Introduction to Public Debt (Part 02)

This article is a continuation of Introduction to Public Debt (Part 01)

With the high level of surging public debts the discussions about defaults are rising the insights from previous studies can be explained as follows. According to Reinhart and Rogoff, (2008) every country has  made a default on external debt at least once in their emerging marker phase which requires external funding for development indicating that defaulting is common phenomenon in the financial markets. Reinhart and Rogoff, (2008) in their study, “This Time is Different” identify few possible causes for default of public debt and global cycles were identified as one major reason. Kaminsky, Reinhart and Végh (2005) identified that the favorable conditions in the terms of trade of a country which is powered by high priced commodities will attract significant amount of public debt and will be left default once the commodity prices drop and market crashes. This was proven by Reinhart and Rogoff, (2008) by using figures from 1800 to 2000 pre-world war figures and post-world war figures where it was clearly identified that when world commodity prices are low, the default of public debt is high. Reinhart and Rogoff, (2008) also identifies inflation as another cause for the default of public debt where emerging market are bound to be affected by the inflationary conditions leading to defaults in public debt and they emphasize that no country including USA was able to exclude the inflationary impact on its public debt and default. Similar conclusion was made by Aghion and Bolton (1990) where they used the examples from left wing parties gaining the power of countries leading to high inflationary situation and ultimately resulting in de facto default. Additionally, Reinhart and Rogoff, (2008) states that exchange rate has been another significant factor that influences public default where they used figures from 1800 to 2006 to prove the situation. It was revealed that during the years with high annual currency depreciation, the public debt default percentage has been increasing proving the effect of causation. Earlier study by Dreher, Herz and Karb, (2006) also provides similar conclusion where it acknowledges that the currency crisis can create debt crisis in a county. Another factor identified by Reinhart and Rogoff, (2008) as a cause for public default is that the amount of varieties of crises where they name five types of crises external default, internal default, currency crashes, banking crises and inflation. In their study they prove that in 2002 Argentina suffered from all five crises at the same time which led Argentina to make a huge default on their public debt. Similar findings were made by Torre, Yeyati and Schmukler, (2002) about Argentina and their debt crisis.

In analyzing the public debt level of countries, Cechetti, Mohanti and Zampolli (2010) states that public debt level and the fiscal policy of many economies are unsustainable and the protective measures need to be taken to avoid any possible future financial crisis as a result of public debt default. However, Spaventa, (1988) states that in determining the margin for the high level of debt there seem to be contradictions as there is no economic theory defines a ratio as too high. Reinhart, Rogoff and Savastano (2003) propose to use a historical approach where the debt level at which previous defaults were occurred is considered to be high debt levels. Further, Reinhart, Rogoff and Savastano (2003) state that the debt tolerance level could be different from country to country depending on historical situations of default as well as the macroeconomic factors and it needs to be further investigated. Additionally, a rule of thumb measure is proposed by Annex to the Maastricht Treaty where 60% of the debt to GDP ratio is criticized by Pasinetti (1997) as he states the ratio seems to be irrelevant expect in the case of Belgium and Italy. In dealing with public debt of countries, there are 02 economics views that can be used and one such view is Keynesian perspective where it supports high public debt to be obtained at the present. (Kim, 2003) Argument is that reduction in tax due to powering public expenditure through debt, increases the disposable income, consumption as well as the aggregate demand of the economy where high debt level will attract high interest crowding out the investment in economy to control aggregated demand. As opposed, Recardian view suggests that present tax cut as a result of increased public debt will lead to future tax burdens to service and the repayment of the debt. (Seater, nd) Diamond, (1965 cited in Kim, 2003) criticizes the Recardian view based on argument of length of planning horizon where if the government decides to collect the postponed tax after the person is dead, it will not affect the consumption decision of the tax payer as he will not be benifited.

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