Evolution of views on the role of state in the market economy
Became a base for development of now industrialized countries, played a key role in mixed economy formation. Appeared in the wake of Great Depression in the USA. State should actively interfere in the economy because free market does not posses mechanisms to help the economy struggle out from crisis.
Тема 9. Государство и фискальная политика
Evolution of views on the role of state in the market economy.
State can influence market mechanism through: its expenses, tax system, regulation, state entrepreneurship.
Merchantelism (16-18 centuries): Stafford, Mann, Locke. Active interference of the state in the economy through export promotion (gold), import restrains (because accommodation of money makes the country wealthy). Introduced term “political economy”.
Phisiocrats (2nd half of 18): F. Quesnay, Turgot. Against state interference in production process and trade. State should maintain “natural order”, support agriculture, fiscal function.
Classical school (17-18): state has a passive role of “night watchman” in accordance with laissez-fair principle (nonintervention). Principle stipulates that the state should intervene in the economy minimally; economy is such a self regulated system, which finds effective equilibrium by itself; state interference distorts the economy and equilibrium becomes unattainable. A. Smith, “Wealth of nations”.
Marginalism (1870-19): Menger, Walras. Were against state interference and for free competition in allocation of economic resources.
Neoclassical school (1st half of 19 century-20): Austrian, American, Cambridge schools, now includes monetarism (Friedman), institutionalism (Coase). For non-interference of the state (capitalism with the help of market mechanism can regulate economic process by itself, providing equilibrium between production and consumption, supply and demand. Neoclassic for free entrepreneurship, free market forces, equal possibilities and self regulation of economy.
Keynesian school (30-60 of 20 century). Became a base for development of now industrialized countries, played a key role in mixed economy formation. Appeared in the wake of Great Depression in the USA. State should actively interfere in the economy because free market does not posses mechanisms to help the economy struggle out from crisis. State should influence the market to increase demand, through flexible monetary policy, change of amount of currency in circulation, increase of tax rate to raise funds for financing of unprofitable enterprises. The policy stops overproduction, decrease unemployment, remove social tension. Key features: high share of national income, state entrepreneurship, stabilization of market, state regulation of aggregate demand through stimulation of state and private investment, increased expenses on social needs; multiplier effect.
State as organization and economic institute
The common definition of State: State is a politically organized sovereign body, usually occupying a definite territory. But scholars have different ideas about definition of the state. For example, Max Weber argued that the state is a supremacy (dominance) relationship of certain people with respect to the others this supremacy is based upon legitimate (or rather perceived as legitimate) force used as a tool. Douglas North considers the state as organization with comparative advantages in implementation of force, extending towards certain geographical region with its borders defined by ability to tax the subjects.
Ideally the state spokesman of national (public) interests => the institution which stands above individual persons and private economic agents. The state as an institution that: - either reconciles different interests, brings them to the common denominator of public interest; - or defends the interests of specific groups at the expense of the others.
The state is an institution with a mission to express and protect national (public) interests.
The state is organization with comparative advantages in implementation of force, extending towards certain geographical region with its borders defined by ability to tax the subjects (D. North).
Estimate of the state interference
Two levels can be marked out to analyse regulatory activity of the state:
A) national level (including regional and local sub-levels)
B) international (including supranational)
There is no “Great Chinese wall” between these two levels.
“A” level (with respect to IET) Foreign economic policy:
- protection of domestic market
- international promotion of domestic companies and their interests
These 2 goals in conflict. Necessity to look for optimal balance between them. Example: FTA negotiations between US and Canada (2nd half of 1980s). FTA for Canada resulted in:
- on the one hand, lower level of domestic market protection
- on the other hand, a) better access to US market b) better dispute settlement mechanism c) no agreement on subsidies
In case of the national level the state by definition “is located” above domestic economic actors
Under the circumstances the state legitimately performs enforcement of the contract function.
But we need “B” level (international) because of insufficiency of national regulations (market failures). Results from the insufficiency of national regulation:
- economic performance has tended to internationalise and then to globalise;
- regulation on the national level generates “externalities” within the framework of world economy. That I why common “rules of the game” desperately needed.
Nowadays no legitimate “world government” exists and no “supreme referee” is above economic actors operating within the framework of world economy. Hence, need for international agreements, international economic organizations, etc.
Level “B” has some “sublevels”:
The latter fits to the circumstances in which there are inefficiencies in traditional bilateral relations or coordination problems that require cooperation among multiple parties
Multilateral sublevel has two “sub-sublevels”: -global (WTO, IMF); -regional (EU, NAFTA)
=> Problem of coordination between different sublevels
In many cases, countries are simultaneously parties to bilateral, regional, plurilateral and multilateral agreements.
Evolution of the economic functions of the state and economic policy
Economic function of the state is internal function that elaborates and coordinates strategic directions of economic development.
In traditional economic system: actions of the state are dictated by historically approved habits of the society. State itself usually follow these habits and enunciates them. Tradition stipulates what goods and services to produce and how to distribute them. Nowadays in some least developed countries with weak access of technical progress.
In market economic syatem: government does not interfere in the state economy. Its role is in support and protection of private property, imposition of laws that facilitate functioning of free markets. Economic activity is formed and managed by system of markets and prices and by private property on resources.
In command economic system: all material resources are state owned and all the economic decisions are made by the state authorities through centralized planning. All entraprises are provided with the plan what and at what amount to produce. State stipulates suppliers and buyers. State distributes resources between the sectors of economy relying on long term priorities. USSR.
In mixed economic system: state has a regulative role and producers have economic freedom. State provides antimonopolistic, social, fiscal and other forms of economic policies to ensure economic development and higher living standards. Now in most of the countries of the world.
Government revenue and government spending
Financial system of the government is a complex of all financial relations in the state. It consists of the following components: government budget, local finances, state-run enterprises finances and state funds. Government budget is a key element in the system; it is major centralized money fund at the state command. It is the state budget that allows government to allocate financial resources in the key social and financial areas, to redistribute national income between sectors, territories, different spheres of public service.
Generally, government budget is a plan of government revenues and government spending for the current year, composed in a form of balance.
Government spending shows the directions and objectives of government financing. All the spending can be subdivided into:
- on social needs;
- on foreign policy;
- on the expenses of the state.
In current conditions, due to the active state policy government spending is rising. This rise was predicted by economist A. Wagner, who had formulated the law of increasing state activity, which stipulates that government expenditures in countries with developing industries should rise quicker than national income volume (Wagner law).
Government revenues are formed from:
- taxes, collected by federal and local authorities;
- non-tax revenues from foreign economic activity, taxes on state property;
- revenues of designated budgetary funds.
In Russia, tax revenues account for 84% of federal budget, non-tax revenues 7%, revenues of designated budgetary funds 9%
The key aim of the budget administration is to provide complete and timely tax arrivals and other payments and revenues on the whole and from every resource, and also financing of activities, approved in the budget for the actual year.
Principles of tax system
Principles were first formulated by A. Smith in 1773.
Tax system is a complex of taxes and duties, established by the government and levied with the aim to create a common state fund of financial resources and also complex of principles, methods and forms of their collection.
Principles are numerous and the major ones are:
- uniformity or single legislative and normative base (all the taxes, duties and so on can be introduced and withdrawn only by the legally authorized state authorities; tax system is formed uniformly and taxation issues are solved in accordance with the single method, common for all taxpayers);
- stability of tax legislation (means stability without any changes and corrections for a set period of time);
- rationality and optimality of tax system in terms of its reasonability; helps to optimize the structure of the system, minimize expenditures for its organization;
- legally-organized structure and organization of tax system (separation of duties between different levels and authorities on the establishment and collection of payments; separation of tax proceeds);
- maximum effectiveness of tax system (maximum collection of taxes);
- target-oriented tax collection into the budgets of the relevant territorial units.
Tax burden and its movement
The amount of income, property, or sales tax levied on an individual or business. Tax burdens vary depending on a number of factors including income level, jurisdiction, and current tax rates.
Tax payers often want to decrease their tax burden and can do it in 2 ways:
- by decreasing of tax liabilities through changes in their economic activities (reduce the activity and thus reduce taxable amounts or increase the activity to gain possible tax preference);
- by switch of tax burden on other agents.
The latter involvs three parties: the state, taxpayer and market intermediator. Formally taxpayer do not decrease its liabilities before government, wholly or partially compensate its payments at the expense of the third party. Movement back (retarction) is from buyer to seller (e.g. lowering of real wages to reduce increased income tax). Movement forward is from seller to buyer (e.g. when taxes are included in the price of a good). Movement of the tax on one market leads to movement on another.
If the market is competitive, when market agents are price takers, possibility to move tax burden defines by elasticity of demand and supply.
When demand is inelastic, tax burden falls on the buyer. When demand is elastic, seller do not has a possibility to include tax in the price because this will reduce demand so the seller pays tax by itself on the expense of its income.
When supply is inelastic, sellers can not influence market, tax burden falls on sellers and their net income decreases. When supply is elastic, sellers have an opportunity to change quantity of goods sold and will sell the good at a price that covers all their expenses. Tax becomes included in the price entirely.
A tax burden falls more heavily on the side of the market that is less elastic.
Movement can not be done at a moment: usually it takes time and includes transaction costs.
is a hypothetical representation of the relationship between government revenue raised by taxation and all possible rates of taxation. It is used to illustrate the concept of taxable income elasticity that taxable income will change in response to changes in the rate of taxation. The Laffer curve postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100%. If both a 0% and 100% rate of taxation generate no revenue, but some intermediate tax rate generates some tax revenue, it follows from the extreme value theorem that there must exist at least one rate where tax revenue would be a non-zero maximum. One potential result of the Laffer curve is that increasing tax rates beyond a certain point will be counterproductive for raising further tax revenue.
Laffers conjecture is that lower tax rates would raise tax revenue.
The idea that cutting taxes can raise revenue may be correct if applied to those taxpayers facing the highest tax rates (like in USA in 1980). In addition, Laffers argument may be more plausible when applied to countries, where tax rates are high. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more tax revenue if it had lowered its tax rates.
Redundant tax burden
- extra losses of the society in comparison with the amount of tax revenue.It is a deadweight loss in taxation.
Taxes rarely stay the same for long periods of time. Policymakers always considering raising one tax or lowering another. Here we consider what happens to the deadweight loss and tax revenue
when the size of a tax changes.
Figure shows the effects of a small, medium, and large tax, holding constant the markets supply and demand curves. The deadweight lossthe reduction in total surplus that results when the tax reduces the size of a market below the optimumequals the area of the triangle between the supply and demand curves. For the small tax in panel, the area of the deadweight loss triangle is quite small. But as the size of a tax rises, the deadweight loss grows larger and larger.
Indeed, the deadweight loss of a tax rises even more rapidly than the size of the tax. The reason is that the deadweight loss is an area of a triangle, and an area of a triangle depends on the square of its size. If we double the size of a tax, for instance, the base and height of the triangle double, so the deadweight loss rises.
The governments tax revenue is the size of the tax times the amount of the good sold. As Figure shows, tax revenue equals the area of the rectangle between the supply and demand curves. For the small tax in panel (a), tax revenue is small. As the size of a tax rises from panel (a) to panel (b), tax revenue grows. But as the size of the tax rises further from panel (b) to panel (c), tax revenue falls because the higher tax drastically reduces the size of the market. For a very large tax, no revenue would be raised, because people would stop buying and selling the good altogether.
Issue of optimal taxation is connected with its history and was first defined in the work of A. Smith (also Laffer). Main principles:
- taxation should not be redundant. Taxes should stimulate economic activity. Excessive taxation narrows tax base due to decrease in production and income and cause tax tax evasion;
- double taxation should be avoided;
- tax payment system should be simple, clear and convenient for taxpayers and tax collectors, with minimal administrative costs;
- tax system should be flexible, and easy to adapt to economic and social changes;
- tax revenues should be sufficient to satisfy state needs;
- system of penalties and fines should be included for non-payers.
There should be an approach when non-payment and tax avoidance is less profitable than fulfillment of tax obligations.
Progressive taxation is considered an optimal one by some finansists, when taxpayers with higher income pay higher taxes.
Government spending and its structure
Gov. spending includes all government consumption, investment but excludes transfer payments made by a state. All spendigs break in three categories:
- Government final consumption expenditure - acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community;
- Government investment (gross fixed capital formation) - acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending (usually is the largest part of the government gross capital formation);
- Acquisition of goods and services is made through own production by the government (using the government's labour force, fixed assets and purchased goods and services for intermediate consumption) or through purchases of goods and services from market producers.
- Transfer payments - redistribution of income in the market system. These payments are considered to be exhaustive because they do not directly absorb resources or create output. Examples include welfare (financial aid), social security, and government making subsidies for certain businesses (firms).
Government spending can be financed by seigniorage, taxes, or government borrowing.
The first two types of government spending together constitute one of the major components of gross domestic product.
J. M. Keynes was one of the first economists to advocate government deficit spending as part of the fiscal policy response to an economic contraction. In Keynesian economics, increased government spending is thought to raise aggregate demand and increase consumption, which in turn leads to increased production.
Classical economists and Austrian economists, on the other hand, believe that increased government spending exacerbates an economic contraction by shifting resources from the private sector, which they consider productive, to the public sector, which they consider unproductive.
Government purchases, net taxes and disposable income.
Gov. purchases - expenditures made in the private sector by all levels of government, such as when a government entity contracts a construction company to build office space or pave highways. Gov. purchase can be declared and take a form of open or closed tender, auction, competition. It is provided to satisfy needs of the state on the federal, local and municipal level in goods, services necessary to fulfill its functions and obligations.
GNP (Y) = C + I + G (+Export), where
C = expenses on consumption, I = investment, G = government purchases.
Ideally, government spendings are formed from G and transfer payments (payments that do not directly absorb resources or create output, e.g. welfare (financial aid), social security, government subsidies for certain businesses). The amount of taxes that forms budget revenues should equal government spending (government purchases and transfer payments). However, transfer payments represent redistribution, that is they finally return to private sector, and their movement is from private to private sector. Here such term as net taxes should be used. Net taxes is a sum of money that private sector pays the government after all transfer payments, coming from the government, were accounted.
Disposable income - the amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy.
Rise in gov. purchases increase equilibrium output of production. Taxation, in its tern, decreases consumer disposable incoms and consequently spending. Disposable income is total personal income minus personal current taxes. In national accounts definitions, personal income, minus personal current taxes equals disposable personal income. Subtracting personal outlays (which includes the major category of personal (or, private) consumption expenditure yields personal (or, private) savings.
Restated, consumption expenditure plus savings equals disposable income after accounting for transfers such as payments to children in school or elderly parents living arrangements.
Correlation between all three: when gov. purchases rise, disposable income and net taxes also rise. Finally rises GDP.
- is the ratio of a change in national income to the change in government spending that causes it. The tax multiplier measures the change in aggregate production triggered by an autonomous change in government taxes. This multiplier is useful in the analysis of fiscal policy changes in taxes.
The formula for the simple tax multiplier. (m[tax]), is:
m[tax] = -MPC*1/MPS = - MPC/MPS
Where MPC is the marginal propensity to consume and MPS is the marginal propensity to save.
Important aspect of the multiplier, is that to the extent that government spending generates new consumption, it also generates "new" tax revenues. For example, when money is spent in a shop, purchases taxes such as VAT are paid on the expenditure, and the shopkeeper earns a higher income, and thus pays more income taxes. Therefore, although the government spends $1, it is likely that it receives back a significant proportion of the $1 in due course, making the net expenditure much less than $1. Indeed, in theory, it is possible, if the initial expenditure is targeted well, that the government could receive back more than the initial $1 expended. This is a simple explanation of the multiplier effect. The multiplier effect is a tool used by governments to attempt to stimulate aggregate demand. This can be done in a period of recession or economic uncertainty. The money invested by a government creates more jobs, which in turn will mean more spending and so on. The idea is that the net increase in disposable income by all parties throughout the economy will be greater than the original investment. When that is the case, the government can increase the gross domestic product by an amount that is greater than an increase in the amount it spends relative to the amount it collects in taxes.
A balanced budget is when there is neither a budget deficit or a budget surplus when revenues equal expenditure ("the accounts balance") particularly by a government. More generally, it refers to when there is no deficit, but possibly a surplus.
Balanced budgets, and the associated topic of budget deficits, are a contentious point within academic economics and within politics, notably American politics. The mainstream economic view is that having a balanced budget in every year is not desirable, with budget deficits in lean times being desirable. Within American politics the situation is much more debated, with all US states other than Vermont having a balanced budget amendment of some form, while conversely the US federal government has generally run a deficit since the late 1960s, and the topic of balanced budgets being a consistent topic of debate.
The balanced-budget multiplier measures the change in aggregate production triggered by an autonomous change in government taxes. This multiplier is useful in the analysis of fiscal policy changes that involves both government purchases and taxes.
Because of the multiplier effect, it is possible to change aggregate demand (Y) keeping a balanced budget. The government increases its expenditures (G), balancing it by an increase in taxes (T). Since only part of the money taken away from households would have actually been used in the economy, the change in consumption expenditure will be smaller than the change in taxes. Therefore the money which would have been saved by households is instead injected into the economy, itself becoming part of the multiplier process. In general, a change in the balanced budget will change aggregate demand by an amount equal to the change in spending.
Simple fprmula: m[bb] = 1/MPS + (- MPC)/MPS = 1-MPC/MPS = MPS/MPS=1
Thus the balanced budget multuiplier is always equal to one.
The government budget deficit equals government spending minus government revenue, which in turn equals the amount of new debt the government needs to issue to finance its operations.
A government budget deficit is the amount by which some measure of government revenues falls short of some measure of government spending.
If a government is running a positive budget deficit, it is also said to be running a negative budget surplus (and conversely, a positive budget surplus is a negative budget deficit).
The meaning of 'deficit' differs from that of 'debt', which is an accumulation of yearly deficits. Deficits occur when a government's expenditures exceed the revenue that it generates. The deficit can be measured with or without including the interest payments on the debt as expenditures.
The primary deficit is defined as the difference between current government spending on goods and services and total current revenue from all types of taxes net of transfer payments. The total deficit (which is often called the fiscal deficit or just the 'deficit') is the primary deficit plus interest payments on the debt.
Therefore, if t is a timeframe, Gt is government spending and Tt is tax revenue for the respective timeframe, then the primary deficit is Gt-Tt. If Dt-1 is last year's debt, and r is the interest rate, then the total deficit is r*Dt-1 + Gt - Tt
Economic trends can influence the growth or shrinkage of fiscal deficits in several ways. Increased levels of economic activity generally lead to higher tax revenues, while government expenditures often increase during economic downturns because of higher outlays for social insurance programs such as unemployment benefits. Changes in tax rates, tax enforcement policies, levels of social benefits, and other government policy decisions can also have major effects on public debt. For some countries, such as Norway, Russia, and members of the OPEC, oil and gas receipts play a major role in public finances. Inflation reduces the real value of accumulated debt. If investors anticipate future inflation, however, they will demand higher interest rates on government debt, making public borrowing more expensive.
Structural deficits, cyclical deficits
A government deficit can be thought of as consisting of two elements, structural and cyclical.
At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditure (e.g. on social security) high. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing social security spending. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.
The structural deficit is the deficit that remains across the business cycle, because the general level of government spending exceeds prevailing tax levels. The observed total budget deficit is equal to the sum of the structural deficit with the cyclical deficit or surplus. Structural deficit forms part of the public sector deficit. Structural deficit differs from cyclical deficit in that structural deficit exists even when the economy is at its potential.
Some economists have criticized the distinction between cyclical and structural deficits, contending that the business cycle is too difficult to measure to make cyclical analysis worthwhile.
Inflation and non-inflation methods for budget deficit financing
Deficit financing, practice in which a government spends more money than it receives as revenue, the difference being made up by borrowing or minting new funds. Although budget deficits may occur for numerous reasons, the term usually refers to a conscious attempt to stimulate the economy by lowering tax rates or increasing government expenditures. The influence of government deficits upon a national economy may be very great. It is widely believed that a budget balanced over the span of a business cycle should replace the old ideal of an annually balanced budget. Deficit financing, however, may also result from government inefficiency, reflecting widespread tax evasion or wasteful spending rather than the operation of a planned countercyclical policy.
There are several options of the budget deficit financing:
- Inflation method. It includes emission, when the government (Central bank) increase money supply, that is emits money to cover its expenses over revenues. Advantages: increase of money supply causes increase of aggregate demand and consequently, volume of production. Increase in money supply stipulates decrease in interest rate, that stimulates investment and leads to rise of total revenue and total output. This measure stimulates the economy and can be a way to go out of recession. Moreover, this measure is “quick”. Disadvantages: in a long run it causes inflation and can cause instability in the economy. Lower interest rate, stimulating total spending, leads to greater economic activity and thus accelerates inflation.
- Non-inflation methods. 1) at the expense of domestic debt, when government emits securities, sells them to citizens (hoseholds and firms) and use raised funds to finance deficit. Advantages: do not cause inflation; fast method. Disadvantages: necessity to pay interest rate on securities. The bigger volume of securities, the bigger is amount to serve them => bigger budget deficit; case of refinancing, which later can provoke necessity for emission => higher inflation; can have spilling effect on investment; can lead to deficit of balance of payments. 2) financing from abroad, through borrowing from other countries or financial organizations (IMF, WB, London Club, Paris Club…). Advantages: large sums can be borrowed; non-inflation character. Disadv-ges: necessity to pay back with interest rate; necessity to take funds from economy to pay back that leads to decrease in domestic production and decline of economy.
Budget deficit burden and government debt.
Budget deficit burden: see disadvantages above.
Government debt is a sum of accumulated budget deficits, corrected on the amount of budget surpluses (if they are the case). Gov. debt is an indicator of reserve, because it is calculated for a certain period of time in comparison with budget deficit, which indicates flow during a set period of time.
Absolute value of gov. debt can not show its burden for the economy. For this purpose an indicator of ratio between gov. debt and national income or GDP is used, that is d = D/Y. If rates of growth of the debt are less rates of growth of GDP, the debt is not very harmful for the economy. Gov. debt becomes a serious macroeconomic problem when economic growth is slow.
Major problem is not in possible bancrupsy. Usually it is not the case because the government builds financial pyramid (refinancing), issuing new borrowings and making new debts to pay back earlier ones.
Serious problems of a big gov. debt are in the following: - effectiveness of the economy declines because finances from production are used to pay back the debt; revenue is redistributed from private sector to state; inequality increases; refinancing causes interest rate to rise that cause spilling of investments in short run and decrease in production potential of the state in the long run; paying the debt can cause tax increase; instable welfare of future generations; foreign debts: transfer of certain part of GDP abroad.
Domestic and foreign debt; consequences for economic growth.
Domestic debt can be caused by financing of budget deficit. Gov. emits securities, which sells to households and firms, and than finance gov. expenditures with raised funds.
Disadvantages: 1) Debts should be payed back. Nobody would buy securities in case they are unprofitable so the gov. should also pay interest rate, which would come from gov. budget. 2) In long run it causes inflation! (thery of Sargent and Wallace). State builds a financial pyramid (refinances the debt). If it is the only measure, in future deficit can be so huge that emission would be necessary. Size of emission will be bigger => upsurge of inflation. 3) Spilling effect of private investments. Increase amoubt of state securities on equity market causes household savings to be spent on securities, but not private firms bonds. It decreases investment and output of production decreases. 4) Can cause trade balance deficit: I + G + Ex = S + T + Im, где I investments, G gov. purchases, Ex export, S savings, T net taxes, Im import. The same: (G Т) = (S I) + (Im Ex) => when gov. budget deficit rises, savings should increase or investment should decrease or trade balance deficit should increase.
Foregn debt can be caused by financing of budget deficit. In this case the states borrows from i=other countries or feom financial organizations (IMF, WB, London club, Paris club). Disadvantages: 1)debt should be payed back with interest rate 2) financial pyramid can not be used here 3) to pay the debt back, finance should be taken from the economy of the country => shrink in production and decline in economy
Government debt may affect a nations role in the world economy. When a government budget deficit reduces national saving, it often leads to a trade deficit, which in turn is financed by borrowing from
abroad. High levels of government debt may increase the risk that an economy will experience capital flightan abrupt decline in the demand for a countrys assets in world financial markets. International investors are aware that a government can always deal with its debt simply by defaulting.
The higher the level of the government debt, the greater the temptation of default. Thus, as government debt increases, international investors may come to fear default and curtail their lending. If this loss of confidence occurs suddenly, the result could be the classic symptoms of capital flight: a collapse in the value of the currency and an increase in interest rates. High levels of government debt financed by foreign borrowing may reduce a nations political clout in world affairs.
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