Policy paper final

ECON3820 Adham Abdel Moneim
Policy paper Student #: 100865929
Global debt
Name: Adham Abdel Moneim
Instructor: Mr. Brian Glabb
Course: ECON 3820
Date: 26th
November 2015
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 Executive Summary:
The motivation behind this policy discussion is to illuminate the radical increment in cutting edge
economies’ public debt, which may hamper growth and development. Efforts to curb deflation through
lowering the interest rates, has not borne any fruits in the recent past. By driving down interest rates and
empowering all the more lending, debts of different types keep heaping up with no reasonable method for
paying off those obligations. This raises the concern of debt sustainability in advanced economies. The
piling publics are bound to be passed on to the future generations. The future generations will, therefore,
inherit debt burdens that they had nothing to do with. In fact, instead of reducing public debts, advanced
economies are characterized by higher borrowing levels compared to their GDPs each year as compared
to the previous years. Economists have over the years established key propositions upon which the
conceptions of public debt should either be completely discarded or radically revised (Buchanan 17). The
decision to radically revise or completely discard is based on whether the propositions are either true or
false.
Inquisitive personalities dived into a captivating yet long McKinsey’s investigation of public debt
and deleveraging after the great financial crisis (Dobbs, Lund and Woetzel 23). It is projected that the
debt will continue to rise given the prevailing economic fundamentals. The current economic policies are
not effective in ensuring that global economies pay these debts without recurring new debts. The rapid
rise in public debts can be highly attributed to the catastrophic recession whereby global economies took
too long to recover. Public debt reduction compels advanced economies to consider new approaches and
restructuring programs such as asset sales, timely taxation and expansion of revenue collection and most
importantly more efficient public debt restructuring plans.
 Background:
In 2008, the global economy was hit by the most catastrophic financial crisis since the great
depression. The crisis began mushrooming in 2006 in the United States where the rate of mortgage
defaults started skyrocketing. Later that year, there was a downfall of housing prices. The most affected
victims of the crisis in 2008 in the US were insurance companies, investment bankers, mortgage lending
enterprises and commercial banks as well. The carnage spread overseas and not just in the financial sector
but other industries as well. The crisis persisted for close to two years a period within which recovery
seemed very unlikely. When the crisis is subdued, advanced economies cut down capital injections and
interest rates a move that was welcomed by investors.
The crisis originated from the US, but its implications spilled over globally. The United
Kingdom, for instance, experienced a 7.4% rate of decline; Germany recorded 14.4%, Japan at 15.3%,
8% in the EU, and 21.3% in Mexico. 1. By 2009, the Arab world experienced a $3 trillion loss globally
all due to the crisis. The US lost close to two million jobs giving rise to the unemployment rate that rose
up to 7.2% in December from 4.4% in March the previous year. The only major difference between this
crisis and the great depression is that whereas the great depression in the 1930s started in the
manufacturing industry, the crisis in 2008 started in the financial sector. By the end of 2009, Arab
countries had lost approximately three trillion dollars, which was attributed to the fall in foreign
investment in the Middle East as the demand for oil declined.
In 2012, IMF global stability report indicated a decline in global growth but there were no indications of a
complete overhaul.
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 Discussion:
1. Debt restructuring:
Debt restructuring processes that allow renegotiation and reduction of debt payment, burden
especially in times of financial turmoil. It involves the review of the conventional terms and agreements
of a debt. In cases of public or private organizations, the new agreement is commonly referred to as
trouble debt restructuring. In an unprecedented scenario where the debtor is in a financial turmoil, the
creditor may decide to change the agreements as opposed to compelling the borrower into liquidation.
The agreement changes include but are not limited to changes in debt interest payments or the principal
amount. In 2007, what started off as mere financial problems progressed into a great depression after
which an element of debt restructuring dubbed debt mediation was introduced.
Global debts restructuring is only applicable where the prevailing policies and market-based
approaches are lacking (Brooks and Lombardi 28). Some economists, however, are of the opinion that the
current policies are not lacking and that the problem lies in their execution. If that were the case, debt
restructuring would not be as fruitful. Other opponents also argue that to maintain a smooth and efficient
global debt market, the prevailing agreements such as sovereign bond terms or contracts should be left
unchanged. A process should be duly established ensuring that the changes are in line with all parties
involved.
Additionally, another opponent school of thought on debt restructuring disputes that changing
borrowing terms ease the repayment burden that may ultimately attract imprudent global borrowing. Debt
restructuring should be costly divergent from which they are bound to happen more frequently.
Restructuring may limit the need for somberness that comes with global debt. It is also not easy to reach a
consensus with all creditors not to mention the whole process is very costly. The primary goal of debt
restructuring as a policy is to reduce the public debt and enhance its sustainability, but this may not
always be the case as investors tend to shy away.
On the other hand, despite the flexibility and ease of debt burden advanced economies will be
obliged to bear the burden to avoid high borrowing costs in future. These economies also strive to keep
their position in the international markets. In his article “The Economics and Law of Sovereign Debt and
Default”, Ugo Panizza asserts that the alarm of prohibition from future global is adequate to support
global debt (Panizza, Sturzenegger and Zettelmeyer 672). This argument, however, is not sufficient, but
its contribution cannot be overlooked.
Extensive studies and research plausibly conclude that debt restricting does not favor the
prevailing finance ministers and politicians (Panizza, Sturzenegger and Zettelmeyer 685). Effective or
not, debt restructuring is bound to stir political, economic and social effects be they positive or negative.
Economic implications of restructuring include reduction of creditor moral hazard and deadweight losses.
Consequently, the key political implication is sustainability, for instance, do the changes enhance the
validity of crisis tenacity policies?
2. Inflation:
Inflation is the rate at which the general prices rise and the rate at which the value resultantly
falls. Inflation as a management strategy for public debt involves the reduction of the real value of debt.
The world war saw the United States accrue a debt of more than its GDP. The economy was, however,
able to reduce the debt by half over a period of ten years thanks to a combination of growth and inflation
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approximately at 4%. Advanced economies are obliged to slow down the inflation process given the
alarming public debt to GDP ratios in the economies.
Inflation reduces the value that creditors received in real terms and relatively less than the initial
agreement but compared to debt restructuring; making it a more preferable policy. In this case, a creditor
is not forced into new terms as stipulated in restructuring thus making this policy less disorganized. The
primary goal of this policy is to aim at reasonable inflation that significantly ease the debt burden
(McCauley, McGuire and Sushko 212).
This policy also faces a few challenges one being its viability. Adequate levels of inflation that
would offset the global debt burden are likely to impact the economy negatively. Such economic
implications are very costly and could cripple the economy as well. Despite the good intentions, inflation
might end increasing the fiscal revenue in an economy and subsequently resulting in negative political
issues, especially in democratic countries. It would, therefore, be challenging to reach a moderate
inflation level and avoid the negative economic and political implications at the same time.
Low inflation rates have little or no effect in mitigating debt burden. The lack of clarity between
inflation and debt burden limits its effectiveness. The ambiguity in the relationship between the two
aspects may also pose as a hurdle. Opponents of this policy argue that inflation could result into a deeper
problem instead of solving the current ailment that is global debt burden.
Comparison between the current economic situation and the past economic situations show traces
of similarities between debt burden and inflation and substantial evidence of instances when the policy
was successful (Aizenman and Marion 528). It is clear that the policy is only applicable when domestic
creditors hold the majority of debt owed.
Although there is the question of fiscal sustainability, a combination of growth and inflation
policies would be immensely valuable compared to debt restructuring. Inflation must, however, be
introduced after inception and come as a surprise to the creditors otherwise the risk of inflation would be
factored in the valuation of borrowing cost.
3. Fiscal consolidation:
Substantial empirical analysis over the recent past shows that the decrease in debt burden is
closely influenced by growth and effective fiscal consolidation measures. Fiscal consolidation
fundamentally involves an increase in revenue collected in taxes or decrease in government spending.
Decrease in government spending in advanced economies is more likely to lower the rate of growth in the
short term as a result of a resultant decline in aggregate demand. It also entails control of the public wage
bill, efficiency in the public sector and sealing of all leakages. Complementing the policy with a
collective debt reductions approach such as augmentation of a tax base and tax policies is the key
ingredient. Mitigation of the public debt burden by the use of fiscal consolidation keeps up
trustworthiness of the governing body, which might frequently be politically troublesome in the long run.
Continued fiscal consolidation in advanced economies leads up to the economic implications of
the policy. If the apparent decrease in economic activities happens to be higher that the debt, the debt to
GDP ratio is more likely to rise. Compared to inflation, fiscal consolidation is, therefore, more efficient,
unlike inflation that lacks in fiscal sustainability.
Fiscal multipliers of the current fiscal policy are significantly above the regular level. The regular
levels were however recorded before the financial crisis. The negative economic implication of fiscal
consolidation is as a result of the loopholes and defects of the prevailing policies and current environment
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such as lack of effective monetary policies, low external demand, to name but a few. The fact that fiscal
consolidation can increase the debt ratio in the short term unlike the inflation policy is good enough an
incentive to boost the confidence of investors. The challenge, however, lays in the political aspects
whereby it may be difficult to implement both the short run and in the long run.
4. Fiscal Repression:
Fiscal repression is measure utilized by governments to decrease debt burden and mostly
incorporate the conscious endeavor to hold down interest rates beneath inflation, signifying an expense on
savers and an exchange of advantages from lenders to borrowers. By so doing, the government influence
buying or holding of government debt instruments by domestic investors at relatively low-interest rates.
Consequently, investors receive returns at rates lower than the initial market rates (Renhart 12).
This policy is however faced with the challenge of effective utilization and implementation and
defining the relationship between domestic saving and investment (Husain and Diwan 271). Effective
investment is dependent on the respective interest rates elasticities. It would not be plausible to draw a
conclusion that if the decrease in investment is always as a result of inefficient allocation. If it so happens
that financial repression maintains domestic saving as at a level below the optimum level, there would
need to worry by the policy makers. Increased borrowing may result in high economic costs thus
hampering current and future growth as well. Reduction in domestic saving as a result of the economic
offset ultimately causes capital flight.
Many countries have in the past successfully used various repressive policies in their domestic
financial institutions a fact that signals the policy’s superiority and effectiveness in comparison with other
policies. After the World War II, advanced economies were hit by huge public debt burdens (Riet 28).
Truncation of the domestic financial system by these economies proved to be immensely valuable.
5. Growth:
The heterogeneity between public debt and growth clearly manifested itself after the financial
crisis that hit advanced economies after the recession in 2007. Growth policy involves lowering the size
of the public debt to about the size of the specific economy. These economies have been striving to fuel
economic changes through subsidies; tax relieves among other fiscal strategies, but it may prove to be
very difficult without an expansionary fiscal policy that also makes the growth policy highly uncertain in
the long run.
Growth policy may be uncertain in the long run due to the traditional crowding out effects some
of which are found in the fiscal repression policy, public expenditure as well as social welfare. It was also
divergent from the fiscal consolidation policy illustrated above. Political implications are arising from this
policy, include the ability of the governing bodies to formulate fiscal policies, such as regulatory control
and also the rule of law. Political stability, therefore, stems from this policy.
 Recommendation:
The backdrop above clearly illustrates that there is not a single option, activity, or policy that will
ease the debt burden in advanced economies. As policy makers, we are therefore tasked with formulating
sustainable strategies that will genuinely decrease public debt and reduce the burden imposed on future
generations. Economic growth should also not be accompanied by an expansion of public debts. No
single policy is sufficient by itself; ideal situations therefore require a perfect mix of policies, or aspects
of these policies as was in the case of growth and inflation in the United States after World War II.
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First, the creation of an integrated program such as the European Union would increase
accountability. Greece was, for instance, accountable to the union in light of the recent economic crisis in
the country. Such programs in advanced economies will not only promote accountability but also boost
healthy competition and collective economic growth. Additionally, negative implications of policies such
fiscal instability in the long would be greatly reduced. G20 is an international platform for the top 20
economies in the world. It is a platform that brings together leaders from these countries to discuss global
policies key among them being global debt and transparency.
Second, it is also crucial to create standardized worldwide rules for reporting the full debt that can
be regulated by the IMF, which will decrease the occurrence of Defaults. As a result, proper debt levels
will be provided. Thus, the sufficient policies needed to promote economic growth and limit the
expansion of debt will be enacted. All countries are in debt for similar but different reasons; therefore
each country will need to pass different policies about each other, which can be effective through
transparency.
Fiscal consolidation could be done selectively depending on whether funded programs are
achieving desired results or not. Governments should stop the funded programs if not effective in making
money, or achieving desired results. This would put a cap on debt before it gets out of hand, and gives
priority to investments that promote economic growth. For this to be done there must be a regulatory
service to check consistently on borrowers, to ensure that they are achieving promised/desired results.
 Implementation:
To start off, Fiscal repression will be very effective to help promote economic growth without
recurring new debt, or having to crowd out. The process to implement the policy should therefore
commence immediately. As explained above, the process is not immediate but progressive as it
fundamentally involves the use of government policy to force domestic investors to buy or hold
government bonds at low-interest rates. This would then increase domestic investment, which promotes
economic growth. Fiscal repression would be very effective if implemented with qualitative easing
strategies to keep rates low on longer bonds. This would provide an incentive for domestic investors to
buy bonds with a longer time to maturity. A combination of these two would work efficiently in a time of
debt. Typically low real interest rates would normally reduce savings, move consumption from future
years into the present, and generate stronger economic growth. The backdrop explains why fiscal
repression policy is the most effective of the other alternatives. After Fiscal repression, the
recommendations stated above should be implemented immediately in the order presented.
 Analysis:
Economic growth is at the heart of public debt elimination. An increase in public debt results in
higher interests that lower the rate of investment that ultimately leads to low or stagnating economic
growth. Government borrowing, on the other hand, may crowd out private investment, which leads to a
further lowering of economic growth forecasts. As a result, the Canadian government would not be able
to control costs anymore.
In addition to considering the level of public debt, it is also important to factor in the type of
debts in determining debt sustainability in the future. Perfect examples are the current structural deficits,
where even with full employment, government revenue will not cover government expenses. This case
exists in most of the advanced economies.
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The government extended fiscal support to troubled banks to stabilize the financial system, and
enacted many large packages to boost output, demand, and employment. This is resulting in lower tax
receipts and increased government spending on programs such as employment insurance. All of these
factors combined contributed to the vast increase in government debt among advanced industrialized
countries.
1. Cost-Benefit Analysis:
With either option selection, there should be a cost-benefits analysis by the government to
determine whether the benefits of option outweigh costs for implementing the option. For each option, the
total cost should be divided by its effectiveness, to complete a cost-effectiveness analysis. On the other
hand, the cost benefits analysis includes an extra step by looking at the total benefits minus the total cost
to show the net benefits of each option. Finally comparing all options to find the optimal option.
While governments take on debt, their ability to pay their existing debt becomes harder and
increases the risk for the investor. As a result, investors will increase interest rates on borrowing to
compensate for risk. Having a higher interest rate means a higher cost of borrowing for future. On the
other hand, governments that have significant borrowing crowds out investment, and decreases saving.
This reduces private investment spending as a result of a supply of funds increase, with no change in
demand for loanable funds, hence increasing interest rates.
There are many positive benefits to lower public debt for an economy that allow governments to
borrow at lower interest rates, which means spending less on a budget of interest payments that allows for
future growth and stability. If we continue with this consistent increase in debt levels, there will be
negative impacts on investment and economic growth in future.
2. Risk Analysis:
An increase in risk should be accompanied by a higher premium to compensate for that risk.
Advanced economies are burdened with heavy public debts that hinder the governments’ ability to fund
future programs and services while debt expenses increase. With high debt burden, governments may not
be able to raise necessary funds to respond to a crisis since the increased debt levels hinder their
flexibility. Borrowing today also shifts the burden of paying for current spending to future generations.
Changing investor’s perception about countries economic stability and ability to repay loan also increases
risk thus increases interest rates, and limits a nation’s access to credit markets.
 Conclusion:
Public debt, an underlying cause of most financial problems in advanced economies continues to
be a menace and hampers economic growth. It has become almost impossible to repay the debts without
incurring more debts a situation which if not effectively controlled will cripple the future generation.
Implementation of the policies discussed above will mitigate the menace and ensure a debt free future.
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 Works Cited:
Aizenman, Joshua and Nancy Marion. "Using Inflation to Erode the US Public Debt." National Bureau of
Economic Research (2009): 524-541. Print.
Brooks, Skylar and Domenico Lombardi. "Sovereign Debt Restructuring." CIGI Papers (2015): 28. Print.
<rules.org/storage/documents/sovereign_debt_restructuring_background_paper_draft2014.pd
f>.
Buchanan, James M. "Public Principles of Public Debt: A Defense and Restatement." Library of
Economics and Liberty (1999): 1-21. Web. <http://garrido.pe/lecturasydocumentos/BUCHANAN
%20(1958)%20Public%20Principles%20of%20Public%20Debt,%20A%20Defense%20and
%20Restatement.pdf>.
Dobbs, Richard, et al. Debt and (not much) Deleveraging. Research. New York: McKinsey & Company,
2015. Print. <http://www.mckinsey.com/~/media/McKinsey/dotcom/Insights/Economic
%20Studies/Debt%20and%20not%20much%20deleveraging/MGI%20Debt%20and%20not
%20much%20deleveragingIn%20briefFebruary%202015.ashx>.
Husain, Ishrat and Ishac Diwan. Dealing with the Debt Crisis. Washington: World Bank, 1989. Print.
McCauley, Robert N, Patrick McGuire and Vladyslav Sushko. "Global Dollar Credit: Links to US Monetary
Policy and Leverage." Bank for International Settlements (2015): 187-229. Print.
Panizza, Ugo, Federico Sturzenegger and Jeromin Zettelmeyer. "The Economics and Law of Sovereign
Debt and Default." Journal of Economic Literature (2009): 651-698. Print.
<http://www.jstor.org/stable/27739982>.
Renhart, Carmen M. "The return of financial repression." Financial Stability Review (2012): 1-31. Print.
<https://www.banque-
france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financi
ere/2012/rsf-avril-2012/FSR16-20-04.pdf>.
Riet, Ad van. "Financial Repression to Ease Fiscal Stress." Journal of Common Market Studies (2013): 37.
Print. <http://speri.dept.shef.ac.uk/wp-content/uploads/2013/06/2013-07-04-Financial-
repression-to-ease-fiscal-stress-in-the-eurozone-SPERI-conference-Sheffield.pdf>.
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