Internal Debt and External Debt

When a government borrows money from its own citizens by selling

bonds or long-term credit instruments a internal debt is created. It is
owed by a nation to its own citizens. So, it may apparently seem that
an internal debt does not impose any burden on society because we
owe it all to ourselves. But this is a wrong position.
Public debt has both short-term and long-term implications as far
as the management of the economy as also its operational
efficiency are concerned Public debt creates three major
problems:
(1) The difficulties of servicing a large external debt,
(2) The efficiency loss from taxation, imposed to pay
interest on public debt, and

(3) Slowing down of the rate of growth of the economy

which occurs when a large debt reduces the rate of capital
formation in the private sector (by diverting resources to
the public sector). To throw light on these three specific
issues we have to examine the pros and cons of public debt.

When a country borrows money from other countries (or

foreigners) an external debt is created. It owes it all to
others. When a country borrows money from others it has
to pay interest on such debt along with the principal
amount. This payment is to be made in foreign currencies
(or in gold).

If the debtor nation does not have sufficient stock of foreign

exchange (accumulated in the past) it will be forced to
export its goods to the creditor nation. To be able to export
goods a debtor nation has to generate sufficient export
surplus by curtailing its domestic consumption.
Thus, an external debt reduces society’s consumption possibilities
since it involves a net subtraction from the resources available to
people in the debtor nation to meet their current consumption
needs. In the 1980s, many developing countries such as Poland,
Brazil and Mexico faced severe economic hardships after incurring
large external debt.

They were forced to curtail domestic consumption to be able to

generate export surplus (i.e., export more than they imported) in
order to service their external debts, i.e., that is, to pay the interest
and principal on their past borrowings. The burden of external debt
is measured by the debt-service ratio.

It refers to a country’s repayment obligations of principal and

interest for a particular year on its external debt as a percentage of
its exports of goods and services (i.e., its current receipts) in that
year. In India it was 26.3% in 1998. An external debt imposes a
burden on society because it represents a reduction in the
consumption possibilities of a nation. It causes an inward shift of
society’s consumption possibilities curve.

Three Problems: When we shift our attention from external to

internal debt we observe that the story is different.

Internal debt creates three major problems:

(1) Distorting effects on incentives due to extra-tax burden

(2) Diversion of society’s limited capital from the productive private

sector to unproductive public sector, and

(3) Slowing the rate of growth of the economy.

These three problems may now be briefly discussed:

1. Efficiency and Welfare Losses from Taxation:
When the government borrows money from its own citizens, they
have to pay more taxes simply because the government has to pay
interest on debt. So there is likely to be adverse effects on incentives
to work hard and to save.
It may be a happy coincidence if the same individual were a tax-
payer an a bond-holder at the same time. But even in this case one
cannot avoid the distorting effects on incentives that are always
present in the case of any taxes. If the government imposes
additional tax on Mr. X to pay him interest, he might work less and
save less.

Either of the outcomes or both must be treated a distortion of

efficiency and well-being. Moreover, if most bond-holders are rich
people and most taxpayers are poor repayment of the debt money
will redistribute income (welfare) from the poor to the rich.

2. Capital Displacement (Crowding-Out) Effect:

Secondly, if the government borrows money from the people by
selling bonds, there is diversion of society’s limited capital from the
productive private sector to unproductive public sector. The
shortage of capital in the private sector will raise the rate of interest.
As a result, private investment will fall.

In fact while selling bonds, the government competes for borrowed

funds in financial markets, pushing up interest rates for all
borrowers. With the large deficits of recent years, many economists
have been concerned with competition for funds and the
consequent higher interest rates which have discouraged borrowing
for private investment.

This effect is known as crowding-out or capital-displacement effect.

Crowding out is the tendency for an increase in government
purchases of goods and services to bring about a decrease in private
investment.

Full crowding out occurs when an increase in government

purchases results in an equivalent decrease in private investment. If
crowding out does occur, there will be a larger stock of government
debt from 100 to 120 and a fall in private capital stock as shown in
Fig. 4.
Full crowding out does not occur if:
(i) Real GDP is less than potential GDP; and

(ii) The budgetary deficit arises from the government’s purchase of

capital on which the return equals (or exceeds) that on privately
purchased capital.

Full crowding out does occur if:

(i) Real GDP equals or exceeds potential GDP; and

(ii) The government purchases consumption goods and services or

capital on which the return is less than that on privately purchased
capital.

This, in its turn, will lead to a fall in the rate of growth of the
economy. So, a decline in living standards is inevitable. This seems
to be the most serious consequence of a large public debt in that it
displaces capital from the nation’s stock of wealth. As a result, the
pace of economic growth slows and future living standards decline.

3. Public Debt and Growth:

By diverting society’s limited capital from productive private to
unproductive public sector public debt acts as a growth-retarding
factor. Thus, an economy grows much faster without public debt
than with debt.
When we consider all the effects of government debt on the
economy, we observe that a large public debt can be detrimental to
long-run economic growth. Fig. 5 shows the relation between
growth and debt. Let us suppose an economy were to operate
overtime with no debt, in which case the capital stock and potential
output would follow the hypothetical path indicated by the solid
lines in the diagram.

Now, suppose the government incurs a huge deficit and debt. With
the accumulation of debt over time, more and more capital is
displaced, as shown by the dashed capital line in the bottom of Fig.
5. As the government imposes additional taxes on people to pay
interest on debt, there are greater inefficiencies and distortions
which reduce output further.

What is more serious is that an increase in external debt lowers

national income and raises the proportion of GNP that has to be set
aside every year for servicing the external debt. If we now consider
all the effects of public debt together, we see that output and
consumption will grow more slowly than. In the absence of large
government debt and deficit as is shown by comparing the top lines
in Fig.5.

This seems to be the most important point about the long-run

impact of a huge amount of public debt on economic growth. To
conclude with Paul Samuelson and W D. Nordhaus, “A large
government debt tends to reduce a nation’s growth in
potential output because it displaces private capital
increases the inefficiency from taxation, and forces a
nation to serve the external portion of the debt”.