Outline the effects of public debt

Public Debt and Consumption
The existence of public debt has an important effect upon consumption. Those who hold government bonds representing the latter's obligation to pay consider these bonds as personal wealth. This wealth would not have arisen if the government had chosen to finance its expenditure through taxation. Moreover, the bond-holders would forget that the bonds represent claims on them as taxpayers in the form of additional taxation. The net result is that the possession of government bonds will induce them to spend not only a larger percentage of their incomes but also spend in excess of their incomes since they can dispose of the bonds to pay for the excess expenditure. Consequently, the net effect of public debt is to increase the
percentage of total income spent on consumption and thus exert an expansionary effect on the economy.

Monetization of Public Debt
Public debt of a country has the direct effect of increasing the total money supply in the country. For instance, deficit financing by the Government actually means Government borrowing from the Central bank of the country which directly increases the money supply in the country. Likewise, when the commercial banking system subscribes to the issue of new Government bonds, they may do so without reducing their other investments or advances to the industrial and commercial sections but through a simple creation of credit. This is what is commonly known as monetization of public debt, that is, the public debt is subscribed to by
the banking system in such a manner that it results in an increase in the money supply of the country.

Public Debt and Liquidity
Public debt is represented by bonds which are highly negotiable. Those who have bonds have
highly negotiable and highly liquid form of assets. Whenever individuals require more funds
for any purpose – transactions, precautionary or speculative motive – they can easily convert
the bonds into cash. Public debt is thus responsible for the existence of highly liquid form of
assets. Another important effect of the highly liquid government bonds is to be found in the case of
commercial banks. The latter hold large amounts of government bonds which can be
converted into cash whenever cash is required. In times of inflation the central bank of a
country may attempt to use bank rate, open market operation and other weapons to reduce the
cash reserves with commercial banks and thus reduce their credit expansion. But commercial
banks can increase their cash reserves through disposing of their government bonds.

Public Debt and Investment
The effect of public debt on investment is not very clear. Two apparently contradictory
effects can be visualized. On the one hand, the existence of huge public debt and the
consequent high rates of taxation to service the debts will generate fear and uncertainty in the
minds of investors. Besides, the existence of huge debts involving huge interest payment may
suggest the possibility of the government introducing capital levy or even the extreme
method of repudiation of debt. All this will affect adversely long-term-investments. On the
other hand, the existence of large public debts will force the government to maintain a low
rate of interest in order to keep its interest obligations at the lowest amount possible.
Accordingly, borrowing and investment will be encouraged. It is, thus, difficult to state
clearly whether existence of public debt will encourage or discourage investment.
As regards the desire to work and save, public debt will generally tend to reduce it. Public
debt, by providing safe and steady channel of investment in government bonds, may encourage savings. But taxation necessary to pay the principal and interest charge will discourage savings. Moreover, the receipt of interest by the holders of government bonds may reduce the latter's desire to work and save to a certain extent.
Finally, as regards division of resources, public debt involves the use of funds on those expenditures which are considered essential and more useful than those on which the funds would have been used otherwise. If idle funds are channeled into the development of railways, irrigation and power projects e.t.c., the diversion will be really justified. The same may be said if borrowing from the banking system is used to create permanent and productive assets. The only wrong diversion will take place when funds which otherwise would have been spent on productive undertakings are spent on defence purposes. But this will have to be judged according to circumstances.

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NatalieR answered the question on June 22, 2022 at 10:34