2. Lecture outline Musgrave’s model of the Ministry of Fiscal Affairs Classical views on public debt management Difference between debt and taxes Alternative views on public debt management

3. Public householding Public householding implies the system of managing revenue and expenditures of the government Musgrave, Richard in his “The Theory of Public Finance. A Study in Public Economy” (McGrow Hill Book Company, 1959) proposes the model of simplified public householding system He explains that budget policy has three main objectives – resource allocation, income reallocation and economic stabilization

4. Ministry of Fiscal Affairs Musgrave proposes the concept of Ministry of fiscal affairs (MFA), which acts to address the issues that market refuses to deal with With the help of taxes, MFA withdraw resources from private sector to public sector and provides services not rendered by the former According to Musgrave, if MFA or government uses these resources for consumption then there is no budget deficit and budget is always balanced (taxes equal expenditures)

5. Ministry of Fiscal Affairs Resource allocation Resource reallocation Economic stabilization Taxes=ExpendituresTaxes=Transfersdeficit or surplus Taxes- (Expenditures + Transfers) 0

6. Economic stabilization and business cycle peak trough recession recovery

7. Economic stabilisation policy Gained importance in 1930s Has its budget calculated as follows:  Sum up panned expenditures and transfers  Calculate potential output and corresponding aggregate demand  Aggregate demand is compared with planned expenditures and the difference is taken to economic stabilization finances Is the only policy in the Musgrave’s model which causes budget deficits or surpluses. In reality, however, there are other than stabilization purposes which make governments run deficits.

8. Different views on public debt management Standard view Alternative view Both views differ regarding debt burden (lower living standards) and crowding out effect of public debt

9. Standard view on public debt management The advocates of the standard view on public debt claim that public debt is harmful to economy. Standard implies that majority of the economists share this view. Ricardian equivalence sees no effect of public debt on growth

10. Classical view on debt David Hume claimed that either nation kills public debt or public debt kills nation. He was skeptical about debt because to his view the government was unable to resist the temptation to gain political points through government expenditures In his “Of Public Credit” (Essays Moral, Political and Literary, Vol. I, New ed.; London, 1882, p. 366. Original edition published in 1742.) Hume criticized the traditional opinion which argued that nation does not get poorer because of debt since people mainly owe to themselves.

11. Adam Smith on public debt Like Hume, Adam Smith had negative views on public debt too. His ideas were mainly based on the excellence of private sector over the government. In his “An Inquiry into the Nature and Causes of the Wealth of Nations, 1776” Smith claims that the government is a bad manager because it takes funds from private sector and uses them for consumption- often this is called “crowding out effect”. Smith argues that private sector could use these funds for productive investments and that the government should always run balanced budget.

12. Adam Smith on public debt But, creditors do not loose anything because government bonds pay higher interest than investment Also, in the case of internal debt, there is no burden of interest rate payments since money changes hands within borders Then why is public debt an issue?

13. Adam Smith on internal public debt People Government Companies

14. Adam Smith on external public debt People Government Companies

15. Ricardian view on public debt David Ricardo shared the views of Hume and Smith. He claimed that public debt is one of the worst disasters. (“On the Principles of Political Economy and Taxation.” John Murray. 1821. Library of Economics and Liberty) However, Ricardo argued that the removal of public debt will not be relief. Instead, he pointed to the importance of savings and cuts in expenditures.

16. Ricardian equivalence For example, assume that the goverment cuts taxes in order to stimulate demand and covers the budget deficit by accumulating extra debt According to Ricardo, people who enjoy lower taxes are rational. They know that next year to pay interest on bonds the government will increase taxes. So, these people do not use extra income from tax cut. Instead they save it to pay future increased taxes! THEREFORE, TAXES ARE EQUAL TO DEBT!

17. Difference between debt and taxes Assume that government expenditures are constant and the government has two options to finance these expenditures: through debt or through taxes In the case of debt: bond holders do not finance government expenditures and their pay-offs in whatever form; they simply expect their debts to be paid back with interest In the case of taxes: tax payers finance expenditures and their payoffs

18. then the question is: Who pays for the government expenditures and pay-offs in the case of public debt?

19. Alternative views on public debt Malthus Thomas Robert did not agree with classical views on the public debt and suggested that public debt is a good thing! (An Essay on the Principle of Population. John Murray. 1826. Library of Economics and Liberty) He put emphases on aggregate demand and claimed that the worst disaster is lack of demand. To him demand motivates production and therefore governments should attract debt to stimulate it.

20. Alternative views on public debt Mill John Stuart in his “Principles of Political Economy” suggested to divide public debt into good and bad public debts Good public debt- debt made of foreign capital or national savings available only due to government demand for them (or savings which would otherwise go to inefficient investments) Bad debt – debt causing crowding out effect as with classical views. Mill also argues that burden of public debt will be extended to future generations.

21. Keynesian approach to public debt In his “The General Theory of Employment, Interest and Money” (Macmillan Cambridge University Press, 1936) John Maynard Keynes put forward the following principles:  Say’s law is abandoned: growth is determined by demand, not supply  Unemployment is rule, not exception  To decrease unemployment, the goverment should provide sustainable demand  For this, balanced budjet rule can be sacrificied  However, deficit should be tolerated, not praised.

22. Summary of classical and alternative views Question: does public debt mean the transfer of debt burden to future generations?  Classical view: yes, at the moment of debt creation, the burden lays on future generations  Alternative view: no, public debt does not imply any transfer of burden in time

23. Summary of classical and alternative views Question: is public debt similar to private debt?  Classical view: yes but private debt is better since it is more productive  Alternative view: it is erroneous to make analogy in every aspect of the matter

24. Summary of classical and alternative views Question: is there any difference between internal and external debts ?  Classical view: no, since both types decrease national wealth  Alternative view: yes, there is significant difference between them

25. Thank you for your attention!