ECON1102 Assignment 2
Thomas Abraham
21145999
University of Western Australia

MACROECONOMICS- Assignment Two
Public Debt, or government debt is the result of an imbalanced budget (defecit), which is when the government-planned expenditure outweighs its revenue, causing for the sale of government bonds to raise funds that will usually have fixed interest rate and are generally regarded as a very safe investment in that governments rarely default on loans. In recent years however, we have seen somewhat unsteady economics conditions, especially in the United States and the “Euro Zone”, i.e. the countries that are apart of the European union, and use the Euro as their currency.

The Risks of public debt depend vastly on the state of the economy. In countries that have strong growth levels and strong employment, Public debt is often viewed as economically viable, not risk free but controllable. This is because the level of borrowing multiplies through the economy and creates a larger than proportional increase in income which will more often than not eliminate the debt plus interest. However with economies that are struggling, risks associated with public debt increase dramatically.

The risk of recurring interest rates on large volumes of debt becomes a genuine threat to an economy that is not performing well such as the Euro areas negative growth rate of -0.3% (European Commission 2012). It creates somewhat a vicious cycle. The selling of government bonds have standard rate of interest attached, which is manageable in small quantities, but when a country like the US has public debt of 15.7 Trillion (US Treasury 2012), the interest becomes so substantial that it cannot be paid back without borrowing, and thus the downward spiral into debt continues. This is a relevant risk to the US and the Eurozone, with high debt creating a vicious cycle.

There is a risk of intergenerational inequity in the practice of public debt. This is the concept that there is a transfer of wealth between those who enjoy the benefits of the public debt and those who finance it, i.e. if a government gives a one off handout to stimulate the economy, this will equate to a large amount of money, and this money will probably not be seen by those of later generations who may well be the ones paying higher levels of taxes in order to decrease a large public debt. This can cause social & political turmoil as well. There could also be a political bias in that a government will act upon re-election motives rather than economic ones, an undesirable factor for fiscal policy and the creation of debt.

The crowding out effect is considered a particularly dangerous side-effect from public borrowing, and it occurs when the government borrows large amounts which results in the private sector competing for a smaller amount of savings, thus driving the interest rate up. With the increase in the real interest rate, investment from the private sector is discouraged as it becomes gradually more expensive to invest, with the real cost of borrowing rising, This “crowds-out” the private sector. This was observed in the bailouts and high expenditure in the global financial crisis in the US (Moneymorning 2010).

Political Instability & Economic collapse are risks of the worst kinds of public debt- but not entirely unrealistic in the situation of The U.S. and the Eurozone. There has been serious speculation about the chance of a break up of the Eurozone (Creditwritedowns, 2010), which would cause havoc amongst the participating countries, adding to violent riots and unrest within Greece, and contagion the world.

Solutions to the public debt problems of both the Eurozone and the US are debatable. The general method is public savings & austerity, however this is hardly effective if the debt is considered high. This is because so much is needed in order to stimulate an economy in dire financial circumstances, yet creating public savings in anything