Effects Of Public Debt On Money Supply

AUTHORS:

HIRA NISAR KHAN, MAHAM KHAWAR, INAM KHAN

ABSTRACT:

This paper examines the effect of Public Debt in Pakistan since the 1980s to 2014. The three economic fundamentals studied include the economic growth, investment and unemployment and the effect of public debt, across the three decades, has been examined on each of the fundamental. The paper's findings through the simple regression models and Ordinary Least Square method emphasize and strengthen the theoretical approach that public debt is a deterrent for economic growth, employment opportunity and investment cloud. The causality test was also conducted to study causation between Public Debt with each of the variables. The study finds that Public debt reduces growth, investment and increases unemployment in Pakistan.

Keywords:

Public Debt, GDP, Investment, Unemployment, FDI, Energy Consumption, Debt Law

Introduction:

Definition of Public debt: This entry records the cumulative total of all government borrowings less repayments that are denominated in a country's home currency. Public debt should not be confused with external debt, which reflects the foreign currency liabilities of both the private and public sector and must be financed out of foreign exchange earnings.

Public debts have bad effects on economic development of many countries but they are a vital tool and an imperative source of financing government budget deficit. Where as a better utilization of public debt can promote economic growth and facilitate to improve social welfare of the citizen, it has also been observed that public debt works like a double-edged sword. Too much dependence on public debt enlarges macroeconomic risks, obstructs economic growth, and hinders economic development. A large number of literatures are available showing negative relationship between public debts and economic growth. Investment is a major component and driving factor of growth which is also directly affected by the accumulation of debt. FDI in turn reduces for a country with rising public debt. When the shadow of public debt takes over an economy, it not only affects the macroeconomic picture by deteriorating growth and investment but has far reaching consequences on micro economic level by increasing unemployment.

Objectives of the Study:

The following objectives have been set:

To examine empirically the impact of public debt in Pakistan on:

A: GDP growth rate

B: Investment

C: Unemployment

Literature Review:

Debt is said to be a two edged sword, at low levels it help the economy to grow and provide welfare but if debt is taken excessively it can destroy the economy. If governments take too much debt then they are unable to provide basic service to the people. Finance and debt is vital for growth or else the poor economies will remain to be poor. Debt is not a bad thing, but up to a certain limit. If this limit is surpassed then the government has to bear the burden of high levels of debt which can harm the domestic economy. In the paper The real effects of debt, authors Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli(Sept 2011), tries to examine and study the Effect of debt on economic growth and also find out the level of debt at which it becomes a problem. A controlled and small level of debt in the economy helps in economic growth and increasing welfare. If too much debt is taken it becomes a huge burden. In their analysis they used data from 18 OECD (Organization for Economic Co-operation and Development) countries from 1980 to 2010.The data collected was on government debt, non-financial corporate debt and household's debt of different countries.

The results of their research supported their initial hypothesis that after a certain level of debt accumulation the economic growth suffered. The results indicated that for government debt beyond 85% of GDP became a burden and a problem. Similarly for corporate debt 90% of GDP and for household debt 85% of GDP was the threshold after which the debt caused problems in the economy. Governments that have high debt levels should take quick action to make sure this debt burden decreases to a more bearable level. In the long run its better for governments to maintain a debt level well below the threshold level the reason being that an unforeseen calamity or a disaster might occur in the future which might force the government to take more loans.

The paper titled "External Debt, Public Investment, and Growth in Low-Income Countries" written by Benedict Clements, Rina Bhattacharya and Toan Quoc Nguyen focuses on how the external debt of low income countries effects their growth. They have also highlighted the impact of rising external debt on public investment.

The results of their research showed that the per capita income of these highly indebted countries rises by 1% points if the total stock of external debt is decreased by a considerable amount. If the debt servicing is reduced in these countries and the finances are directed towards public investment this would boost up the economic growth and the growth would increase by an additional 0.5% points per annum.

The research said that high levels of debt slowed down the economic growth. In presence of high debt there is inefficient use of resources which was found to be the main reason for negative effect on growth. Debt seems to be a problem if it passes a certain threshold. An average figure for External debt of 50% of the GDP is considered as the threshold level. Substantial decrease in the external debt would increase the GDP growth by 0.8-1.1%.

Another finding of the research was that public debt indirectly effects growth via public investment. Directly public debt has no effect on investment but debt servicing has an inverse relation with public investment. A 1% point increase in debt servicing (as a % of GDP) decreases the public investment by 0.2% points. So if we decrease debt servicing (or get debt relief) that would lead to a rise in investment. Countries can increase growth and reduce poverty if a good portion of debt relief is allocated towards public investment.

In the literature the negative effect of stock of external debt on growth is termed as "debt overhang". Krugman in 1988 in in his article "Financing vs. forgiving a debt overhang: Some analytical issues" defined debt overhang as situation where the countries accumulated debt exceeds the countries debt repayment ability. This debt accumulation has a bad impact on the investment and growth of the country. As the debt increases uncertainty rises regarding the fact that the government might adopt distortionary measures to finance the debt (one of the measure could be to increase taxes) .Such type of uncertainty in the economy discourages the investors from investing they tend to wait .It might also contribute to capital flight as the private investors would want to avoid the increased taxes.

Naeem Akram in his article "Impact of Public Debt on the economic growth of Pakistan" studies the effects of public debt on economic growth and investment in Pakistan, the time period examined was from 1972-2009.

Pakistan in the past has been unsuccessful to generate enough revenue match its budget deficit. Secondly majority of Pakistan's developmental projects have financed through loans from external or domestic sources. A certain level of debt is vital for a country like Pakistan that faces scarcity of funds/resources. Such loans help Pakistan to develop and increase its economic growth which would not be possible to do on the bases of their own revenue. But the negative side of debt is seen through the "crowding out" effect and the "Debt overhang" effect.

The author has designed a model that also takes into account the effect of public debt on the growth equation and has used the Autoregressive Distributed Lag (ARDL) technique to estimate the model.

The results of the article support the past literature by confirming the presence of the overhang effect in the economy and show a negative relationship between public debt and investment and per capita GDP.

The results however didn't confirm the existence of crowding out effect as the relationship between debt servicing and investment as well as per capita GDP was insignificant. But domestic debt was negatively effecting investment and the relationship was significant so we can say that domestic debt has crowded out private investment.

The research suggested that dependence on external debt should be minimized. External debt harms the investment in the country and slows down the economic growth. Secondly Pakistan should focus on ways to increase revenue and decrease the level of expenditure instead of relying too much on domestic debt which has already crowded out private investment.

One paper by Reinhart and Rogoff (2010) examined the relationship between high public debt levels and growth. It was a multi-country analysis based on historical data. 44 countries were included in the sample, spanning over 200 years. The researchers found that at normal levels of debt, the relationship between growth and debt is relatively weak but as the debt levels rise over 90 percent, median growth rates for these countries are about one percent lower while the average (mean) growth rates are several percent lower. In advanced economies, in particular, debt in excess of 90 percent over the past two centuries has generally been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), and compared with growth rates of over 3 percent for the two middle categories (debt between 30 and 90 percent of GDP). Similarly, for emerging economies, median and average GDP growth is around 4–4.5 percent for levels of debt below 90 percent of GDP, but median growth falls markedly to 2.9 percent for high debt (above 90 percent); the decline is even greater for the average growth rate, which falls to 1 percent.

Another paper by Wolfgang Streeck (2013) showed that average public indebtedness among OECD countries more than doubled in the roughly four decades between the 1970s and 2010 from about 40 percent of GDP to more than 90 percent. This lead to declining growth rates and rising unemployment in the OECD world, which in turn lead to greater income and social inequality.

One study by García-Jiménez and Ashok K. Mishra in 2010 examined the role of government debt on determining the level of employment in United States. The model used in the study employed a standard Cobb Douglas production function having government debt affecting the growth of productivity, and it was found that increasing levels of public debt lead to higher unemployment. The US debt to GDP ratio gross has increased from 43.57% in 1980 to 63.25% in 2008. It was seen through the study that for 1% increase in debt, employment was reduced by 0.042%.

Data Analysis and Regression:

While doing the regression, the fiscal limitaion and debt law (2005) was used as a policy dummy for the data of public debt in all three regression analysis. This way the study took into account the effect of debt limitation law to keeping debt as 60% of GDP and then study the impact of the Public Debt on GDP, Investment and Unemployment.

The regressional analysis with GDP as the dependent variable and Public Debt and Change in Energy Concumption as the explanatory variables shows that Debt reduces GDp growth rate in Pakistan and the relation is significant.

The causality test also shows that Public Debt causes a reduction in GDP growth rate with a level of siginificance at 5% and a lag of 4 years.

The regression analysis with unemployment as the dependent variable and Public Debt and GDP growth rate as the explanatory variable shows that unemployment increases as debt increases, as shown by the positive relation which is significant.

The causality test also shows that a rise in Public Debt causes unemployment with a lag of 6 years.

The regression analysis with Investment as dependent variable and Public Debt with change in GDP and Interest rate as the explanatory variables shows a significant and negative relation between investment and debt. As debt rises, investment falls.

The causality test also shows that public debt causes investment to reduce with a lag of 4 years, at 5% significance level.

Conclusion:

The report shows that the rising burden of debt in Pakistan has had a negative impact on the country's GDP growth rate and has decreased investment in the country. The economy has been affected negatively with debt accumulation and debt is a causing factor for poor growth and limited investment. Also, the public is directly affected with debt burden when the unemployment rates rise. Since the data covers a timeline of almost 30 years and the trends in the relation are significant, it can be safely said that Pakistan must reduce its debt burden by following the debt limitation law of 2005 in order to prevent a decline in its growth, investment and employment rates.

Reference:

Carmen M. Reinhart and Kenneth S. Rogoff, 2010, "Growth in a Time of Debt" American Economic Review: Papers & Proceedings, 573–578

Carlos I. García-Jiménez1 and Ashok K. Mishra, 2010, "The Effects of Public Debt on Labor Demand in the United States"

Wolfgang Streeck, 2013, "The Politics of Public Debt: Neoliberalism, Capitalist Development, and the Restructuring of the State"

Naeem Akram, "Impact of Public Debt on the economic growth of Pakistan" http://pide.org.pk/psde/25/pdf/AGM27/Naeem%20Akram.pdf

Benedict Clements, Rina Bhattacharya and Toan Quoc Nguyen, "External Debt, Public Investment, and Growth in Low-Income Countries"http://www.mafhoum.com/press6/176E15.pdf

Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, Sept 2011, "The real effects of debt" http://www.bis.org/publ/othp16.pdf

DATA: