the supply of credit appended a list of common factors that loss-making if inflation exceeded 5%. To

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FIGURE 1 INTEREST RATE DETERMINATION REAL INTEREST RATE

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REAL INTEREST RATE

invested SGD1000 in US government bonds (denominated in USD) would have to convert the Singapore dollars into US dollars, based on the exchange rate today, which turns out to be about USD800. However, if the Singapore dollar appreciates against the US dollar, the USD 800 that he got back at bond maturity would be converted to less than SGD1000—even before factoring in SS SUPPLY OF CREDIT inflation and other complications. On a more macro scale, having a large percentage of foreign lenders supplying credit to fund the domestic economy has greater political and economic implications, especially in terms of debtservicing and escaping a debt crisis. We’ll examine this in the later sections of the article. DD DEMAND FOR CREDIT

CASE STUDY 1: Volume of Loans THE CROWDING OUT EFFECT

In the A Level Economics Syllabus, we the problem calculate the approximate real interest interest rates is more complicated in the of crowding out when evaluating fiscal interest rate predicted by the model, Real interest rate rate, we can use the following equation: realReal world than policy. In essence, when a government dueFACTORS to the difficulty predicting inflation, FACTORS chooses to increase AFFECTING in DEMAND FOR CREDIT AFFECTING SUPPLY governmental OF CREDIT and hence the difficulty in setting the spending, funded through the issuance real interest rate. This is the reason why of government bonds, it is said to be less = Real Interest Rate + Inflation some newer financial instruments have effective as it “crowds out” corporate and domestic investments. One good FIGURE 3 Higher interest rates causing crowding out effect Note: The equation is an approximation example of this was the American that is sufficiently accurate at small values Recovery and Reinvestment Act of interest rates and inflation. of 2009 [ARRA], a USD 831billion stimulus package by President Since the nominal interest rate is often Obama, which was mostly funded set in stone after a contract has been by the borrowing. Government signed, lenders and borrowers factor in deficits rose to USD 1.41 trillion the expected inflation during the time in 2009. This is in contrast to period and the targeted real interest rate. countries like Singapore, which For example, if a borrower and lender instead of borrowing, dipped into agree to a real interest rate of 2% and, our reserves to fund the SGD using government statistics, forecast 20.5 billion stimulus package in expected inflation to be around 3%, they 2009, and it can be argued that would set the Nominal Interest Rate variable interest rates, where the interest Singapore bounced back much stronger (which is the interest rate to be quoted in rate to be paid varies on a year-on-year than the US following the recession in the contract) at about 5%. basis, revised at the end of each year in 2008. This would, in turn, create a new set accordance to inflation. One of the reasons offered to of complications, as the real inflation explain the difference in recovery was experienced by the economy might be FOREIGN LENDERS the crowding out effect. In fact, the higher or lower than the 3% predicted. A If domestic lenders have to deal with Congressional Budget Office in the US higher than expected inflation (let us say inflation in their decision-making, foreign actually expected GDP to fall in 2014 4%) would reduce the real interest rate lenders have an additional headache: when the crowding out effects of the (reduced to 1%), benefitting the borrower, exchange rate fluctuation. Most of the ARRA was predicted to come into effect. since the real cost of borrowing has fallen. credit demanded by local companies and Looking at the Loanable Funds Model, we A lower than expected inflation (let us say governments are denominated in the can see that an increase in budget deficits 1%), would increase the real interest rate domestic currency, so foreign lenders will increase the demand for credit in the (increase to 4%), which this would benefit have to be wary of potential movements economy, shifting the demand curve to the lender. in the exchange rate. the right (Figure 3). Therefore, the process of determining For example, a Singaporean who has As a result, the total volume of loans FACTORS AFFECTING QUALITY OF CREDIT DEMANDED

wouldAFFECTING have encountered FACTORS QUALITY OF CREDIT SUPPLIED

NOMINAL INTEREST RATE

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DD DEMAND FOR CREDIT

Volume of Loans

TORS AFFECTING QUALITY CREDIT DEMANDED interest rate

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TORS AFFECTING DEMAND FOR CREDIT

F CREDIT

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FACTORS AFFECTING QUALITY OF CREDIT SUPPLIED

FACTORS AFFECTING SUPPLY OF CREDIT

FIGURE 4 CAUSES OF LOWER REAL INTEREST RATES

increases, and so does the real interest rate. However, closer inspection would reveal that the increase in Demand (DD1 to DD2) is less than the final increase in total volume of loans (Q1 to Q2). Seeing that the budget deficit, represented by the increase in demand, has to be completely funded by some method, it would mean that the volume of loans for corporate and consumer uses has fallen. This is the phenomenon of crowding out, as the higher demand for loans caused by the incurred government deficit raises the equilibrium interest rate, which in turn lowers borrowing in the consumer and corporate sectors. The overall impact of the stimulus package is thus limited, as the increase in aggregate demand (rising government expenditure, but falling consumption and investment) before the multiplier effect is only a percentage of the intended stimulus package. Comparing this to a country like Singapore, where the entire stimulus package is funded by our reserves, the financial market for loans is untouched, as no borrowing was required on the part of the government, so loans are still readily available for consumers and private investors. Of course, such an isolated analysis of fiscal policy has its limitations, as the Federal Reserve in the USA did artificially cut the federal interest rate amidst the implementation of the stimulus package. It is unsure how the two policies interlinked, especially since the interest rates were artificially dampened. Nonetheless, the crowding out effect remains a problem for fiscal intervention by debt-ridden governments and explains, partially at least, why Singapore rebounded quicker and more strongly than the US. Singapore actually set a record expansion of GDP by 14.7%

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FIGURE 5 HIGHER SUPPLY OF LOANABLE FUNDS IN JAPAN

deficits, the solution must lie in the latter of the two, a high supply of funds, as reflected in Figure 5. Now that we have identified the theoretical basis, is there a rational explanation? Indeed there is. The high supply of loanable funds of Japan is due to the interplay of various factors. The first is a in 2010, while growth in the US averaged high level of savings compared to 2.8% since the global recession ending in western countries, a characteristic of June 2009. Asian economies due to our individual emphasis on thrift and savings for CASE STUDY 2: a rainy day. Before the turn of the THE ANOMALOUS INTEREST millennium, Japanese saving rates have RATES OF JAPAN been significantly above 10%, standing Ever since chaos and panic broke out on at about 11.4% in 1998. Such high the European front, Japan has been an savings rates are the reason why much intriguing country, as it presents a queer of Japanese debt is held domestically antithesis to the European sovereign debt rather than internationally. problem. On the surface, many found Second, and perhaps more importantly, it absurd that despite having the largest is the role of the Japanese Central Bank national debt in the world at 234% of GDP, to expand the supply of loanable funds investor confidence in Japan remains high and to artificially dampen the interest and credit rating agencies have continued rate. There are many channels in which to list Japan as a country with a low risk the Central Bank is able to do this, such of default. It has even been estimated by as implementing policies to guarantee The Economist that Japan would require loans, which encourages banks and other a fiscal surplus of around 23% of GDP credit agencies to lend more. Another between now and 2020 to meet the IMF method is to lower the reserve ratio of criteria of sustainability by 2026. Such the banks. Simply put, the reserve ratio a feat is almost impossible when you refers to the percentage of deposits consider that 23% of the Japanese JPY475 The central bank of a country trillion economy, adding up to about 110 will stipulate a percentage trillion a year, exceeds the entire fiscal of any deposits to be held budget for 2012, which was only JPY92.4 in cash so that banks will be able to meet trillion. the needs for the cash withdrawals of its How then is it possible for Japanâ&#x20AC;&#x2122;s depositors. This minimum percentage is economy to be still functioning? It would known as the reserve ratio requirement. seem logical to expect that such a high demand for loans, due to the massive banks have to set aside and not loan budget deficits and current debt-servicing out in order to cover potential liquidity costs, would have driven interest rates demands. A reserve ratio of 10% would through the roof, but Japan has managed mean that banks are legally required to to keep its interest rates at almost zero. keep 10% of all deposits in liquid forms How is this possible? and can only loan out the other 90%. Looking at the Loanable Funds Model, Lowering the reserve ratio to 5%, for we can see that there are two factors example, would allow banks to extend that could potentially drive the interest more loans and increase the total supply rate downwards. As shown in Figure 4, of loans in the economy. the only two ways to achieve the lower Combined, these factors constitute interest rate is to have a lower demand a large supply of loanable funds in the (DD1) or a higher supply (SS2). Since Japanese economy, explaining the low the former is unlikely in the Japanese interest rates. However, that being context, given the sheer size of budget said, many economists have predicted

that Japan may be heading towards a fiscal collapse in the near future. Saving rates in the country are falling, reaching only 2.2% in 2007, probably due to the aging population problem and an increasing dependency ratio. Growth in the country has slowed in recent years and confidence in the economy is starting to dip. Furthermore, national debt is a problem that cannot be put off indefinitely. Interest rates will cause the debt snowball to continue growing and the debt burden continues to grow each time the government refinances or rolls over existing debt payments. Only time will tell, as the struggling Japanese economy clocked another period of negative GDP growth of almost 0.5% in 2011 after the tsunami and nuclear disaster in March of last year. However, a closer look at the figures shows that it grew at an annualized 6% in the third quarter of 2011, despite the disasters. Perhaps there is still hope and optimism for this diminished economic giant.

REPAYING LOANS

Up till this point, we have taken a positive approach to the role and importance of lending in an economy, but there is a flip side, as wellâ&#x20AC;&#x201D;debt. Loans are important as lubricant to the gears of economy by allowing you to use future profits to offset current costs, but what happens when the future profits are not sufficient? What happens when an investment does not succeed, and you do not have money to pay back the loans? What happens when a government cannot pay back its debts? This is the problem that has plagued

Europe, but this not the first time the world has encountered a debt crisis. How can we solve a debt crisis? On paper, there are five main methods,

each working to reduce the debt burden directly, increase the revenue to pay off the debt, or to reduce budget deficits to limit the expansion of debt.

HIGHER GDP GROWTH RATE Having stronger growth in national income will in turn generate higher tax revenues, since taxes are a percentage of the income of citizens. The question, however, is how can the country generate higher growth rates, since stagnant growth is one of the causes of a debt crisis? This is also especially difficult as the government is cash-strapped and cannot employ expansionary fiscal policies. A LOWER INTEREST RATE ON PUBLIC DEBT Having a lower interest rate lowers the debt servicing cost of a country, giving it more time to pay off outstanding and maturing debt. BAILOUT A form of transfer payment or capital transfer from abroad, without interest, to pay off outstanding debt. More often than not, bailout packages also include restrictions and agreements for economic restructuring in the debt-laden country. AUSTERITY MEASURES AND TAX INCREASES These include cutting of excessive governmental spending, such as downsizing the civil service and cutting back on social welfare. Tax increases, on the other hand, increase the tax revenue to finance debt burdens. These measures may backfire as they are contractionary in nature and may reduce GDP growth. SEIGNIORAGE, OR PRINTING MONEY The central bank can print money to pay off outstanding loans, but this requires control over national monetary policy, and will generate inflation in the economy. Higher rates of inflation may also actually lower the real costs of loans. DEFAULT Non-compliance with the original terms of the contract, including repudiation, moratorium, restructuring, rescheduling of interest, etc.

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It seems, theoretically, that it is straightforward, economically at least, to overcome a debt crisis, but things are often easier said than done. Political issues also play a big role in making the resolution of a debt crisis more complex. For example, some degree of austerity or rising taxes is often required in the recovery from a debt crisis, but in a democratic system, such policies are not well liked by the people, so governments are not keen to pursue such policies. Defaults or seigniorage are also seemingly get-out-of-debt-crisisfree cards, but most countries today are under significant international pressure by foreign countries not to do so. International reputation is important as well. Defaulting on loans will discourage further investment in a country in the near future.

LESSONS FROM THE PAST

Have countries successfully recovered from debt crises in the past? The answer is yes, although it would require a loose definition of the term “recovered”. Here we can look at the two big debt crises of the 20th century.

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America facing similar debt crises. The recession in Europe and America led to a collapse of Latin America export revenue, causing poor economic growth. Coupled with failures in government investment and development, significant government debt incurred when governments borrowed from foreign sources to fund infrastructure development, almost all Latin American countries except Argentina defaulted on all foreign-owned sovereign debt.

1980S: LATIN AMERICA DEBT CRISIS

Latin America was in crisis again, this time after the oil shocks in 1970 that led to stagnant economic growth in the “Lost Decade”. Stagnating incomes, coupled with growing foreign debt (Europeans were in a Golden Age and much of the excess savings was channeled into investment in Asia and Latin America), meant that Latin American governments were once again unable to repay their foreign liabilities. However, this time, the IMF and World Bank stepped in to renegotiate debt repayments, preventing default and fears of global contagion effects.

Following the devastation of World War THE DIFFERENCE: II and the Treaty of Versailles, Germany LENDER IDENTITY was made to pay enormous sums of Before we continue to look at the current reparations to the Allies, totaling USD64 Eurozone debt crisis, it is important to billion (1919 prices, equivalent to look at lessons from history. Comparing USD834 billion today), and even the Allies the debt crises of the 1930s and the themselves racked up significant war 1980s (and specifically in Latin America debt. The UK and France had significant to have a common basis for comparison), sovereign debt held by the US. there are certain major differences that The only thing that kept the system can be identified with regards to the from falling apart was that America had resolution of the two crises. The 1930s extended a series of short-term loans to debt crisis was essentially “solved” by Germany to aid in reconstruction, which Latin American governments using a helped alleviate some of the debt burden. string of sovereign defaults, while its However, following the Great Depression, 1980s counterpart saw transnational America fell into a recession and recalled organizations stepping in to protect their loans. Germany was unable to repay investors and prevent default. Why was its debt and fell into hyperinflation as it there a difference? turned to excessive printing of money It can be argued that transnational to finance its loans. The other Allied organizations were not well established countries followed soon after as stunted in the 1930s, a point that is indeed true, economic growth, coupled with the lack but the bigger difference was the identity of reparation payments from Germany, of the lenders. Economic historians resulted in countries like UK and France Eichengreen and Alejandro have put encountering problems repaying their forth an argument that most of the Latin own debt. American debt held by foreigners in the Beyond Europe, the 1930s crisis was 1930s was in the form individually-held also a global crisis, with countries in Latin private bonds. Individual investors thus

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had no bargaining power to influence the decisions of foreign governments and European governments were largely ambivalent to the plight of investors. To the governments, this was considered a private mistake of an investor—just another investment project gone awry, with no threat to the national economy. In 1980, however, most of the Latin American debt was held by large European banks, much like the Eurozone crisis of today. This time, national governments were concerned, as these banks were deemed too large to fail. Latin American default would have left these banks insolvent, and could have resulted in a global downturn. Hence, governmental pressure was quick to come into play, pressuring Latin American countries into renegotiation and rescheduling of debt repayments. Organizations like the IMF and World Bank facilitated these discussions and provided funds to guarantee Latin American bonds as a short-term measure to ensure that the funds required for economic restructuring in Latin America continued to flow in. Was the 1980s crisis more successfully resolved? Perhaps, if you were in the shoes of an investor or banker. It is interesting to realize that Latin American default in 1930 actually sped up the region’s recovery from the Great Depression, albeit being an internationally disliked approach. Investors suffered and entered bankruptcy, but countries were able to start afresh with no lingering burden of debt. In 1980, the “resolution” of the debt crisis literally translated into a lost decade for Latin American countries. Debt rescheduling and roll-overs provided governments more time, but it also increased the amount of funds to be paid ultimately.

CURRENT EUROZONE DEBT CRISIS: PROBLEMS AND DIFFICULTIES

Portugal, Ireland, Italy, Greece, Spain (affectionately known as PIIGS) have been the focal point of the Eurozone debt crisis over the past few years. The problem is straightforward: unsustainable public debt. Greek national debt is 166% of Greek GDP, at around EUR0.4 trillion; Italian national debt is at 121% of Italian GDP, at around EUR2 trillion; and the list goes on.

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Eurozone countries are highly interconnected in terms of lending and borrowing and European banks are heavily exposed to European sovereign debt. Irish borrowers owe British banks $140.8 billion, Italian borrowers owe German banks $161.8 billion, Italian borrowers owe French Banks $416.4 billion, and even within PIIGS, Portugal owes Spanish borrowers $88.5 billion, or almost 39% of Portuguese GDP. Such an intricate web of connections means that the collapse of any strand would likely lead to the financial collapse of Europe, eventually spreading to the rest of the world. We will gloss over the intricacies of the causes of the crisis and focus on the main problem faced by European governments: Sovereign debts are held by foreign lenders, especially banks, and are denominated in euros. Now that we have identified the lender’s identity, it should be evident how difficult a problem the Eurozone crisis is.

The fear of contagion due to high foreign bank exposure to sovereign debt means that European countries are under severe international pressure and scrutiny, with countries trying to prevent any potential default. The chances of default in European countries are higher than countries like Japan, as the latter’s debt are mostly domestically owned and defaulting on domestically owned debt is literally government suicide. Furthermore, domestic and international pressures restrict foreign aid. German citizens would not agree to the German government bailing out Greece for free—or any other country, for that matter. Such domestic and international pressures also lead to bailout packages that have stringent regulations and austerity requirements, which in turn create social conflict and economic contraction in the country that is being bailed out.

European countries in crisis cannot print their way out of the crisis, nor can they manipulate the interest rate, as they have no control over the monetary policy of the euro. This effectively removes two of the six ways to solve a debt crisis (seigniorage and lowering of interest rates) as national

SUCH AN INTRICATE WEB OF CONNECTIONS MEANS THAT THE COLLAPSE OF ANY STRAND WOULD LIKELY LEAD TO THE FINANCIAL COLLAPSE OF EUROPE, EVENTUALLY SPREADING TO THE REST OF THE WORLD. governments have no ability to control their money supply.

Certain policies, such as increasing taxation, are more economically detrimental for a country with massive foreign debt, as this would mean that you are taxing local citizens to pay foreign lenders. Thus, money is flowing out of the country. Compare this to a country like Japan, where most of the debt is domestically owned. In such countries, increasing taxation or introducing a lump sum tax on all bond-owners essentially is a transfer payment from the citizens of the country to bond owners, who are also Japanese citizens. Such a transfer ensures that majority of national wealth remains within the country, so taxation in these situations is less contractionary than in places like Europe. This is one of the reasons why Japan has remained an economically stable country with a low risk of default.

CONCLUSIONS

Loans are a double-edged sword in an economy. They can accelerate development, but failure of proper debt management can land a country in a severe debt crisis that will be difficult to solve. This article has introduced the theoretical background of the Loanable Funds Theory, which allows you to understand the economic theory behind loans and interest rates. In the application of these theories into the real world, however, you must realize that the theory is insufficient and that other factors, predominately political, come into play. The importance of the identity of the lenders, as we discussed, is essentially a political factor, determining the strength and severity of political pressure placed on a debt-ridden country.

This article has shown you just one of many real-world problems that require more than just economic theory to resolve, and as economics students, despite our burning interest in the subject, we have to be cautious about our myopic tendencies and look at real-world problems through a wider lens. Maybe then we can make the world a better place. REFERENCES Protopapadakis, A. (2012, July 18). The European Debt Crisis: An Alternative Solution. Retrieved July 2012, from Huffington Post: http://www.huffingtonpost.com/arisprotopapadakis/the-european-debt-crisis-_b_1683646. html BBC. (2011, December 22). What really caused the eurozone crisis? . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-16301630 Feaster, S. W., Schwartz, N. D., & Kuntz, T. (2011). It’s All Connected: A spectator’s guide to the Eurozone Crisis. Retrieved July 2012, from The New York Times: http:// www.zerohedge.com/sites/default/files/images/user5/ imageroot/2011/10/who%20owes%20what.jpg BBC. (2011, November 18). Eurozone debt web: Who owes what to whom? . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-15748696 Horesh, R., & Bollier, S. (2011, December 6). Q&A: Eurozone debt crisis . Retrieved July 2012, from Al Jazeera. Haydon, P. (2012, June 1). It’s not a case of austerity v stimulus for Europe . Retrieved July 2012, from The Guardian: http://www.guardian.co.uk/ commentisfree/2012/jun/01/europe-austerity-v-stimulus Gros, D. (2011, May 24). External versus domestic debt in the euro crisis . Retrieved July 2012, from VOX. Gros, D. (2911, May 25). External versus Domestic Debt in the Euro Crisis. CEPS Policy Briefs , 6. BBC. (2012, June 18). What could happen next if Greece leaves the eurozone? Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-18074674 Spike Japan. (2011, July 17). Japan: How bad is the fiscal mess? . Retrieved July 2012, from Spike Japan: http:// spikejapan.wordpress.com/2011/07/17/japan-how-badis-the-fiscal-mess/ The Economist. (2011, June 16). Running out of road . Retrieved July 2012, from The Economist: http://www. economist.com/node/18834323 BBC. (2011, January 3). Singapore economy sees record expansion in 2010 . Retrieved July 2012, from BBC News: http://www.bbc.co.uk/news/business-12106645 Comparing Savings Rates: U.S. vs Japan . (2012, February 3). Retrieved July 2012, from Wise Bread: http:// www.wisebread.com/comparing-savings-rates-us-vsjapan The Economist. (2011, November 19). Whose lost decade? . Retrieved July 2012, from The Economist: http://www.economist.com/node/21538745 Evans, G. R. (1999). http://www2.hmc.edu/~evans/ chap3.pdf. Retrieved July 2012, from Harvey Mudd College: http://www2.hmc.edu/~evans/chap3.pdf

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KEY POINTS OF QUERY Why and when do governments borrow? How do we make comparisons of sizes of national debt? What is sovereign debt? What are the costs of rising debt levels? How can countries be allowed to accumulate so much debt? Source: http://johnharding.com/wp-content/uploads/2011/08/most_indebted_countries_rgb.jpg

FIGURE 1

GDP GDP

GDP

T US $39,858,833,607,149 18

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hirty-nine trillion, eight hundred and fifty-eight billion, eight hundred and thirty-three million, six hundred and seven thousand, one hundred and forty-nine American dollars. This staggering figure is the current level of global public debt, according to the Economist’s World Debt Clock, as we begin this article. To give you an idea of how big this figure is, taking the world’s population to be approximately 7 billion people, the global public debt per person would add up to almost US $5,600. That is huge. Over the past two years, the economics scene has been dominated by fears of various debt crises, from the raise of the US debt ceiling to the ongoing Eurozone sovereign debt crisis, and one might wonder how the countries in the world have ended up in this state. How could governments have borrowed and owed so much, and for so long? Like how a debt-saddled individual can be refused further credit by the bank or greeted by a pig’s head on one’s doorstep courtesy of the loan sharks, shouldn’t there be consequences for debt-laden countries as well? How do these debts occur in the first place, and are there any countries

that are debt-free? And where does Singapore fit into all this? This article aims to provide answers to these questions, but in a novel way. In each of the subsections to come, we will first present a myth—an excerpt from an online article or diagram that contains a conceptual error or logic fallacy. Take some time to critique the source before reading on, and you will take away a lot more from this article. Alright, let the mythbusting begin!

HAVE YOU FOUND THE ANSWER?

Admittedly, it’s not the biggest of conceptual errors, but the debt to GDP ratio actually shows much less than most people think it does. In economic terms, comparing debt (which is a stock concept) to GDP (which is a flow concept) is like comparing apples to oranges. There is simply no common basis for comparison. The only sensible justification is that the debt to GDP ratio scales the debt burdens of each country according to the size of each economy (shown by GDP), and WHAT IS THE SOURCE OF DEBT? gives a more accurate portrayal of the Let us start with some questions about debt burdens of an economy. After all, it’s measuring national debt. Consider the likely that a larger country can sustain a following graphic from the US Treasury: bigger absolute value of debt compared The Top 10 Most Indebted Countries to a smaller one. in the World (Figure 1). We won’t show As such, extrapolations of this statistic the entire list here, but we’ve cropped including “Years when debt is lower than it to show the top three: Japan, Greece, GDP” and “Years when debt is higher and Italy. The graph not only shows than GDP” simply don’t give us much the absolute value of the debt, but it understanding of the problem. Some also shows the debt to GDP ratios and have argued that since tax revenues are highlights the years where debt was lower correlated to national income, having a than or exceeded GDP. It a common set debt stock that is higher than GDP would of statistics, but is something amiss here? mean that the debt can’t be paid off that It might help to consider what the debt to year. However, in reality, tax revenues of GDP ratio statistic actually entails. countries amount to about 15% to 40% of GDP, and whether the debt is repaid THE DEBT ISSUE

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or not doesn’t depend on the magnitude of tax revenue, but on whether a government has a budget surplus or deficit. Having tax revenue of $100 million means nothing if government expenditure for that year exceeds $100 million, as that would add to the debt. Furthermore, there is no cutoff debt to GDP ratio that renders a country’s debt unsustainable. Debt servicing costs differ from country to country, so how much debt a country can withstand also varies. Japan has always topped the list for the largest public debt burden, but in reality they are able to sustain such high burdens due to the fact that the Japanese government can borrow at low interest rates, a result of high domestic savings providing a ready supply of loanable funds. Japanese bond interest rates are the moment are hovering under 1%, an absurdly low interest rate, given the size of its debt, but this also means that debt servicing costs are low. Greece, on the other hand, has a debt to GDP ratio of 139%, but has already required a Eurozone bailout due to interest rates rising to more than 16%. Hence, debt servicing costs are incredibly high. The debt to GDP statistic is really an arbitrary value economists have derived to show the size of a debt burden relative to the size of an economy, and it doesn’t show much more than that. Looking back at the graphic, it’s kind of funny how it’s now less relevant. The only conclusion one can draw from it is that absolute national debt is much bigger for Japan than Greece or Italy, but the debt to GDP ratios seem to be rising for all three countries. However, we have to be cautious about the latter statement as well: debt to GDP ratios can be rising even when the absolute stock of debt is falling, such as if GDP is contracting more than national debt. Theoretically, if a country is in recession with a negative 5% GDP growth rate but has national debt that is contracting at 4% per annum, the country’s debt as a percentage of GDP will actually be rising. The lesson? Think twice before falling for pretty diagrams with impressive figures. Before we move on to the next problem, let’s clarify a definition issue. The terms

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the previous paragraph, if the foreigner chooses not to spend the $3,000 he earned on bonds, preferring to hold on to it as cash, the current account deficit still stands at $3,000 but no indebtedness has been incurred. On the flip side, we can also see that not all national debt is financed internationally, as some of it can be financed by domestic savings. One When households and firms have high levels of savings, this increases the supply of loanable funds in an economy and the government has ready access to loans from domestic sources without having to borrow from overseas.

prime example of this is Japan, which has had massive national debt burdens in absolute terms (reflected in the first graph), but has been running a consistent trade surplus. The reason for this

national debt and public debt are interchangeable and both refer to the total amount of debt owed by a central government, regardless of the lender. Sovereign debt, however, refers specifically to national debt that is Sovereign debt is also known as external debt. Governments borrow money by issuing and selling bonds. In the case of sovereign debts, by issuing and selling these bonds in a different currency from its own, the purchasers or lenders to the government are foreigners to a country.

held by foreign bond holders. Therefore, the European sovereign debt crisis is not just about the fact that many Eurozone countries are horribly debt-laden, but also about the fact that other Eurozone countries hold so much of the debt that any default will cause massive contagion effects.

DEBT AND THE TWIN DEFICITS

On to the next problem. In October 3, 2006, Nobel Laureate Joseph E. Stiglitz penned an article in the New York Times titled “How to Fix the Global Economy,” in which he discussed the causes and

potential solutions for global fiscal imbalances, which in essence refer to how governments around the world are spending far beyond their means. Here we have appended the opening paragraph of the article. Take a look and see if it makes sense. The International Monetary Fund meeting in Singapore last month came at a time of increasing worry about the sustainability of global financial imbalances: For how long can the global economy endure America’s enormous trade deficits — the United States borrows close to $3 billion a day—or China’s growing trade surplus of almost $500 million a day? The New York Times, October 3, 2006 The misconception here is more glaring than the first problem and lies in Stiglitz’s justifications for America’s borrowing. Instead of pinning the blame on America’s budget deficit, he goes on to question America’s trade deficit and China’s growing trade surplus. But wait. Is there a link between the current account and a country’s fiscal situation? Does a trade deficit mean that a country will experience a budget deficit, or vice versa? The crux of the problem is that borrowing from foreign lenders to

finance a government deficit will appear on the current account, but this doesn’t mean that the current account deficit is synonymous with a budget deficit. Critiques of Professor Stiglitz’s article have questioned the source of information for his “United States borrows $3 million a day” claim and it was soon realized that it was achieved by taking the US projected budget deficit and US current account deficit for the year and dividing it by the number of days in a year. Two fundamental errors were made here. Firstly, he has double-counted. When a foreigner buys an American product and uses the dollars he earned to invest in newly issued US Treasury bills, the US current account deficit rises, as does America’s overall debt. But this is not two debts—it’s just one. Suppose a foreigner has sold $3,000 worth of goods to America but uses the $3,000 he earned to buy newly issued US Treasury Bills worth $3,000, issued by the government due to a budget shortfall of $3,000. In this case, the budget deficit is $3,000, but the fact that the foreigner has sold goods to America to earn the money to buy the treasury bills will also appear as a deficit of $3,000 in the current account. The total amount of indebtedness incurred by the

American government is only $3,000, so summing both the current account and budget deficit ($6,000 here) is a case of double-counting. Secondly, a trade deficit is not completely synonymous with indebtedness, for a number of reasons. A current account deficit simply means that the dollar value of imports has exceeded the dollar value of exports, giving no information whether any indebtedness has occurred. If export revenue is $200 This $700 billion net revenue earned by foreigners can be the financial capital that is used to purchase American assets, in which case there is inflow into the capital account.

billion and import expenditure is $900 billion, what exactly happens to the $700 billion discrepancy? The $700 billion is actually spent on acquiring American assets and not on the purchase of American goods and services. Holders of this excess currency can invest in American real estate, American equities, or simply hold it as cash. Only if the foreigner chooses to lend America money by investing in newly issued government bonds will government indebtedness rise. Referring back to the example in

When a country’s debt is owed internationally, it affects the country’s BOP through the current account as interest repayment on loans causes outflows in its current account under net income flows. Historically, some countries, such as Argentina in 2002, experienced unique situations where the country’s trade balance was larger than its current account balance as there were huge outflows recorded under the current account due to large interest repayments.

difference is that most of Japan’s debt is financed domestically, due to its high savings rate (in the past, at least). Very little of it is held by foreigners. In fact, almost 95% of Japanese debt is held by its citizens, as compared to countries like Spain, where domestic citizens only own 35% of the national debt. Therefore, we can see that a country’s indebtedness arises solely from the budget deficit, even though some The reason for debt is that a country’s government is unable to pay because of its depending on a lean year from its sources of revenue—hence running a budget deficit for that year. This does not lead to the need for borrowing if the country has past budget surpluses to finance any year’s budget or fiscal deficit. Prolonged years of running budget deficits lead to accumulation of debt. THE DEBT ISSUE

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foreign borrowing is reflected in the current account. That being said, it can be observed that many of the countries running massive budget deficits are also running current account deficits and there is some form of causation in play here. Running a massive budget deficit that can’t be financed completely by domestic means forces some loans to be taken from foreigners. This foreign demand for the domestic currency for the purchase of bonds can cause appreciation of the domestic currency, preventing the self-regulating correction of the current account deficit.

IS THERE SUCH A THING AS GOOD DEBT?

As we venture deeper into the issue, let’s explore some fundamental questions about national debt. Why do governments need to borrow, and can there ever be “good” debt? Additionally, how can governments owe so much for so long without any consequences? Take some time to ponder these questions. Then we’ll address them, one by one.

WHY DO GOVERNMENTS NEED TO BORROW?

It is important to understand that government expenditure doesn’t just include the basic wages of the civil service, unemployment, and other welfare schemes, money required for the implementation of government policies (such as stimulus packages and bank bailout schemes). It also includes government investment, especially in infrastructure. Countries embarking on massive infrastructure development, such as construction of rail systems or expressways, would find it difficult to finance such large projects using only one year’s worth of government revenue. Such multi-year projects require some form of borrowing in the short term that can be repaid over the next few years. Such forms of public debt are inevitable in a country’s development, especially in times of economic contraction. In times of recession, Keynesian would also advocate stimulus packages to revitalize the economy, and such boosts would sometimes require some borrowing to

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be financed. Singapore actually ran a 3.7% budget deficit (SGD 8.7 billion) in the fiscal year of 2009 to finance Singapore’s Resilience Package in a bid to stimulate the economy. $5.1 billion was spent on schemes like the Skills Programme for Upgrading and Resilience (SPUR) and the Workfare Income Supplement (WIS), $4.4 billion was spent on upgrading infrastructure, and $2.6 billion was spent on supporting lower income families. Thankfully, fiscal prudence meant that Singapore was able to finance these packages by tapping into our reserves without borrowing, but similar stimulus packages in countries worldwide (like the US) required borrowing from the sale of government bonds. One could argue that the need for borrowing to finance Keynesian spending leads to crowding out effects, but we’ll ignore that for now.

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There is no simple way out. Examples of austerity measures include trimming public services and raising taxes, but the former will cause some unemployment and the latter will reduce disposable income available for consumption. Both are contractionary in nature. How then have governments managed to rack up so much debt? Based on the paragraph above, it seems that fiscal prudence should be a government’s priority. The potential devastating circumstances of economic collapse, coupled with the fact that reversing a massive fiscal debt seems to be a macroeconomic policy nightmare, would suggest that governments would go allout to ensure that they don’t get trapped in a debt crisis. But in reality, they don’t, due to the myopic nature of democratic governments. Ministers are often only in power for a term or two and are more than happy to spend during their stint, especially during a recession, and leave the problem of debt servicing to the next administration. Investors are often willing When the government borrows to spend, they make lenders as well. Unlike corporate banks, up a source of demand for countries are less likely to default on a loans, which causes interest rates to be debt, especially with national pride and pushed up. With higher interest rates, this reputation on the line. causes lower levels of investment that Tough austerity measures are also not would now be profitable. This is seen as a voter friendly, and any politician daring movement along the MEI curve. to engage in such economically-sensible moves gets voted out of office. This is one HOW CAN GOVERNMENTS OWE of the reasons for the public uproar in SO MUCH, AND FOR SO LONG? Greece over German Chancellor Angela Logically, there are negative Merkel’s demands for austerity cuts in consequences when a country is bogged exchange for a bailout. down by too much debt. A government That leads us to another cause: incurring debt is similar to any other moral hazard. Large countries know investor taking a loan. It’s based on the that international aid will always flow expectation that future revenues will in to prevent any form of economic be sufficient to cover the cost of the collapse or default due to the fear of debt. However, as foreign and domestic triggering a global recession. The latest investors begin to lose faith in the ability Eurozone crisis is a testament to this. of a government to repay the debt, it Fears of contagion effects arising from forces bond interest rates to rise, which a Greek default have led to an inflow of in turn increases the future debt burden international aid that has kept Greece on the government. Being unable to pay afloat, but the knowledge of such a safety off bonds that have reached maturity net creates no urgency or impetus for forces governments to roll over the debt fiscal prudence on behalf of the Greeks. and to issue new bonds. What is a healthy level of national debt? On the policy front, policymakers The truth is, no one knows. There are are hit with a conundrum as austerity countries with zero debt, such as Brunei, measures to trim the budget deficit are but the lack of government spending often contractionary in nature, and a could also indicate lackluster national contracting economy means lower tax development. The debt threshold varies revenues and lower government revenue. from country to country, but once the

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debt to GDP ratios reach unsustainable levels, it would be very difficult for government officials to correct the problem without losing their jobs.

SINGAPORE: ARE WE IN DEBT?

Where does Singapore stand in the midst of all this? The Singapore government has always emphasized fiscal prudence as a pillar of Singapore’s economic success and stability, but a look at reports from Fortune magazine and the Economists’ World Debt Clock would seem to suggest otherwise. Here we’ve appended the data from the Economists’ World Debt Clock: Country: Singapore Public debt: $214,901,917,808 Public debt per person: $42,318.14 Population: 5,074,246 Public debt as % of GDP: 102.1% Total annual debt change: 7.5% Can these numbers be right? Has the Singapore government tricked us all along or is there an economic and rational explanation for this? Before we get labeled anti-government conspiracy theorists, let’s assume that both the Singapore government and the data are correct. The issue lies in the official definition and calculation of public debt. All the figures for public debt listed so far in this article and many statistics on the Web only account for liabilities, and don’t consider the value of assets. After all, technically, the holding of assets doesn’t mean that any national debt has been repaid. In the Singapore scenario, if we exclude investments by our sovereign wealth funds like GIC and Temasek Holdings, we do run a budget surplus on most years. However, any surpluses, as well as contributions to each Singaporean’s CPF, are invested overseas by GIC and Temasek Holdings. On paper, it would seem that the government has taken a “loan” from its people to acquire international assets and will appear as a red mark on the balance sheet. But this doesn’t mean that the government doesn’t have the ability to pay to service the government “debt”. In fact, this investment by sovereign wealth funds is the only way the government can offer a respectable interest rate for our CPF

accounts. It is not surprising, however, that the release of these figures caused some pandemonium in the online Singapore community, but putting a little thought into it will allow you to realize that it’s a mere discrepancy in calculation. Of course, such moves entail some risk as the values of our assets fluctuate and also runs the risk of liquidity shortages due to the need to pay interest and to repay maturing bonds—and assets are generally illiquid. However, the Ministry of Finance issued a statement to put liquidity.

Assets take a longer period of time to sell and to be turned into cash to meet the need for

these worries to rest. In the statement, it was revealed that investment returns are more than sufficient to cover debtservicing costs. Overall, the Singapore government maintains a net asset position with deposits in the banking system totaling to 46% of GDP. Monetary Authority of Singapore Foreign Exchange has reserves amounting to 92% of GDP, and even GIC’s assets are known to be well over 40% of Singapore’s GDP. Comparing this to a debt to GDP ratio of slightly over 100%, we are well in the black and the government is in an excellent fiscal position.

CONCLUSION

As the world watches while Europe tries to fix itself amidst the Eurozone sovereign debt crisis, it is clear that public debt problems will be a lingering issue for countries once they find themselves sliding down the slippery slope. It’s key for Singapore’s progress that we maintain a tough fiscal stance and be prudent in our spending. As voters in a democratic nation, it’s easy to fall prey to populist policies that have no fiscal basis, but we have to be more aware and critical of the potential backlash of government spending. To the student relishing in the relief of finally reaching the end of a long read, we hope this article has demonstrated the importance of questioning and of not be satisfied with taking things at face value. More often than not, data, statistics, and even arguments can be warped by a writer to achieve the desired effect, but as readers we have to be sharp enough

to sort deceit from truth. In fact, even we might have glossed over certain portions to prevent this article for dragging on too long. We wonder if anyone has been sharp enough to notice that. As a parting thought, it’s surprising how big a problem national debt can be—and will be in the future if we don’t start doing something about it. In the short span of time you spent reading this article, the global public debt has risen by another $7 billion. Thirty-nine trillion, eight hundred and sixty-five billion, six hundred and fifty-eight million, nine hundred and seventy-four thousand American dollars, as of July 12, 2012. We wonder what the figure is now?

US$ 39,865,658,917,000

Note: All estimates for the Current Global Public Debt can be derived from World Debt Clock created by The Economist, and can be found online at http://www.economist.com/content/ global_debt_clock REFERENCES The Economist. (2010, October 6). The Global Debt Clock. Retrieved July 2012, from The Economist: http://www. economist.com/content/global_debt_clock Boudreaux, D. J. (2006, December). The Trade Deficit Is Debt? It Just Ain’t So! The Freeman , 56 (10). Stiglitz, J. E. (2006, October 3). How to Fix the Global Economy. Retrieved July 2012, from The New York Times: http://www.nytimes.com/2006/10/03/opinion/03stiglitz.html ?ex=1317528000&en=a39150307a637eda&ei=5090&partner =rssuserland&emc=rss CFA Institute. (2012, April 19). The Japanese Debt Crisis (Part 1): Has Japan Passed the Point of No Return? Retrieved July 2012, from Enterprising Investor: http://blogs. cfainstitute.org/investor/2012/04/19/the-japanese-debtcrisis-has-japan-passed-the-point-of-no-return/ Ministry of Finance (MOF). (2011, August 26). Singapore is net creditor, not debtor: MOF. Retrieved July 2012, from Central Provident Fund: http://www.cpf.gov.sg/ imsavvy/infohub_article.asp?readid=%7B903818759-99943676263689%7D Harding, J. (2011, August). The Top 10 Most Indebted Developed Countries. Retrieved July 2012, from John Harding: http://johnharding.com/wp-content/ uploads/2011/08/most_indebted_countries_rgb.jpg Eng Yeow, G. (2012, June 28). Singapore Government Bonds a Safe Haven. Retrieved July 2012, from The Straits Times: http://www.straitstimes.com/BreakingNews/ Singapore/Story/STIStory_815972.html Pasquali, V., & Aridas, T. (2011). Total Debt in Selected Countries Around the World. Retrieved July 2012, from Global Finance: http://www.gfmag.com/tools/globaldatabase/economic-data/11855-total-debt-to-gdp. html#axzz1qeA9ONVs Rajan, R., & Acharya, V. (2011, November 24). Sovereign Debt, Government Myopia and the Financial Sector. Retrieved July 2012, from VOX: http://www.voxeu.org/article/ sovereign-debt-government-myopia-and-financial-sector Taylor, B. (n.d.). Global Financial Data. Retrieved July 2012, from Global Financial Data: http://www.globalfinancialdata. com/news/articles/government_debt.pdf

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Let’s break the dominance of the big five banks. Let’s turn five into at least seven so there is proper choice for the consumer (a) What type of market structure would the banking industry be classified under? Explain. [10] (b) Examine whether there is a need for governments to intervene in the banking industry? [15]

PART A

enjoyed by incumbent firms are a major natural barrier to entry. A new bank considering entering the market will have fewer customers (Q) compared to an existing bank with a larger number of customers (Q2). Hence, the new entrant will face a higher average cost of production compared to the existing firm. This higher average cost serves as a natural barrier to entry. Besides the market structure of banking industry being oligopolistic due to high natural barriers to entry, there are also significant artificial or created barriers that restrict competition, resulting in a few large players dominating the market. Banks differentiate themselves by building brands to distinguish themselves from their competitors. By spending large sums of money on advertising and on renovating outlets in unique ways, banks

FIGURE 1 Internal economies of scale as a natural barrier to entry

he banking industry should be classified under market structure of oligopoly. The characteristics of the industry determine the behavior of firms in the industry, which further determines the type of market structure those firms are classified under. A feature of the banking industry is the presence of a small number of big firms. As given in the prompt, five banks share the entire market, which gives each bank a substantial market share and customer base. The industry of banking is dominated by a few large firms—a key feature of oligopoly. Another feature of oligopolistic firms is that firms are price setters, since they dominate the market and sell differentiated products or services. Each firm faces a downward sloping demand curve for its products and services. Banks are price setters, since different banks can charge different prices for loans, since the terms and conditions of the various loan types differ. Different prices are also seen from the differing deposit rates offered between banks as they differentiate between the types of loans and the service as well as credibility of banks. Banks are also differentiated in terms of the location of the banking outlets, the network of ATMs, and the types of privileges offered to various types of credit cards. This feature of a

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selling firm being a price setter makes the market structure one that is imperfectly competitive. Another feature of the banking industry that makes it an oligopolistic one is the presence of high or significant barriers to entry. Barriers to entry serve to deter or to make it difficult for new firms to enter and exist in various forms—categorized broadly into natural and created barriers to entry. Due to the high financial capital required in setting up a bank, for rental of branches and for the cost of setting up branches, this serves as a significant form of barrier to entry for new firms looking to enter as they need as much financial capital. Because of the higher setup cost, there are significant internal economies of scale to be reaped. Greater internal economies of scale

It’s important to occasionally bring in key linking sentences to relate back to the key part of the question, which is reasons for the categorization of a particular industry as a certain market structure.

build brands that serve as an artificial barrier to entry. Given that a country’s banking industry is regulated by the central bank of the country, an important barrier to entry is the need to obtain banking licenses from the government. This limits the number of firms in the industry and makes the industry oligopolistic. Existing banks with large financial resources and accumulated profits may exploit strategic deterrence actions by practicing limiting pricing or predatory pricing, selling their products at prices lower than those of newcomers. This is also another form of created barriers to entry. The above barriers discourage new firms without lower cost of production or large financial capital from setting up from entering, as the actions of the existing firms have raised the barriers to entry, thus limiting the number of firms in the industry. Lastly, behavior of banking firms also reveals their market structure. Banks

SUCH INTERACTION AMONG BANKING FIRMS IS MADE NECESSARY BY THE FACT THAT THERE ARE ONLY A FEW BANKS IN THE MARKET, SO ONE PARTY’S ACTIONS WILL HAVE A SIGNIFICANT IMPACT ON OTHERS. are always watching each other’s actions closely. For example, the banks in Singapore are constantly upgrading their services and financial products. They have intense competition with each other in terms of price, product quality, and service reputation. Such interaction among banking firms is made necessary by the fact that there are only a few banks in the market, so one party’s actions will have a significant impact on others. Rivalry is a proof that banks belong to the oligopoly market structure.

PART B

overnment intervention is often advocated when the free market on its own fails to achieve the goals of equity and efficiency. This means that the free market forces of demand and supply do not achieve maximum society welfare. Free market outcomes instead lead to welfare losses as the conditions of allocative and productive efficiency are not attained. THE DEBT ISSUE

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Allocative efficiency occurs when output is produced where price exactly equals marginal costs, while productive efficiency occurs when a given level of output is produced using the least cost method and cost of production incurred is at the minimum point of the long run average cost curve. In this case of the banking sector, being an oligopolistic market dominated by only five large firms gives rise to deadweight losses from prices charged by banks that are above the marginal costs of production, as seen in Figure 2. Each bank charges a price that maximizes the firm’s profits (where MC=MR). In Figure 2, the firm charges a price P1 at profit maximizing level of output Q1. Though this level of output ensures maximum profits for firms, it is not in the interest of society. The shaded area is the deadweight loss to society before government intervention. Quantity Q1 to Q2 are not produced due to the higher price set by oligopolistic firms so that consumers are buying less quantity than they would otherwise. The welfare loss is from units that confer net benefit to society that is not produced. Hence, government intervention is based on improved efficiency. Governments intervene with policies to improve Such clear statements specifically identifying the grounds for intervention or the basis of government intervention is important.

the allocative efficiency of the industry by encouraging levels of output beyond Q1. At Q2, which shows the equilibrium of a perfectively competitive industry, society welfare is maximized. So as the government intervenes and the market power of a firms gets reduced, output is reaching Q2 while price is reaching P2. As a result, the shaded area gets reduced For such a question asking for the reasons for government intervention, you need to also include the end objective of the government’s intervention in order to fully explain the purpose or reasons for the government to step in, which in this case is to bring prices down and output up.

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This results in firms earning supernormal profits at the expense of consumers. Governments intervene to prevent further excessive profits by preventing collusive actions of price fixing amongst banks or by preventing further gains in market power through mergers and acquisitions. Government intervention through prevention of anticompetitive acts is along the way and welfare loss is reduced. meant to prevent further inequity. This can be done through restricting However, by breaking up firms into further accumulation of market power smaller ones, governments create and deregulating the industry to prevent new problems. As with any form of firms with high market power from government intervention, there are costs raising prices even more and causing P to as well as benefits. Let us first look at the be much greater than MC and worsening benefits of intervention. the market failure. If the government turns five firms into seven, the market power of each firm Though there is no need to will be reduced. Customers have more explain the policy options substitutes to turn to, so firms are going the government can use to to lose customers if they charge higher deal with the problem, there is a need to prices, as the firm’s demand is now spend sufficient effort in explaining the more price elastic. The competition for purpose or reason for the government customers becomes more intense. To intervention. attract customers, the cost of borrowing Market power arising from an set by firms will be reduced and banks oligopolistic market structure is a form of will be more eager to give out loans. market failure, as such there is a strong Various improvements in service will ensue with more choices for savers. Putting in descriptive words Governments intervene for these benefits like “strong” and “most to be realized. important” helps improve the Besides benefitting consumers, quality of the answer. government intervention to prevent the basis for government intervention to domination of a few large banks has prevent further welfare loss. wider social effects, such as encouraging entrepreneurship and encouraging One evaluative point that can the growth of other sectors. Increasing be added here is that since competition makes loans more easily oligopolies with only a accessible to startups. Also, the few large players can easily collude, so lower interest rate makes loans more governments need to be especially alert affordable to firms, especially small and and prevent any collusive behaviour that can further worsen the welfare of medium enterprises. The expected rate consumers. So, another basis for of return on investment will rise, ceteris intervention is to prevent collusion. paribus. Hence, firms will be more likely to buy capital goods, which enlarge the Besides efficiency, governments also productive capacity of the economy. PPC intervene when equity issue becomes will shift outward in the long run and prominent. An oligopoly market is economic growth will be achieved. likely to create equity problems due Lastly, reducing market power prevents to the price setting ability of firms. the fear of having big banks collapse,

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FIGURE 2 WELFARE LOSSES FROM MARKET POWER

since being extremely large means many jobs will be lost. If a bank is extremely large, it may become complacent and will be less careful in its investment and planning. It may engage in more risky operations, thinking that the government will rescue it if it one day goes bankrupt to avoid massive unemployment and financial disaster. If the size of a firm is reduced, the impact of its bankruptcy is reduced, too. The government may not protect it from ruin, given plenty of alternative banks to support the function of the entire economy. This forces banks to be more responsible in using customer money. Informed investment activities are beneficial to the nation as a whole. However, there are drawbacks of government intervention. First, the extent of internal economies of scale enjoyed This section of balancing the need for intervention (benefits of intervention) against the costs of intervention is crucial, as it helps evaluate the need for intervening.

by local firms is reduced as local firms are less cost competitive compared to international counterparts. This poses difficulty for local banks to venture overseas and makes them less likely

to survive if international giants set up local branches. Government intervention becomes all the more harmful if a nation, like Singapore, aims to be an international financial centre. Without a strong local banking industry, a nation will not internationalize its banking industry extensively, hampering long-run economic growth brought about by FDI and flow of funds. Breaking up big firms leads to erosion of supernormal profits. Firms have less profit for innovation and upgrading of services. The slower expansion and growth of banks may ultimately hurt customers who may have enjoyed better service. In severe cases, banks may collapse if the cost of operation can no longer be covered. This harms customers who cannot get their money back, and society in general through lower investment confidence. Lastly, government intervention will incur inefficiency from the process itself. Firms facing the prospect of being divided may lobby governments for favorable treatment. Such rent-seeking behavior may defeat the purpose of breaking up big firms, as firms receiving preferential treatment may still retain great market power that lowers the effectiveness of government intervention. Moreover,

breaking up firms may create internal inefficiency. The conflicts between new departments, the division of labor, and the discrepancy of corporate culture and philosophy are all instances of inefficiency. This lowers the cost competitiveness and standard of service of new banks. Ultimately, whether a government should intervene depends on the aim of the economy. If the government thinks that building the nation into an international financial centre is a priority, the breaking up of local firms is undesirable, as local firms are unable to reap the benefits of internationalization due to small size. If internationalization is not an urgent issue, the government can put more attention locally by forcing firms to upgrade their services under more intense competition. Moreover, whether to intervene also depends on the nature of the product. It is a trade-off between price and choice. If the product is an essential good, the government must ensure an affordable price. If the product isn’t essential, enhancing variety can greatly improve the welfare of consumers. In this case, improving variety in banking industry is more important. THE DEBT ISSUE

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(a) Explain the relationship between the business cycle and the government’s budget. [12] (b) Examine the view that a budget deficit is not harmful as it is a countercyclical tool. [13]

PART A

government’s budget consists of two elements: government revenues and government expenses. The bulk of government revenue comes from taxes of various forms, such as corporate tax, personal income tax, and value-added taxes. Other forms of revenues to fund government expenditures include payments for licenses and administrative charges levied by government agencies. Expenses of the government are for services or goods purchased by the government, such as the cost of investment projects or transfer payments for nonproductive work done. Government expenditure can be divided into three categories: expenditure on capital goods, expenditure on goods for current consumption, and transfer payments. Government expenditure is based on meeting several needs for managing the economy. The government’s expenses are for the provision of merit goods, such as education and healthcare (microeconomic goals), as well as macroeconomic goals of stabilizing growth (through the conduct of fiscal policy). As one primary tool for stabilizing the growth of the economy is through fiscal policy, government budget, which is dependent on the stance of the fiscal policy, will vary according to the business cycle. There are two forms of fiscal policy, one being automatic stabilizers and the revenue, the government is said other being discretionary fiscal policy. to be running a budget deficit The automatic stabilizing feature of fiscal for that year. On the contrary, policy refers to the in-built automatic when a government’s revenue mechanisms of a progressive income exceeds the spending for a tax system and unemployment benefits. particular year, it runs a budget Discretionary fiscal policy refers to surplus for that fiscal year. deliberate changes to either government A business cycle is made up spending or taxes (or both) in order of a peak, trough, upturn, and for a government to use fiscal policy downturn, and due to changes in national as a countercyclical tool to stabilize the income level it will affect a government’s economy. budget through both the automatic The government’s budget is rounded stabilizing as well as the discretionary up in each fiscal year. For a particular fiscal policy, affecting the government’s year, if government expenses exceed budget.

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ECONOMICS demand cannot be met by corresponding increase in aggregate supply, posing the risk of demand pull inflation. Hence, the government wants to avert inflation. To do that, the government has to reduce expenses so that AD does not rise as quickly as the cutback in G helps to offset the rise in AD due to other components, such as consumption and investment by firms. At the same time, the government prevents further increases in AD by raising direct taxes, such as corporate and personal income taxes. This causes the government to see rising tax revenues, especially since taxes are the main form of revenue. These two deliberate changes to government spending and taxes will cause a government to deliberately run a budget surplus during a boom. Besides deliberately running a budget surplus, the budget tends to go into a surplus automatically, due to the features of the automatic stabilizers. During an economic boom, as national income increases and employment levels are high, the government will see a fall in its spending due to fewer unemployed citizens claiming unemployment benefits. This decreases payouts and lessens government expenditure. As the income of individuals rises, profits of firms will cause individuals and firms to pay a higher absolute amount of taxes. Lower levels of unemployment cause an increased tax base as more people contribute to tax revenue. Furthermore, with increases in salary, individuals get pushed into higher tax brackets, which causes tax revenue to increase further.

During the peak of the economy, aggregate demand is rising fast. General price levels are also rising fast as increases in aggregate Since the question is about the relationship between government budget and the business cycle, the student needs to clearly state the relationship before explaining it. During an economic downturn, the government’s budget tends to go into deficit. While during an economic upturn, the government’s budget tends to go into surplus.

At the same time, the automatic features of more unemployment benefit payouts as unemployment numbers climb and reduced taxes from falling incomes will cause revenue to fall, causing spending to exceed revenue. During an economic boom, countries see their budget positions improve and generally record budget surpluses. During economic recessions, the budget position worsens and the government records budget deficits.

PART B

his essay will examine the consequences of a budget deficit and whether or not it is harmful. Whether or not a budget deficit is harmful depends on several factors, such as the circumstances leading to the deficit and the extent of the problem, as well as whether it is a one off deficit or prolonged and the amount of budget deficit incurred. Though the points here are valid in considering whether or not a budget deficit is harmful, however, this discussion is not an exact interpretation of the question. The question requires a discussion of the view that running budget deficits with the intent of stabilizing the economy through expansionary fiscal policy is not harmful.

There are many reasons for a government to run a budget deficit. One is from the use of fiscal policy as a countercyclical tool. Given that the purpose behind the budget deficit is

to prevent the economy from sinking deeper into recession, the deficit poses less of a problem since the budget deficit has countercyclical effects. During a recession, the aggregate demand of the economy is weak. Households do not wish to consume and firms do not wish to invest due to an uncertain and pessimistic outlook. To boost economic activity, a government has to increase its spending on building bridges and hospitals or transfer grants to lower income households. This additional spending will help increase the aggregate demand from AD to AD1 and prevent aggregate demand from falling further. A government will also reduce taxes, such as the corporate tax, to encourage investment from firms by allowing more post-tax profits to be retained and personal income tax to encourage consumption by raising the disposable income of households, thereby boosting aggregate demand. As increased consumption and investment flows into the economy, it encourages further rounds of increases in income and expenditure. The multiplier effect will bring about an increase in national income that is higher than the initial increase in government expenditure or tax cuts. As the level of economic activity increases, this also helps create jobs in an environment of job losses. The large amount of government expenditure pumped in will also enhance confidence of investors, both locally and from abroad, encouraging investment by lifting economic gloom through the expansionary fiscal policy. Hence, running

FIGURE 3 POSITIVE EFFECTS OF A BUDGET DEFICIT

During a recession or economic downturn, a government’s budget tends to move into deficit, due to both the automatic stabilizing effect and deliberate fiscal stimulus enacted to counter the recession. During an economic recession, the reverse happens. Countries tend to suffer budget deficits. Given that AD tends to fall rapidly, a government will adopt a deliberate expansionary fiscal policy of increasing government expenditure and/ or fall in taxes. Increased spending, along with reduced tax revenues collected due to tax cuts to spur more consumption and investment, will cause the budget to go into deficit. THE DEBT ISSUE

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a budget deficit is not harmful, as it helps stabilize economic growth and prevent further job losses. However, such a way of managing an economy has its drawbacks. If conducting expansionary fiscal policy results in a one off budget deficit, it is not harmful. But Here, it will be good to see the problems of running a budget deficit due to the conduct of expansionary fiscal policy to be grouped under (i) problems or limitations of fiscal policy that cause other macro problems in the short term and (ii) problems of a budget deficit in the longer run. Hence, the problem of crowding out of private investment can be considered a short-term problem along with the problem of budget deficits taking a long time to start helping the economy (long time lags) such that by the time the policy takes effect, the economy may have already recovered on its own, causing the economy to over-expand instead. This causes growth to be more unstable.

if continuous conduct of expansionary fiscal policies results in prolonged budget deficits and accumulated debt, despite the benefits of stabilizing growth, it is creating harmful effects on the economy. The US economy is facing such a situation now. To pay off accumulated debt, the government has to find ways to pay for expenditures not covered by government revenues. One way is to borrow. Under the condition of limited loans in the funds market, the large amount of borrowing from the government increases demand for loans, thus forcing interest rates to rise, forcing private individual loan-seekers who cannot afford the higher interest rate to leave the market. The crowding-out effect discourages investment by private firms. The decrease in private investment may even outweigh the injection of spending from the government. As a result, the effectiveness of the government’s policy to get the economy out of recession is limited. If private investment is discouraged, the amount of taxes a government can collect from firms is also limited, further worsening the deficit for that year. Another consequence of government deficit is the need to raise taxes in the long run. Both personal income tax and

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corporate tax will need to increase in the long run to be able to pay off government debt incurred from expansionary fiscal policies. Households expecting such tax increases are less willing to consume, even if disposable income has risen due to tax cuts. Hence, any current expansionary policies will not be as effective as households and firms are curbing spending while government debt mounts. Rising taxes in the long run also lowers people’s standard of living as well as the long-term economic growth achieved by investment. The lowered SOL also comes from the need for GDP to be spent on repaying the loan and interest payments and not for improving infrastructure or provision of merit goods, such as healthcare and education.

Moreover, chronic budget deficits affects a nation’s financial reputation if the problem persists. Recent examples can be seen in EU countries plagued by prolonged adversity policies or austerity measures, which include increased income tax and reduced welfare benefits. Such countries also suffer from lower financial credit. That further limits their borrowing liberty while sending a Here, it is important to look at the source of loans to the government running a debt. Usually when loans are internal, meaning borrowed from savings within the country, it is considered less harmful. This is the case of Japan, whereby despite a large debt amount, it is of now not considered to be at large default risks, since the huge supply of loans domestically allows the government to borrow at a lower interest cost. Furthermore, an internal loan is also safer, since it does not involve foreign exchange risks. Loans borrowed from overseas will run the risk of foreign exchange risks. When borrowing in a foreign currency and the domestic currency depreciates, the loan amount balloons in domestic currency terms. This makes repayment of debt even more difficult. It is good that the student writes clearly to distinguish the fact that budget deficits are for a particular fiscal year while debt is a stock concept that is determined from many years of budget surpluses vs. budget deficits.

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BOTH PERSONAL INCOME TAX AND CORPORATE TAX WILL NEED TO INCREASE IN THE LONG RUN TO BE ABLE TO PAY OFF GOVERNMENT DEBT INCURRED FROM EXPANSIONARY FISCAL POLICIES. negative signal to investors who may be afraid the government will resort to “default” so they won’t be able to get their money back, thereby preventing those countries from taking on fresh loans to service interest payments on debts already incurred. Countries will be seen to be at risk of defaulting, since the cost of interest repayments take up a larger and larger portion of their GDP. A pessimistic mood discourages both consumption and investment and nations continue to be mired in recession. During extreme cases, a government may choose to print a lot more money to pay the debt. Excessive circulation of money, according to the monetary theory, leads to monetary inflation. Desperate printing of money, like what was done in Germany, leads to hyperinflation. The general price level skyrockets and the economy become highly unstable, causing a fall in export competitiveness and the loss of investors as the country becomes uncompetitive. In conclusion, using budget deficit as a way of stabilizing economy has its shortterm efficacy ,provided a budget deficit is only for the short term and best financed by subsequent years of budget surplus. The benefits of a budget deficit are that it helps stabilize growth and employment in an economy. However, when used as a countercyclical tool and if it leads to prolonged deficit, such a process can be harmful, as it means that a country is accumulating debt, which will cause longterm macro-instability for the economy.

NO Are budget deficits harmful? (Are expansionary fiscal policies harmful?)

Countercyclical tool to stabilise the growth of economy Budget deficit is one - off or does not lead to long term debt

Leads to long term debt problems

YES

Short term problems of debt deficit

Austerity policies causing further contraction of economy Fear of collapse of economy and pessimism

Crowding out effect

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MACRO ECONOMICS

THE CHAINS OF

DEBT A DEVELOPING ECONOMY PERSPECTIVE

Countries in Africa, such as Nigeria and South Africa, are well known to have struggled with national debt for a long time. The debt incurred by them is both internal and external. Internal debt implies that borrowing takes place within the country, and external debt refers to borrowing abroad. Since the 1960s to 1975, Nigeria, for example, started borrowing abroad in smaller amounts with lower rates of interest and a longer time frame provided for loan repayment. However, in the 1978 Nigeria began borrowing from international financial centres in huge sums, from private sources at floating interest rates, and had a shorter time frame for loan repayment. In 1982, the value of Nigeria’s external indebtedness was 160% of its GDP in that year. However, in 2012 it has been reported that Nigeria’s total indebtedness stands at 17.47% of her

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Is there any good debt, by which taking on debt results in higher economic growth? How does debt eat away economic growth? Why does debt affect not only one economy but also have the ability to affect other economies at the same time?

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GDP in the same year. Indeed, countries like Nigeria and other similar economies have come a long way toward reducing the debt accumulated over the years. We will examine how their growth has been impacted in the process of having to struggle with their debt repayments.

POSITIVE EFFECTS OF DEBT ON GROWTH

Debt can have a positive impact on growth for developing countries because capital accumulation is extremely important for economic development. Studies have shown that “developing countries in Africa are characterized by inadequate internal capital formation due to vicious circle of low productivity, low income, and low savings”. Hence, with insufficient savings and loans available for borrowing for capital investment, incurring external debt is the next best alternative countries in Africa can employ to break out of the vicious circle. In theory, with more capital accumulation at present, there can be a higher level of output produced in the future. This in turn will increase the real national income of the country, and when households earn more, they are able to save more, which will help increase the stock of savings within the

DEBT AND ECONOMIC GROWTH

Only by borrowing money to purchase expensive machinery can countries increase productivity and command higher levels of production and GDP. Increasing the level of capital goods will mean an increase in aggregate demand and this in turn results in a multiplied increase in national income. In the long run, the completion of the manufacturing facilities will mean that the country’s production capacity will be raised, increasing potential growth.

domestic economy. This will reduce their reliance on external debt. With higher real national income, at the same tax rates, tax revenue will also increase for the government. Therefore, the need for the government to borrow, whether internally or externally, is also lowered. In this ideal scenario, a self-sustainable long-term growth should take place for the country eventually. So the entire basis of embarking on debt is to make possible the start of an economic restructuring program that allows the country to increase its chances of generating higher levels of GDP through moving into higher value-added production.

IN THEORY, WITH MORE CAPITAL ACCUMULATION AT PRESENT, THERE CAN BE A HIGHER LEVEL OF OUTPUT PRODUCED IN THE FUTURE. THIS IN TURN WILL INCREASE THE REAL NATIONAL INCOME OF THE COUNTRY, AND WHEN HOUSEHOLDS EARN MORE, THEY ARE ABLE TO SAVE MORE, WHICH WILL HELP INCREASE THE STOCK OF SAVINGS WITHIN THE DOMESTIC ECONOMY. THE DEBT ISSUE

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HENCE, THE UNFORTUNATE TRUTH IS THAT PUBLIC INVESTMENT THROUGH INCREASES IN GOVERNMENT EXPENDITURE MAY RAISE NATIONAL INCOME IN THE SHORT TERM, BUT IT STILL HAS TO BE COMPLEMENTED BY PRIVATE INVESTMENT FOR LONG-TERM GROWTH TO TAKE PLACE IN THE SPECIFIC CONTEXT OF AFRICAN ECONOMIES. is also required to be in place to attract potential private investment opportunities which in turn can help develop more sophisticated infrastructure for the purpose of production. Hence, the unfortunate truth is that public investment through increases in government expenditure may raise national income in the short term, but it still has to be complemented by private investment for long-term growth to take place in the specific context of African economies. Thus, a lower ability to service debt will lead to a lower chance for growth.

However, there are some strong assumptions behind the ideal scenario. Debt incurred can only generate positive growth in the country when the extent of growth in national income is high enough to service the existing debt and still be channelled into further economic activities. However, in the case for Nigeria and South Africa, studies have shown that the debt repayment was challenging for the following reasons: The huge size of debt, the increased proportion of debt subjected to floating interest rates (total interest repayments on the debt increases when the interest rates rises), and the shortened maturity of the loans. Moreover, both Nigeria and South Africa export mainly raw natural resources, such as oil and agriculture produce, whose price are subject to world price volatility, thus providing unstable export revenue. The primary nature of goods exported also implies that the terms of trade tend to be less favourable, which also reduces the export revenue earned. As such, a significant proportion of investment returns and increased national income has to be allocated to servicing a debt of a larger principal sum and higher interest repayments and this has to be done more frequently. All of these come at the expense of other economic activities

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the EU economies are at “high risk with regard to fiscal sustainability” as a result of debt accumulation. For example, some of the European economies (typical to most developed countries) face the problem of an ageing population, which will require more government spending in the healthcare industry. At the same time, tax revenues that used to be contributed by the retired group of workers diminish, and in turn they may

FIGURE 1

2011 DEBT TO GDP RATIOS: GLOBAL COMPARISONS 2010 GROSS DEBT AS A PERCENTAGE OF GDP

A CLOSER COMPARISON BETWEEN NIGERIA AND SOUTH AFRICA

that could contribute to growth. The unstable and slow rate of increase in national income based on home grown natural resources alone also reinforce the difficulty in servicing their debt. In the context of developing economies such as Africa, public expenditure for both social and economic reasons is an important prerequisite for further private sector investment. Due to the weakness of private sector forces, government intervention in the form of intervening to “crowd in” private investment becomes crucial. Hence, any government attention that is turned towards using financial resources towards repayment of the debt comes at a high opportunity cost. Not only is welfare reduced from a lack of provision of merit goods, but there is also a loss of the ability to attract foreign direct investment. For example, basic urban infrastructure, such as roads for transport, schools for education, and

Terms of trade is calculated by taking the index of prices of exports divided by the index of prices of imports. Due to falling prices of exports in the form of falling agriculture exports for developing countries, their terms of trade becomes less favourable as these countries end up exporting more units of agriculture products in return for a unit of imported goods. Instead of using any increase in GDP towards funding the building of infrastructure that can further fuel greater growth, countries find that they need to use GDP towards repayment of debt with little left for propelling growth.

hospitals for a healthy workforce, would require the government to develop. When left to the private sector, these goods will be not produced or will be under-produced because of their public good characteristics or the positive externalities generated. Beyond the social implications, basic infrastructure

Detailed empirical studies have shown that even though Nigeria and South Africa share common characteristics as African economies, debt has a different impact on growth for each of them. It was found that South Africa “services her external debt conscientiously,” whereas Nigeria doesn’t. Hence, Nigeria’s stock debt will build up over time whilst South Africa’s reduces. In line with the discussion in the previous section, we would therefore expect South Africa’s debt to have a more positive impact on growth as a growing proportion of return on investment and hence increase in national income (made with the loans) will be further channelled to productive activities along with debt repayments— and vice versa for Nigeria. However, in the same study it was reported that Nigeria was the beneficiary of a debt relief scheme to reduce its debt stock, in the hope that it would provide a better chance for economic growth in the future.

A DEVELOPED COUNTRY PERSPECTIVE

The following figure shows country comparisons of debt to GDP ratios. Before we go away assuming that African economies are the worst off in terms of their debt commitments, the figure below proves otherwise. From Figure 1,

Source: I-Net Bridge

NEGATIVE EFFECTS OF DEBT ON GROWTH— IMPLICATIONS OF DEBT SERVICING ABILITY

in 2011 South Africa’s debt to GDP ratio was actually the lowest when compared to European countries. For example, Greece’s debt to GDP ratio was four times more than South Africa’s, contrary to popular belief. Studies on the impact of various European economies’ debt on growth have highlighted the following issues. Similar to the case in Africa, debt can have both a positive and negative impact

on growth. However, in the case of European economies, it was found that a debt to GDP ratio above the range of 90–100% would have negative impact on economic growth. Hence, at least half of the European countries shown above are expected to face a severe macro problem of slow or negative growth in the future. In the European Commission’s sustainability report, it was reported that A big determinant of whether debt has a positive or negative impact on GDP depends on the nature or the cause of the debt. Is the debt for the purchase of capital goods or is it private in nature, used to finance private consumption?

receive pay-outs from the government. On top of the existing debt incurred, further fiscal budget deficits may add to the debt burden. In response, households and firms may expect tax rates to increase in the future so the government can collect more tax revenue to finance their debt. As a greater proportion of income is taxed away, post-tax profits for firms are reduced, which will reduce the financial ability of firms to make investments. Household incentive for work may be reduced, lowering labour productivity in the economy. A lower disposable income for households also implies that stocks of savings will be reduced in the economy over time, lowering the supply of loans and driving up interest THE DEBT ISSUE

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rates for borrowers. This will discourage expenditure and growth. The crowding out effect is also a stark reality for governments in severe debt. which will eventually drive up interest rates and discourage spending. Through the various channels and inner workings in the economy, short-term and long-term growth will be compromised.

THE CONTAGION EFFECTS OF DEBT

As observed in the figure, Greece has the highest debt to GDP ratio amongst its EU counterparts, and that debt doesn’t only impact its domestic growth. but also the growth of the whole region. News has reported that up to $240 billion euros have been given by European Union countries and IMF to help Greece repay its debt under the condition that Greece undertakes dramatic austerity measures involving cutting public expenditure and raising tax rates to reduce current

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budget deficits lest it add to its debt accumulation. The opportunity costs of this choice imply less funding to propel the growth of other individual EU economies. Also, Greece’s debt situation has sparked tremendous economic uncertainty, both amongst the EU community and globally. Investors will not only have no confidence in doing business in Greece, but they will also be cautious about investing in the other EU countries, knowing that EU growth prospects have been compromised by the real possibility that Greece will default on its loans. For example , Greece borrowed from French, German, UK, and US banks, and if those banks were forced to write off Greece debt or if Greece defaulted on the loans, banks around the world would be reluctant to give out loans and would be less able to lend to one another, as well. This would have a great impact on the spending ability of firms and households, bringing the EU economy’s growth to a standstill. The poor economic situation caused by the debt crisis in the Eurozone has also caused a severe weakening of the euro. By the market mechanism, the supply of euros increases and the demand for euros falls as people prefer to transact or hold their assets in currencies that are more stable. However, this weakening favours growth for certain countries, such as Germany, the Netherlands, Belgium, and Ireland. The weakened currency helps increase export competitiveness generate a surplus in their current accounts and contributes to short-term economic growth. However, these countries have something in common. Their debt to GDP ratios are lower than that of Greece. Even though some are still in the unhealthy range, these economies probably have better fiscal discipline, more robust export industries, and stronger economic fundamentals

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than that of Greece. This means that they are more likely to have a debt burden that they are competent in carrying. On the other hand, weaker economies that are experiencing a current account deficit will experience a slower growth because of rising imports of raw materials, such as oil. Hence, the weakened euro, as a result of uncertainty from the debt crisis, reinforces the negative outlook on growth for some economies.

CONCLUSION

The theoretical linkages between debt and growth are not difficult to comprehend and can be analysed via the understanding of the commonly utilized AD-AS model. The complexity of the issue may vary, depending on the characteristics of the economy— developing or developed—the underlying specific causes for debt in each economy, etc. However, one crucial factor that determines which direction growth takes is the ability of a country to service its debt. In the light of global debt problems, we learn not to take the discipline of Singapore’s fiscal and banking industries for granted.

REFERENCES: Ayadi, F. S., & Ayadi, F. O. (2008). The Impact of External Debt on Economic Growth: A Comparative Study of Nigeria and South Africa. Journal of Sustainable Development in Africa, Vol.10, No.3, 234-264. Bakare, A. (2010). Debt Forgiveness and its Impact on the Growth of Nigerian Economy: An Empirical Study . Pakistan Journal of Social Sciences, 7 (2) , 34-39. Checherila, C., & Rother, P. (2010). The impact of high and growing government debt on economic growth: An emprical investigation for the Euro area. European Central Bank Working Paper No. 1237, 1-42. Ezeabasili, V. N., Isu, H. O., & Mojekwu, J. N. (2011). Nigeria's External Debt and Economic Growth: An Error Correction Approach. International Journal of Business and Management Vol.6 No.5, 156-170. Hoveni, J. (2012). South Africa's 2012/13 budget: building infrastructure to support growth and provide jobs. Johannesburg: Momentum Manager of Managers (Pty) Ltd. WEBSITES: http://business.asiaone.com/Business/News/ My%2BMoney/Story/A1Story20110718-289679/6. html

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THE DEBT ISSUE

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he presence of debt in an economy, whether incurred by the public or the private sector, can have different impacts on the macroeconomic performance of a country. Debt can be incurred by the government and can also be incurred by private businesses and households. In this article, we will be examining the interaction between debt and inflation, the impact of debt on inflation, and of inflation on debt.

GOVERNMENT DEBT AND ITS IMPACT ON INFLATION

What is the usual observation in terms of the relationship of debt on general price

KEY POINTS OF QUERY

Whenever a country suffers from high levels of debt, does it lead to situations of inflation or deflation? What have the ways of reducing debt got to do with triggering inflation during a debt crisis? What about the effects of inflation on the level of debt? In a period of inflation, does it encourage more or less borrowing amongst households, firms, and governments?

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levels in an economy? Does a greater level of debt in a country coincide with a higher inflationary pressure within an economy, or does it happen the other way around, which is that high levels of debt result in low rates of inflationâ&#x20AC;&#x201D;or even deflationary pressures? When government debt is present, the next course of action by any sound government would be to think of way to solve the debt problem, commonly known as a budget deficit. One major way of financing government debt would be to issue new money or to increase the money supply in the country. One may wonder how printing new money helps to solve a debt problem. A government can borrow money by selling government bonds to other parties, such as private investors located domestically or abroad (including other foreign governments). Each bond is transacted at a certain price, with a promised interest repayment upon the maturity date of the bond. The government can use the new money to repay lenders when the government bonds mature. In another scenario, the government can issue new

money to directly finance government expenditure (as opposed to borrowing). However, this process is commonly known through empirical evidence and theory to almost guarantee a situation of inflation, ceteris paribus. American economist Irving Fisher postulates a theory that hypothesizes the relationship between money supply and price levels. At the heart of the theory, Fisher claims that the total nominal value of goods and services produced in an economy must equal the total stock of money supply, multiplied by the number of times the money is circulated within the economy. Hence, by simple intuition, rising prices happen when the money supply increases whilst the quantity of real output and the number of times money changes hands remains the same. It will create a situation where higher nominal dollar votes are cast for the same stock of goods and services. Hence, prices of the unchanged quantity of real output increase in alignment with the signalling and rationing function of prices. Whilst the increase in price levels is certain, the duration of increase depends THE DEBT ISSUE

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in the US today, where high levels of debt run parallel with high levels of unemployment, general weakness, and pessimism. Pessimism is the reason that the radical policy move of quantitative easing was announced in June 2011 (Figure 1). Given that such a policy can trigger inflationary pressure, the goahead of subsequent rounds attest to the environment of falling prices and low inflationary fears that made such a policy possible. In today’s actual policy implementation, a more subtle and indirect form of increasing the supply of money within the economy has been taking place, termed as a quantitative easing policy. This method became increasingly popular when cuts in interest rates to near 0% levels still were not effective in stimulating more spending. The primary objective was to increase economic growth and employment. The central banks help stimulate spending by placing more money into

on how the increase in money stock is spent. If the increase in money stock is used to finance government investment projects, it will eventually induce an increase in real output. In the short term, when real output remains constant, we can expect prices to rise, as explained in the previous paragraph. However, in the long term, when more real output is produced via more capital stock accumulation, the higher nominal dollar votes cast will be simultaneously met by an increase in supply of real output, thereby increasing the stock of real output available in the economy for purchase. Thus, the average price of goods and services in the economy will increase by a smaller extent or remain the same. The inflation consequence of government debt is not merely a theoretical prediction. It has been observed historically, as affirmed by research. “High budget deficits that inevitably caused extreme inflation of up to 50, 100, or even 500% per year have been recorded in the mid-eighties in Latin America and Israel. In

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the 1980s, in Mexico the monetary basis increased, for instance, with 80–90% per year, producing an increase in 100–130% in the inflation rate in that period”. This goes to show that high levels of debt are tied to high levels of inflation as a result of the chosen policy tool for solving In fact there have been economists who suggest that governments favour rising inflation as a way to reduce their burden of the debt and an easy way to reduce their debt to GDP ratios. If the inflation rate is high enough, nominal GDP can grow faster than the deficit, reducing the debt to GDP ratio. With the nominal value of the total debt unchanged, inflation can reduce the real value of the debt as well.

debt problems—that of printing money. In view of the lessons learnt from past economies, contemporary economies have taken measures to prevent history from repeating itself by putting laws in place to prohibit the use of money issuing to finance government debts. For

example, within the European Union, the Treaty of Maastrict “prohibits the direct monetary financing of public deficits by central banks”. Though we can see how debt can easily be associated with high inflation, the occurrence of high levels of debt and corresponding periods of deflation have also been researched. This can be understood as high and dangerous levels of debt causing pessimism and slowdown in major economies as consumers cut back on spending to increase savings. The cutback in consumption slows growth. With aggregate demand falling, prices fall. High levels of debt get linked to periods of pessimism and high rates of unemployment, much like what we are witnessing in today’s euro crisis. In fact, a famous economist has even gone so far as to link the occurrence of high debt and deflation to the start of economic depressions, since deflation causes the burden of the debt to increase as money owed increases in purchasing power. This triggers even more cutbacks, bringing on depressions. Somehow, this scenario sounds strangely familiar to what we are seeing

FIGURE 1 NEAR ZERO INTEREST RATES

Despite nominal interest rates being that low and the cost of borrowing extremely cheap, this was not helping to stimulate the economy, since low interest rates coincided with a lack of money to lend—otherwise known as a credit crunch. To get the entire engine moving, the central bank needs to put cold hard cash into the economy.

the hands of firms, households, and governments in exchange for some form of assets. This money is generally newly printed money. Quantitative easing differs in that assets are sold to the central bank in return for cash. These assets are mainly bought from banks to help free up cash into their accounts for extending loans. This differs from the traditional policy where money is simply printed without taking in assets.

However there are variations to such a policy that can achieve the same effect without having to print more money. An example would be the central bank of America. They sell short-term assets to raise money to buy long-term assets from investors. Without printing more money, they increase the quantity of cash in the current time period for investors who otherwise would have to wait a longer period to cash out their assets.

Governments that are not under such monetary regulations find their central banks empowered to finance government debt directly by buying government treasury bonds with newly printed money. The central bank buys the treasury bonds and in turn places money into the hands of the government for further spending needs. This does not solve the problem of debt directly because eventually the bonds the central bank is holding will mature and the principal, with interest, will have to be repaid by the government. However, the participation of the central bank in purchasing government bonds helps cut the government’s borrowing costs. Some form of security and stability is introduced into the situation as the central bank’s involvement signals to the general public that there is credibility in the government’s ability to repay the loan. Hence, it reduces the perception of the risk involved in lending money to the government, which reduces the government’s borrowing interest rates. This has further benefits as lower borrowing costs for the government in the current period reduces the likelihood of having to raise tax rates to repay higher interest rate repayments in the future. There are also costs incurred with such a policy. The buying up of government debt by the central bank distorts the market signals of the government’s

FIGURE 2 UNDERSTANDING QUANTITATIVE EASING

In economies where debt is a major feature of the economic landscape, quantitative easing can have secondary benefits on the debt issue, as well. In the case of the European Union, since the Treaty of Masstrict holds, the central bank can only buy government debt from the private sector. Since the restriction was on financing of public sector debt. Here the Treaty of Masstrict was preventing the easy way out of government debt being paid off by printing money, which would trigger runaway inflation. Whereas, in the case of quantitative easing, the intent was really to jumpstart and put some growth into the economy. The central bank thus acts as a buyer of assets and the price paid for these assets is the key question. Are these assets worth the amount being sold for?

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cost of borrowing, which may lead to the government borrowing even more. Artificially low interest rates may also reduce the pressure on governments to address the fundamental problems with their public finances. The central bank could also lose a level of control on inflation if the general public loses confidence in the government and the central bank has to take over the debt burden. When that happens, more money will be injected into the economy in exchange for the bonds held by the public. Hence, spending will increase, fuelling a situation of demand pull inflation. The presence of government debt can also lead to inflationary pressures even without the government issuing new money and increasing the money Though high levels of debt can easily cause pessimism and deflation, which can lead to further actions that can cause inflationary pressures to be set off, as seen here.

stock. It also boils down to people’s sentiments and expectations about the government’s course of action. The size of the government debt could be so huge that households and businesses may come to believe that the government will eventually have to print more money to pay off the debt. As a result, there could be a collective selling of domestic currency in the foreign exchange market for foreign currency as people expect the internal value of domestic money to fall. Assuming a freely floating exchange regime, the exchange rate would therefore depreciate, making price of imported goods more expensive in terms of domestic currency and leading to an imported inflation situation. On the other hand, the depreciation would also cause prices of exports to be cheaper in terms of foreign currency, encouraging increase in foreign demand for domestic goods and bidding up the price of goods and services. The combination of these two effects could also encourage a wage-price spiral where higher nominal wages are negotiated to maintain real wage levels for workers as average price levels increase. Hence,

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market sentiments, when collective and massive, can bring about a self-fulfilling prophecy. The above discussion examines the theoretical linkage between debt and its consequence on inflation. However, given that legislation has been put in place in modern economies to govern monetary policy, the likelihood of experiencing inflation in this manner is low.

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have higher purchasing power to buy more consumer goods and services apart from housing. Through the AD-AS model, a sustained increase in consumption maybe encouraged, causing AD to increase and resulting in a rise in general price levels when the resources in an economy are near full employment levels.

BUSINESS DEBT AND ITS IMPACT ON INFLATION

RISING PRICES AS PRECURSOR? Businesses, like the government and HOUSEHOLD DEBT AND ITS IMPACT ON INFLATION

In the above paragraphs, we’ve seen how policy approaches towards government debt may cause average price levels to increase. Household debt can also contribute to an increase in average price levels by influencing the market prices of specific goods, such as housing. The relationship between household debt and housing prices has been widely examined in academic literature because a house purchase is the most common reason households are in debt. In the case of Thailand, for example, the “household debt cycle appears to be correlated with the house price cycle. An increase in household debt is associated with an acceleration in housing price inflation and vice versa”. This can be easily explained by a simple demand and supply framework. Households increase their effective demand for housing through increased purchasing power via borrowing. With a given supply of housing, this bids up housing prices via the price mechanism and higher equilibrium prices of housing is observed. The extent to which housing prices influence the average price levels of a country will depend on the weight given to the housing commodity amongst a selected basket of goods adopted by a country in calculating inflation rates. Incidentally, housing prices are not only determined by demand factors, but also by supply factors. Developers of private housing, for example, may also rely on borrowed money from private banks to fund their housing developments, which in turn influence the supply of housing. This affirms the close relationship indebtedness has with housing prices and the average price levels of a country. In general, greater household indebtedness implies that families can

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households, borrow money to spend. Typically, loans are for investment expenditure, such as the purchase of capital goods, intermediate goods for final goods production, and so forth. Similarly, via the AD-AS framework, investment expenditure increases, resulting in an increase in AD. Assuming the economy is operating near full employment level of resources, average price levels of goods and services can be expected to rise.

INFLATION AND ITS IMPACT ON DEBT—GOVERNMENT, HOUSEHOLD, AND BUSINESS

Having looked at the effects of debt on price levels and seeing that it can be linked to either inflation or deflation, let’s now look at how inflation can impact on debt. “People know that inflation erodes the real value of the government’s debt and, therefore, that it is in the interest of the government to create some inflation”. Ben Bernanke In the case of highly indebted countries, inflation can help reduce the real value of the government debt, which in this case makes the government a winner in the redistribution effects of inflation and lenders the losers, since the real value of debt repaid has also been reduced. However, this only applies if debt is incurred in terms of national currency because inflation influences only the internal value of money. Should debt be incurred in terms of foreign currency, inflation would have no beneficial effect on the real value of debt. But this benefit is short-lived, especially if nominal interest rates are indexed linked to the rate of inflation. Hence, the real value of interest repayments would remain the same or increase when the rate of increase in nominal interest rates is faster than the rate of inflation. Thus the

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benefits are nullified. is prepared to accommodate sharp On the other hand, nominal interest increases in the inflation rate, which in rates can also be deliberately set below itself will spark other forms of economic the inflation rate to the extent that the costs. Also, it is less beneficial to use real value of interest rate is negative. This inflation as a tool for debt erosion scenario is popularly known as financial because the American government is still repression. This effectively enables issuing fresh bonds today. The real debt a government to receive payments value of the past may be reduced, but the even when in debt, which then helps new debts incurred would be indexed the government raise more money for linked to inflation, as lenders have a built expenditure. in expectation that inflation would occur The effect of inflation on debt reduction in the future. was helpful to America after the Second At times a government can be faced World War. However, it was only helpful with the macro problem of rising price to a small extent. It was estimated that levels as well as existing debts. Let’s “less than a quarter of the reduction in say that inflation is the main problem a America’s debt to GDP ratio between government wants to tackle. By theory, 1945 and 1974 came from negative real contractionary monetary policy, such as rates of return on government bonds,” raising interest rates, could be employed. according to George Hall and Thomas However, this would increase the size of Sargent. the existing government debt. Following The primary source of debt reduction an increase in interest rates, the total came from strong post-war economic interest repayment from the government growth as the consequential budget to lenders would increase, thus surpluses accumulated. Moreover, the compounding the total amount of debt. higher inflation rates eroded the value In such a scenario, there needs to be of debt on bonds that had a medium “monetary-fiscal policy coordination” to to long term maturity (five years or ensure that reducing inflation is matched more), whereas bond with shorter term by the ability of a government to raise maturity were in the position to negotiate more revenue to repay its debts. for higher nominal interest returns as In respect to household indebtedness, a result of the inflation situation. It is inflation rate influence on nominal still of interest as to whether America interest rates will also impact the size will adopt a similar approach towards of household debt. In times of lower inflation and debt. The temptation to do inflation rates (e.g. 2% and nominal is huge as empirical research has shown interest rates 5%), individuals borrowing that an “an inflation of 6% over four years four times their annual salary will only be could reduce the debt to GDP ratio by a paying 20% of it in mortgage payments significant 20%”. in the first year. However, in times of However, the favourable conditions high inflation rates of 12% and nominal of the past may not apply now. The interest rates of 15%, that same person bulk of public debt incurred by America would be paying 60% of his gross salary has an average maturity of five years, in mortgage payments in the first year unlike an average of seven years in the (with similar conditions of borrowing past. Hence, the scope for debt value four times the annual salary and real erosion is limited, unless the government interest rates constant at 3% in both

HOWEVER, THE FAVOURABLE CONDITIONS OF THE PAST MAY NOT APPLY NOW. THE BULK OF PUBLIC DEBT INCURRED BY AMERICA HAS AN AVERAGE MATURITY OF FIVE YEARS, UNLIKE AN AVERAGE OF SEVEN YEARS IN THE PAST.

examples). Hence, inflation rates and their coordination with nominal interest rates have a significant impact on the proportion of a person’s annual salary allocated to mortgage repayment, which in turn affects the total size of debt and loan a person undertakes. With specific reference to housing, rising housing prices can also encourage more household indebtedness. Housing can be a form of collateral used when households borrow from banks. As housing prices increase, the value of the collateral also increases. This in turn increases the quantity of money the borrower can take from a bank. The bank is also more willing to lend because if the borrower defaults on the loan, the house will then belong to the bank, allowing it to recoup the loss.

CONCLUSION

Governments, households, and firms, through uncoordinated borrowing, can collectively exert inflationary pressure on an economy. However, if the source is from households and firms, it might not necessarily be a bad thing. An increase in indebtedness in the private sector could be a reflection of increased consumer and business confidence in the economy’s performance—at present and in the future. For example, an expectation of higher income for firms and households would enable them to repay loans comfortably, which would increase levels of borrowing. Hence, signs of inflationary pressure are not a large concern unless it is excessive in nature, coupled with a scenario where the private sector is unable to service its loan repayments.

REFERENCES Angela Boariu, I. B. (2007). Inflationary effects of budget deficit financing in contemporary economies. 77-82. Cochrane, J. H. (2011). Inflation and Debt . United States: National Affairs . Guy Debelle. (2004). Macroeconomic Implications of rising household debt. Switzerland: Bank for Interntional Settlements, Monetary and Economic Department. Nickell, S. (2004). Household Debt, House Prices and Consumption Growth. London: Bank of England Monetary Policy Committee and London School of Economics . Sbrancia, M. (2011). Debt and Inflation during a Period of Financial Repression . Job Market Paper , 1-73. Subhanij, T. (n.d.). Household sector and monetary policy implications: Thailand’s recent experience. Switzerland : Bank for International Settlements, BIS Working Papers No. 46.

THE DEBT ISSUE

Savings Glut

Consumer Revolution

Opportunity Cost

Housing Markets

Recession

Rising Prices

International Finance

Debt Crises

Market

Currency Markets

Government Intervention

Bear Markets

Bull Markets

Banking Collapse

Trade Surplus

Regardless of whatever Economic Phenomenon,

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