ECON 101 Chapter Notes - Chapter 1-6: Balance Sheet, Risk Premium, Internal Debt
26 May 2018
School
Department
Course
Professor
Economics 101
Lori Leachman
Extra Credit Book • What We Owe by Carlo Cottarelli
Chapter 1 - what is public debt?
• Definitions
o Total of nation debts (include local, state, and national), indicator of spending financed
by borrowing instead of taxation
o Government, or, fiscal deficit - imbalance between gov. spending and revenues
o Amount owed at end of year - called public, government debt
o Debt = sum of all previous deficits
o Primary deficit = deficit net of interest payments (the 10,000 in house example)
o Governments borrow by selling securities (bonds) to investors through auctions
• Gov. debt riskiness and yield
o In advanced economies, gov securities are regarded as risk-free assets (thus can offer
lower interest rates than securities issued by private sector bc government can tax people
to raise revenue)
▪ Some think public debt is desirable bc economies need steady supply of risk-free
assets for investors (as gov sells them to “borrow” money)
▪ Raising taxes does not win elections (so sometimes gov doesn’t raise taxes and
no revenue to repay debt)
o Factors that affect risk and yield (risk premium) request by investor lending to gov
▪ Size of public debt - larger public debt, more tax revenues required - declare
bankruptcy
• Indicated through debt to GDP ratio as taxes are normally from GDP
▪ Composition of who buys gov securities
• If foreigners, the risk is higher bc foreigners are more likely to run if
doubt in gov willingness to repay debt - foreigners do not vote, and the
negative impact on debt repudiation on national economy is smaller
▪ Share of securities held by central bank
▪ Average maturity
• The more debt that matures quickly, the more money will be rolled over
(must sell more bonds to cover growing debt), increases gross borrowing
requirement, which leads to more pressure if gov can repay debt, higher
risk
▪ Currency denomination - what currency is the security sold in? (US, euro, yen..)
▪ Interaction between gov and central bank on how directly/indirectly it can
finance through borrowing outside of public sector and by printing money
• Money and public debt
o Printing money - most modern countries have ability
▪ Profitable - printing pieces of paper cheap in return for a dollar banknote
• Seigniorage - profit from printing money
▪ Gov benefits from Central Bank printing money
• Though not owned by gov, CB passes on bulk of seigniorage $ to gov
▪ Gov borrows from CB does not have to worry about interests and rolling over
securities
• Gov basically makes profit borrowing from CB
• Not really “borrowing” as profits passed on to gov
▪ CB can also create electronic money through credit
• Buy gov security from commercial bank, they pay through credit in the
CB
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▪ PROBLEM: printing money leads to inflation and depreciation of dollar - lose
confidence and people will want to get rid of currency
▪ Debt borrowed in domestic currency (can be fixed by printing/inflation), foreign
currency leads to higher risk
• Derivatives and Pension debt
o Not usually included in standard definition of public debt
▪ Debt from derivative contracts
• Enter contract at fixed interest rate - if rates increase, gov makes revenue,
if rates fall, gov makes payments
• Market value of these derivative contracts equal to sum of future
payments the gov has to make - debt
• Usually small, but still relevant
▪ Social security or pension debts
• Related to payments gov has to make in the future through SS
• Quite large sum that is not counted in debt in some countries as they are
not yet payable as employees have no retired
o Pressures of future not captured in today’s deficit figures
• Pension spending to GDP ratios are increases
• Lead to risk of rollover crisis and larger debt
Chapter 2 - Surge in public debt
• The surge
o Rising public debt to GDP ratio since 2007 were unprecedented, not this high since the
wars with heavy military spending and the great depression
▪ Great depression: GDP declines, public deficits rise because revenues fall and
spending (like employment benefits) rises
• Larger deficits - faster accumulation of debt
o More controlled decline in GDP due to active fiscal policy reduces output losses (2008-
09 recession vs. Great Depression), but more public debt
o Increase public debt due to higher spending for health care and social security programs
that were only partly matched by increases in taxation (or by delayed)
• Now - cross country snapshot
o Japan is the highest debt to GDP ratio then Greece, Italy... etc
o U.S. is about 7th in the nation
o Some people view U.S. debt to GDP ratio as excluding subnational (like states and
municipalities) debt and report the ratio to be lower
▪ This is misleading because GDP accounts for subnational product
▪ U.S. debt is usually larger than reported by many
o High level of debt is a necessary but not sufficient condition to get into trouble
▪ Some countries suffer problems with money strain while others’ currencies are
regarded as a safe haven regardless of debt level
o Some countries debt (like Japan and Canada) can be considered lower as the countries
may hold large financial assets - they can use the interests on these assets to alleviate debt
▪ Most economists focus on gross debt as financial assets may bear lower yield and
not be liquid enough to protect from rollover risks
• Other features of debt - cross country differences
o Average residual life/average maturity
▪ UK has rly long matuiry (15 years)
▪ Most major countries around 5-7 years
▪ US has about 5.7 years
▪ Smaller countries have longer average maturities
o Composition of investors (domestic or foreign)
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find more resources at oneclass.com
▪ Japan has highest domestic debt holdings, which is why despite having insane
amounts of debt, does not fall into crisis
• Japanese people hold gov securities - strong investor base - not much
diversifying of assets
▪ US has a lot of debt held by foreigners are held in foreign central banks
• US currency is held as reserve currency (held in foreign reserves) bc is
liquid and considered risk-free
• China holds a large portion of US debt due to its export surplus to the US
(currently 6.5 percent)
▪ Pension debt - not rolled over every month, but a pressure on future finances
• Debt rise due to population aging as well as rise in life expectancy and
retirement age
• High pension debt in Korea and other countries like US
• Low to negative debt in countries like Italy (decline in spending, pension
system reforms)
• High debt indicates pressures on public spending will increase in the
future, especially aggravating when financial debt is already high
▪ “Health care debt” -
• Rise in debt due to technological advances more than population aging
o Tech advancements lead to better equipment that is more
expensive
• This debt is expected to rise significantly in the future - huge health care
debt figures
o Concerns about the viability of current fiscal policy framework
in US
o US debt is estimated to be 117 percent of GDP
• Interest rates puzzle
o Despite the surge in gross public debt to GDP ratios, the interest rates have fallen
▪ Usually interest rates would increase as investors demand more money to buy
risky assets ‘
o Decline in inflation and inflation expectations can lead to falling interest rates as falling
inflation would yield the same real interest rate (fisher equation: i = r + p)
o Availability of increased savings to be invested in gov assets
o Central banks have been buying gov paper in massive amounts
▪ They literally buy up a portion of the increased debt
• In US about 1/3 of increasing debt was purchased by Fed
• Japan basically all of increasing debt was purchased by Japanese bank
▪ Support the economy by injecting liquidity (money) into financial system by
buying gov paper directly
▪ Increase in the monetary base - amount of money in economy
o Basically, potentially negative effects of rising debt has been muted by large central bank
purchases of gov paper... what does this lead to?
Chapter 3 - how debt can cause crisis***
• Too much public debt can lead to a crisis in the government bond market
o Recession/economic crisis causing surge in debt as tax revenues were declining and gov
was spending money to support economy - larger deficit
o Large debt during peacetime raises doubts of gov ability or willingness to repay their debt
▪ Leads to crisis in gov securities
• Investors stop buying gov securities due to doubt and lost confidence in
country’s ability to repay debt, stop buying government paper
• People also stop investing in private sector which is backed by gov
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Extra credit book what we owe by carlo cottarelli. Indicated through debt to gdp ratio as taxes are normally from gdp: composition of who buys gov securities. 09 recession vs. great depression), but more public debt. Increase public debt due to higher spending for health care and social security programs that were only partly matched by increases in taxation (or by delayed: now - cross country snapshot. Japan has highest domestic debt holdings, which is why despite having insane amounts of debt, does not fall into crisis. In us about 1/3 of increasing debt was purchased by fed. Japan basically all of increasing debt was purchased by japanese bank: support the economy by injecting liquidity (money) into financial system by buying gov paper directly. Improvements to primary balances and purchases by central banks improve debt ratio situations and reduce risk.
