The impact of public and private debt on economic growth


Scientific Study, 2020

44 Pages, Grade: 12


Excerpt

Abstract

Albania has managed to maintain positive economic growth and macroeconomic stability over the past decade, but its high level of public debt, with an upward trend over the last three years, has been seen as a concern by many domestic and foreign economists. When it comes to debt, both public and private debt must be taken into consideration. Private debt analysis takes on particular importance because private debt is associated with financing business projects and increasing consumer demand, which serve economic growth and improve the country's macroeconomic parameters. This research aims to study the impact of public and private debt on economic growth in Albania during the period 2014-2018, as well as the main determining factors for both indicators. The methodology used is based on econometric regression analysis. The results showed that public and private debt has a statistically significant impact on economic growth in Albania. The study will answer the question: Does private and public debt have an impact on economic growth in Albania?

Key Words: Albania, Economic Growth, Private Debt, Public Debt, Regression Analysis

CHAPTER I

INTRODUCTION

Sustainable economic growth is of vital importance to all economies, particularly developing countries like Albania, which is before the challenges of macroeconomic and political stability, reducing unemployment and membership in the European Union. Economic growth is also a motive of any developing country, which aims to control the budget deficit, which has to face many challenges. Also economic growth is regarded as one of the central objectives of macroeconomic stabilization. This is due to the fact that economic growth is closely related to the living standards of a country's population. An increase in the standard of living increase in the population seeks necessarily increase the goods and services production. An important indicator of living standards would be output per capita.

Theory suggests that the three economic means available, for a government to fulfill the promises and obligations to its citizens, are taxes, print money and debt which transformed into tangible public goods such as infrastructure, schools, hospitals, etc. But under the existence of the primary economic problem where "Resources are limited to meet the needs of unlimited desires", a government is in front of a choice, which of the three economic tools should choose. A good government chooses to borrow for three main reasons. First, the country can exploit investment opportunities for long periods, and a growing economy would be inappropriate taxed a current generation of the poor to finance investments which would benefit from a richer generation to the future. Secondly, it allows a more efficient way to convey the counter-cyclical policies or meeting the urgent spending needs. Increase or frequent tax cuts could lead to loss of efficiency and generate economic uncertainty. Thirdly, excessive confidence in the printing of money can lead to increased money supply, higher interest rates, and consequently in increasing inflation, which would hurt the domestic and foreign investments.

The financial crisis, with whom was the face of her many countries has drawn the attention of economists, mainly on issues related to public debt, leaving out attention to another debt equally important species for the economy of a country such as private borrowing. In circumstances where alternative sources of financing business projects outside the banking channels are limited, private borrowing has great impact on the country's economic growth. When it talked about debt, it should be considered as public debt, as well as private debt. Currently, while public debt in Albania it is in alarming numbers, private debt is low compared to its size in the region, as the figures of private debt in developed countries can not be compared. Analysis of private debt takes on a special significance to the fact that private debt is linked to the financing of business projects and increasing consumer demand, which serve economic growth and improve macroeconomic parameters of the country. This analysis assumes a special importance, especially in terms of an economy in recession. The economic crisis of 2007 forced many countries to borrow, because one side of their fiscal revenues declined as a result of the recession, on the other hand, public spending grew by application of the wrong social policies that were undertaken by governments these countries. Public debt is one of the main macroeconomic indicators, which forms the image of the country in international markets and a determining factor in increasing the flow of foreign direct investment. It represents a lever, which is used well and efficiently, giving a positive impetus to economic growth. If it used wrong, it can go so far as to lead the country to the limits of the financial crisis. Moreover, foreign securities, their term of interest rates and overall debt financing costs have an impact on the economy, on the future of enterprises and social well-being not only for the present generation, but for generations next. Today the problem is not the original debt, but debt accumulated and unpaid growing every day. So, the problem is not what we owe, but how much repayment power it have and how sustainable are our cash flows to repay this debt. This is the problem today of every Albanian borrower if the is government, business or household. Management of Public Debt in countries in transition and developing countries is more complex and crucial than in developed countries. In this weak economy, the choice of public debt financial structure is key to ensuring fiscal stability due to the high volatility of macroeconomic and financial conditions. In addition, the dynamics of public debt burdens weight of fiscal risk as a source of macroeconomic instability in each country. One of the problems facing the Albanian economy is also performing loans phenomenon, which since 2008 has been growing. High- performing loans has shown that certain important factors that may affect the mitigation of this phenomenon have not worked with all possible facilities. Despite the efforts that are doing the commercial banks along with central banks, bad loans are back to worrying levels. The Albanian economy over the last decade has seen a steady economic growth and relatively satisfactory compared with other countries in the region. Processes of economic transformation and restructuring, as well as macroeconomic policies pursued in the last ten years have resulted in higher growth rates in the Eastern European region. GDP per capita has increased by about 2.3 times during the period 2010-2016, an annual average increase of about 6.66%. But, despite the high level of economic growth, according to data published by the World Bank, Albania remains one of the poorest countries in Europe, with about 25% of the population living below the poverty level,

GOAL AND OBJECTIVES

The purpose of this study is to analyze the effects of public debt and private debt on the country's macroeconomic indicators, especially the emphasis is on efficiency of public and private borrowing borrowing on GDP. The effects of public debt on GDP vary from one country to another, studying the factors that influence the emerging differences between these countries and made possible the comparison of private and public borrowing borrowing effect on the economy of any country. Following the goal, this study will focus on: the necessity of state debt and how the state ensures that debt, the importance of private sector development and business role over private borrowing on the role of public debt and private borrowing growth economic situation of the country, presented how the future of lending to banks.

CHAPTER II

LITERATURE REVIEW

2.1 Introduction

This chapter provides a summary of the theoretical literature, which is necessary to create expectations on the relationship between public debt and economic growth, as well as the relationship between private debt and economic growth. Initially, it is tried to summarize the main economic schools opinions on the relationship between public debt and economic growth, studies that did not result in the same conclusions. In the second part it is tried to bring the different economic theories concerning the relationship between economic growth and private borrowing, positive and negative effects of this relationship. In addition, to make clear the effect of economic growth on private borrowing,

2.2 Review of the literature on the relationship public-debt growth

The relationship between economic growth and sovereign debt is quite an issue discussed by economists. In this section, it is first given the definitions of debt and national economic growth,

State debt it is the total amount of state debt, issued in local currency and/or in the official currency different from the national currency, which does not include the financial obligations of municipalities/or any other authority of local government. State debt includes the debt of the Republic of Albania, established before the entry into force of this law. For purposes of calculating the state debt, when an unpaid obligation is issued in a currency different from the national currency, it is estimated in the national currency, according to the official exchange rate announced by the Bank of Albania, at the moment of evaluation.

Growth it is to increase the economic capacity of a country to produce goods and services in a specific period of time, compared with the previous period. Economic growth can be measured in nominal terms, which included inflation, or in real terms, which does not include

According to Aizenman, J., K. Kletzer and B. Pinto (2007), state debt is important for self effects it brings, either directly or indirectly, in the country. National debt could affect monetary policy. A country with a high government debt tends to face higher interest rates, and monetary authorities may be under pressure to reduce these intermediate monetary policy rate. This strategy may cut interest rates in the short term but in the long run will be unchanged real interest rates and inflation and nominal interest rates higher. The growth of these two indicators will be reflected in the reduction of private investment, and therefore the reduction Product of Gross Domestic Product (GDP) and economic growth.

Secondly, the state debt could affect the political process, which sets fiscal policy. Some economists argue that the possibility of a government borrowing reduces the discipline of the budget process use. With this latest we understand that if a government makes additional expenses that are not related to the income tax, the policy makers and the public worry less if these costs are appropriate. Inefficient use of additional funds for consumer goods and downtime, the government will translate into a negative effect on economic growth.

Thirdly, the state debt makes the economy of a country vulnerable to an international crisis of confidence. A senior government debt puts pressure on the balance of the bank through several different channels. For example, it increases the cost of financing to financial institutions following the rise in risk assets. Financial institutions, which hold a large share of sovereign debt of countries with an "economic stress" perceived as risky, may have to pay higher interest rates and have difficulty in raising funds in all market. They can also be found under potential pressure to increase capital and liquidity. All these factors make the increase of debt service costs, which will negatively impact on economic growth. Finally, according Adam, C. S. and D. L. Bevan (2005) financial institutions may face capital outflow and asset replacement. All the factors mentioned above indicate that a high level of public debt affects the reduction of the country's international confidence, would harm the business climate will affect the reduction of investment and economic growth.

Throughout the theoretical literature can be mentioned classics, who see public debt as a burden on society; neoclassical view, which sees public debt as detrimental to investment and growth; ricardian view that considers the state as a tax debt in the future (Adam, C. S. and D. L. Bevan, 2005). Modern economists, who see public debt as a driver of economic growth if the funds are used for productive purposes, and conventional point of view, according to which public debt stimulates aggregate demand and growth in the short term and promotes the reduction of capital and national income long term.

Classic economists created their conviction as they felt that balancing the annual budget by the government was a virtue for the government itself, and a budget deficit for those seen as a sign of state bankruptcy. David Ricardo, one of the main representatives of the Classical school, referring to the debt as "... one of the most terrible dangers, that was ever invented, that can affect a nation" as "... a system which tends to make us less thrifty, and blind to our real situation " (Buchanan, J. M., 1958). On the other hand neoclassical economists claimed that the level of public debt is important because of the existence distorting taxes, and the fact that economic agents can not properly predict the effects of tax changes in t he future. In such cases,

In the Ricardian view, state debt was considered equivalent to future taxes (Schclarek, A., 2004). Considering the rational and forward-looking, value added tax, which came from the growth of the latter to finance the deficit, it would be equivalent to the current deficit. So, according to the Ricardian view to financing the budget deficit through tax will not have the net effect on national income in the long run (Adam, C. S. and D. L. Bevan, 2005). On the other hand, modern economists, waving a complete reversal. They were convinced that if the state carried borrowing for productive purposes, and not for consumption goods and services, then they respected this action in every respect. They see government debt as a necessary tool for a modern economy, especially for developing countries,

An important contribution comes from the conventional point of view, according to which the state debt stimulates aggregate demand and growth in the short term and promotes the reduction of capital and national income in the long run (Smyth, D. and Hsing, Y., 1995). In the short term, an increase in public debt will continue to increase demand for output. If it is assumed that the government creates a budget deficit, maintaining costs and reducing income tax, this results in an increase in disposable income individuals, and possibly an increase in their welfare. According to Conventional analysis assumed that the increase in income and welfare of individuals will increase spending on consumption goods, so will boost aggregate demand for goods and services. According to this view, in the short term Keynesian theory works, which have prices and wages solid. So, in the short term an increase in aggregate demand will increase national income, which means that there is a positive relationship between public debt and growth in the short term.

In the long term, an increase in public debt will result in the reduction of national savings. According to the classical theory, in the long term it has flexible prices and wages. It makes fiscal policy affect national income only by changing the bid for the factors of production. To better understand how it works in the long term should be kept in mind several identities. Let Y denote the national income, C private consumption, private savings S, and T difference in taxes to government transfers.

According to the private sector have budget limitations:

Abbildung in dieser Leseprobe nicht enthalten

The national income may also be submitted in the following form:

Abbildung in dieser Leseprobe nicht enthalten

By combining the above two equations it is get:

Abbildung in dieser Leseprobe nicht enthalten

Where are domestic investment, G is government spending on goods and services, and NX is net exports of goods and services. Equation (2.3) shows that the sum of private and public savings should equal the amount of investment and net exports. Assuming again that the government maintains constant costs and lowers tax revenues, then we creating a budget deficit and public savings have decreased. One way that equation (2.3) to hold the balance after reduction of public savings is to reduce the investment for a certain period of time, which leads to a decrease of the capital. These stock means less output and less income for the country . Decrease in capital stock brings the country to a marginal product for higher capital, by raising interest rate and rate of return on any equity units.

Besides the contribution of the main economic schools, other economists have studied the relation of public debt to economic growth. Chalk, N. and V. Tanzi (2004), pointed out that the national debt is a direct consequence of the resultant deficit from domestic budget. They referred to the budget deficit equation:

Abbildung in dieser Leseprobe nicht enthalten

where DF is the budget deficit, Go are state expenditures for goods and services, T are spending on transfers, BUS is a budget surplus, and (Go + R) are total government spending. From the equation above shows that there is a negative relationship between debt and economic growth (Smyth, D. and Hsing, Y., 1995).

From the above theoretical literature, it can be say that economists have not been in tune to the relationship between public debt and economic growth, although the dominant opinion is a negative relationship between them. Given the conventional view, on which will be based also our work, it can say that the public debt has a positive effect on economic growth in the short term, and a negative effect in the long term. So, the relationship between public debt and economic growth according to the conventional view takes the form of a U- inverted, defined by economists as the Laffer curve.

2.3 Transmission mechanisms of growth of public debt on economic growth

There are different channels in which an increase (decrease) in public debt may have a negative effect (positive) economic growth in the long term. In this section are presented the three main channels, such as channel net savings, the channel's cost of debt service, and channel national credibility.

First, an increase in public debt generally corresponds to a reduction of net national savings volume. This is because those national savings, which before growing public debt will be used for investments, after growth of public debt will be used to finance the cost of servicing public debt. A reduction of net national savings, stimulates interest rates, and the latter affecting the reduction of investment and reduce the growth of the capital stock. It should be pointed out that the impact on interest rates depends on the size of the country. In the case of a small open country, the impact on interest rates will be very modest. While in the case of a large country and more integrated with the countries of the region where it is part of the pressure to increase interest rates will be more visible.

Second, an increase in public debt would entail an increase in the cost of service for this debt. This would reduce public investment and growth of capital and labor taxes, which have to finance this increase in public debt. The capital raising taxes leads to lower stock of capital in the country and curb domestic or foreign investors, who want to expand their activity. On the other hand, the increase of labor taxes will reduce labor supply, and can affect the growth of the informal economy and tax evasion. These last two factors will negatively affect directly to the state budget, bringing less investment in infrastructure, education, health etc. Also the business climate in the country will deteriorate making less preferred location for Foreign Direct Investment (FDI). On the other hand, an increase in labor taxes will reduce consumer purchasing power, which translates into less consumption, fewer sales to businesses and less taxes collected to the state budget. All these factors make the decrease GDP and consequently economic growth in the country.

Thirdly, an increase of public debt affects the level of international confidence in the country. This would lead to increased interest rates for individuals or firms. Rising interest rates would translate into less demand for loans from businesses and individuals. So, business can not be expanded and individuals can not expand their consumption. In addition to other factors, such as weak institutions, low private savings, low competitiveness, high unemployment and a weak banking system, would help the effect on interest rates. All these factors will translate into a country categorization as "country risk", and it will be offered very high interest rates to get foreign capital loans. But, rising interest rates will also mean less public and private investment, which brings a lower GDP. So, an increase in the public debt level would bring a reduction of economic growth in the long term. It should be noted that the analysis of the effects of an increase (decrease) in GDP on public debt, would have is that the same arguments as above, which means that an increase in GDP would help reduce public debt.

2.4 Review of the literature on the relationship private-debt growth

Always there have been discussions on the role of private capital and its positive or negative effects on economic growth of a country. The economic development of a country or region is a key factor for economic growth, particularly in emerging markets. The economic growth of a country can be defined as an expansion of the Gross Domestic Product (GDP) or Gross National Product (GNP). GDP is a function of capital, labor, land and entrepreneurship. Fosu, Augustin K., (1999), define GDP as the value of all final goods and services produced in a country within a certain period of time, while GDP shall refer to all goods and services produced by citizens, including remittances. Therefore it will say: a nation increases the productivity of capital and capacity through technological advances or increase its labor productivity through investment in human capital, by promoting successful entrepreneurial initiatives (Deshpande, Ashwini, 1997). In their research Aschauer, D. A. (2000) have studied economic growth in some countries before the recession and after obtaining debt. They conclude that: a high level of debt before a recession associated with a lower economic growth as the economic slowdown is over. In contrast, the highest growth of credit before a recession associated with higher growth in GDP after crisis. Debt effects on consumption are negative, implying that after the recession people consume less to save more than they did in the period before the recession. However, the overall economic effects of debt to GDP and consumption growth are limited. According to them, in a similar way, at the corporate level, a high debt burden inhibits the growth of turnover and investment and recruitment of new employees. Companies with a high debt burden are obliged to respond to the economic downturn faster. In an economy with debt exceeding several mechanisms can be effective in reducing economic growth. Overcoming debt occurs when corporate debt is higher than profit from new investments used to cover losses and recovery of existing loans. As a result, investors are not interested in new financing. They used data from 31 OECD countries for the period 1960-2007 and 20 from developing countries for the period 1980-2007.

For the preliminary analysis presented relations between key variables and found a negative relationship between the growth of consumption and debt to GDP and a positive relationship between consumption and the growth of private credit. In the end it is concluded that there is no relationship between the change of debt to GDP and GDP growth. According to them, all relationships, the variance of growth of GDP is high, which indicates that there are various factors that affect the growth of GDP after crisis. However, many studies have made clear the impact of private equity on economic growth, since the relationship between private capital and economic growth can be the opposite, which means it is economic growth that contributes to private activity and increased private capital. Khan, Mohsin S., and Manmohan S. Kumar, (1997) argues that the challenges in undertaking such studies is contrary to the explanation of causality that causes this growth, the contribution of private investment, rather than vice versa. Credit is vital to the economic activity of any business or individual. Families receive borrow to smooth consumption and buying houses. Firms often seek loans to finance long-term investments. Private sector borrowing is related to economic policy. It affects the monetary transmission mechanism and is the main determinant of financial stability. Families receive borrow to smooth consumption and buying houses. Firms often seek loans to finance long- term investments. Private sector borrowing is related to economic policy. It affects the monetary transmission mechanism and is the main determinant of financial stability. Families receive borrow to smooth consumption and buying houses. Firms often seek loans to finance long-term investments. Private sector borrowing is related to economic policy. It affects the monetary transmission mechanism and is the main determinant of financial stability.

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Details

Title
The impact of public and private debt on economic growth
Grade
12
Author
Year
2020
Pages
44
Catalog Number
V520336
ISBN (eBook)
9783346115256
ISBN (Book)
9783346115263
Language
English
Quote paper
Arjeta Hallunovi (Author), 2020, The impact of public and private debt on economic growth, Munich, GRIN Verlag, https://www.grin.com/document/520336

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