Unlike the classical economists’ assumption that the economy is always at full employment level or self-adjusting towards full employment, the Keynesians argue that such economy may result in underemployment equilibrium. Underemployment equilibrium refers to a situation whereby there are resources that may be unemployed by the private sector for a length of time in the absence of corrective actions by government (Gupta, 2007).Therefore, Keynesians argue that government allocation of resources does not rob the private sector of anything but rather raise aggregate production and income by making use of those untouched resources.
John Maynard Keynes, commonly referred to as the father of Keynesian economics, proposed that during recession, government should prevent using taxes. He suggested that government should rather borrow (as a source of finance) and it should pay back debt in periods when the economy is in a better shape with a budget surplus. Then
government needs to motivate activities in the economy by directly or indirectly purchasing goods and services.
The reason why this action is necessary is because expectations in periods of economic downturn are low or worse, and so, governments do not increase taxes as it sends bad signals to stakeholders. Instead, they use loans from the capital market or Central Bank to take care of its budget deficit. Budget surplus can be achieved either by cutting expenditures or raising its tax revenue. This rise in tax revenue could be achieved by raising tax rates or a notable increase of GDP at current tax rates (Becirovic et al., 2010). Keynes also opined that for a government to reduce its spending in the budget, there are automatic stabilizers that can adapt to the economic situation.
The alternative to increasing tax is reducing costs or spending. For every budget, there are automatic stabilizers that aid in the dampening of fluctuations in the real GDP such as personal taxes and welfares. For instance, if the economy is facing a depression, unemployment welfare increases, whereas they reduce during an economic upsurge. Sometimes, the government can face challenges when trying to intervene in the economy. These challenges could come in the form of costs of projects. A project may involve large capital and/or may need political backing before it can be undertaken. The period of time before it gets the backing may take a lot of time or the completion date could be long term. While steps to carry out this project are still ongoing, the economic situations can change rapidly, so the extra public demand for money and resources can create crowding out or inflation because the aggregate demand is higher than aggregated supply, but these expenses cannot be ‘evaporated’ until the project is completed.
In addition to the challenges that governments face with spending cuts, there is also an issue with cutting subsidies and cancelling projects for political reasons. Such reasons can stem from bargaining power of pressure groups such as labour unions, with the inability to cut expenditure resulting in growth of debts.
Keynes also opined that the magnitude of public debt does not matter and the size of the interest to be paid does not form any burden on society. According to him, an increase in public debt means that the government can access savings and make productive use of the funds raised with the aim of raising the national income or economic growth. In periods of unemployment, a rise in public debt adds to the capital formation, as it helps the development of sources of savings institutions such as banks, financial markets, etc.
An important contributor to the Keynesian school is Franco Modigliani. He believed that an increase in debt is beneficial to those present at the time of increase. This increase will place a burden on the future generation because of the decrease in the stock of private capital. Also, that the burden of public debt can be narrowed as long as the rise in debt is followed by a rise in public expenditure which adds to the real income of future generations.
Modigliani argued that irrespective of how a government finances its public debt, the amount of the current resources remains the same. However, the choice of financing may adjust the allocation of resources to private investors, therefore, consumption and investment will be largely affected.
In closing, Keynesians do not conclude if public debt has a negative or positive impact on economic growth because it depends on the economic state. Therefore, there is no general recommendation to policy makers. Thus, they need to identify the state of their economy and take appropriate measures (Tesic, et al., 2014).
2.2.4 Criticism of The Keynesian Economic Thought on Public Debt
Keynes contrary to classical economics emphasised government intervention and borrowing instead of levying taxes. As mentioned earlier, he argued that when an economy is in a recession, government should avoid the use of taxes but should rather borrow to fund its spending and then should back when the economy is in a better shape with a budget surplus. The main criticism of this suggestion is that high rate of borrowing can lead to crowding out of investment. This is because increased level of borrowing causes the cost of borrowing (interest rate) to increase and investors, and high rate of interest causes investors to look elsewhere for better deals, resulting in the crowding out of investment. Examples of high rates of borrowing, high interest rates and crowding out can be seen across major financial instabilities (discussed in section 3.5).
Keynes did not believe that government spending could negatively affect the confidence of private investors. According to him, government spending stimulates economic activities and can in the long run revert a budget deficit. But this is not always the case especially in a recession. For instance, the effect of government borrowing during a recession is exemplified in the case of Greece during the Euro debt crisis, where the government borrowed in order to meet its obligations, however the
economy did not get better. They borrowed over two years and even sold government enterprises to the private sector as a way to raise funds (Anand et al. 2012).
Additionally, a major challenge facing government intervention is financing costs such as costs for repayment and interest. For long term projects, long term loans are taken. These costs cannot be expunged, except if the loans are repaid earlier than the maturity date. But because the long term investments are huge, it is hard to attain and it is not beneficial for the creditors to lower interest rate due to lower interest earnings. Furthermore, if in the short run government revenues reduce due to lower rate of economic growth, the government will collect fresh loans to finance old debts, consequently, the effect of compound interest raises debts.
Another criticism of the Keynesian economic thoughts on debt came from the Austrian School of economics. Keynes intervene in a recession by borrowing, however the Austrian economists argue that a recession period is part of the natural order of the business cycle and it is usually followed by a recovery period. Therefore, government interference during a recession only weakens and impairs recovery (Jahan, et. al. 2014).
2.3 CHANNELS THROUGH WHICH PUBLIC DEBT AFFECTS THE