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Subject ECONOMICS

Paper No and Title 7: Theory of Public Finance

Module No and Title 38: Public Debt- Classical view of public debt;
Compensatory aspect of debt policy
Module Tag ECO_P7_M38

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Concept of Public Debt
4. Classical view on Public Debt
5. Compensatory aspect of debt policy
6. Summary

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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1. Learning Outcomes

After studying this module, you shall be able to

 Learn the concept of public debt.

 Know the Classical Debt theory and classical views on public debt.
 Learn the compensatory aspect of public debt.

2. Introduction

The study of public debt is an integral part of the study of public finance apart from the
study of public revenues and expenditures. Since the Great Depression of 1930, public
debt has assumed greater significance in the process of economic growth. Keynes saw
public debt as an instrument of mobilizing saving, investment and improvement in the
standard of living.
Public debt refers to the borrowings of the government from internal and external
sources. A government borrows money when its revenue falls short of its expenditures. In
this chapter, we will highlight the concept, causes and sources of public debt.

3. Concept of Public Debt

Public debt refers to all type of government borrowings. Prof. Taylor defines public debt
as, “Government debt arises out of borrowings by the treasury from banks, business

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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organizations, and individuals.” The government sources debt from both internal as well
as external sources such as foreign governments.
The role of government debt has been a source of debate. The classical economist such as
Adam smith saw the state as wasteful that borrows from private capitalist for
unproductive purposes and hinders capital formation. They believed in a laissez-faire
economy. Ricardo, Malthus, Say and other classical economists disapproved the notion of
public debt. Accordingly, government borrowing withdraws resources from private
employment and unbalanced budgets expand government activity and lead to
irresponsible government activity. They argued that public debt lead to currency
depreciation and the loan repayment along with interest payments makes future financing
even more difficult.
However, when the Great depression struck, there was a marked shift in the thinking of
economic pioneers. Keynes argued in favor of public debt and was of the notion that it
does not constitute any burden on the society. He believed that there is an existence of
unemployed resources in the economy and the entire increase in income is not consumed,
part of it is saved. Therefore, an increase in government expenditure would cause income
and output to expand through a multiplier process. The public debt, during the period of
great depression, was instrumental in getting the economy back on track. Through debt
creation, the government could mobilize private savings, raise resources for capital
formation and thus generate employment and raise effective demand. It curbs
consumption and raises savings necessary for the future capital formation and income
generation. Since then, public debts of nations have increased many-fold and occupy an
important position in government budgets.
In this chapter we highlight the Classical view on public debt and then move on to
discuss the compensatory aspect of public debt.

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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4. Classical View on Public Debt

The classical school of thought considered that government debt was an impediment to
economic progress. They were a proponent of laissez-faire and advocated a market
economy. The individual were characterized as rational decision makers who are far
sighted unlike myopic individuals as assumed by the Keynesian school. These individuals
respond to real changes in their wealth and plan their consumption behavior over their
entire life cycle.
David Hume, a classical economist was perhaps the first one to convey his thoughts on
public debt. In 1752, he said, “either the nation must destroy public credit or public credit
will destroy the nation.” Accordingly he was skeptical about the power vested in the
hands of creditors who could abuse the debtors. Public debt, according to him can pose
adverse social- political consequences and was threat to the security of the state as it
encourages an idle and useless rentier class and oppresses the poorer class.
J.B say made a distinction between a private borrowing and the government borrowing.
The purpose of private debt is to create beneficial employment whereas public debt
creates barren production and consumption and the burden is transferred to the future
generations. Adam smith (1776) held the view that,” The progress of the enormous debts
which at present oppress, and will in the long-run probably ruin, all the great nations of
Europe, has been pretty uniform.” He considered the state as wasteful. Public debt takes
away resources from the private capitalist; the annual produce is directed towards
servicing of debt rather than to capital formation and towards the maintenance of
unproductive labor. He argued that land and capital will be burdened by the higher taxes
imposed to service debt. Public debt will lead to a transfer of resources to unproductive
creditors and as a result “the ruin of trade and manufacture will follow the declension of
agriculture.”
He and Ricardo were concerned with consequences of public debt- the usage to which it
was put. The consequence of debt is the destruction of capital caused by it. Ricardo

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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advocated one-time capital levy as a means of redemption of debt and use of tax revenues
for the financing of the war. The aim should be to be debt free within the period of three
years. According to him, a nation free from public debt will witness high private capital
formation and thus enjoy higher economic growth. One time tax in form of a capital levy
will free the nation from the debt otherwise continuous tax burden will drive resources
out of the economy and thus discourages economic growth.
Malthus also recognized the evils of public debt. He argued that high debt and
accompanying higher taxes are injurious to food production, could lead to burdensome
tax increases and tempt voters to default. He recognized that disequilibrium exists in the
market in the form of high unemployment, poverty, disinflation, lower profits and
economic recession. However, he was not in complete agreement with Ricardo regarding
levy of one-time tax. Rather he believed that it would aggravate the economic problems.
According to him both overconsumption and under-consumption hinders economic
growth. The public creditors namely the Capitalists and the landlords would find it
difficult to increase their consumption and demand to the extent necessary to close the
gap between production and consumption, instead, the gap between the two would widen
resulting in further distress to the economy.
John Stuart Mill (1848) was against public borrowing as it destroys capital which
otherwise could be used more productively. A country should raise debt within
acceptable limits, Accordingly a country would be spared from the evil effects of public
debt if it pays it off expediently through general contribution or out of the surplus
revenue.
The classical theory on public debt took the best shape with the works of H. C. Adams,
C. F. Bastable, and P. Leroy-Beaulieu. They carefully analyzed the effects of public debt.
They made a clear distinction between the creation of public debt and effects of public
expenditure. Adams argued that debt creation per se does not adversely affects the
lenders. According to him, "A loan calls for no immediate payment from the people....

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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the lenders are satisfied since they have secured a good investment." He refuted the
argument that burden of expenditure cannot be forwarded.
Bastable stated that public credit is only one form of credit in general and is governed by
the same principles, which control private credit. Further, he made a distinction between
loan finance and tax finance. "A loan is voluntary and supplied by willing givers, taxation
is levied on the willing and unwilling alike to make things smooth for the present at the
cost of the future is not the duty of the wise and far-seeing Statesman." He believed that
loans are made out of capital and taxes are paid out of new income. Both public debt and
taxes affects income as well as capital.

Paul Leroy - Beaulieu, made a clearer piece of the classical position on public debt. He
maintained an open position on public debt i.e. neither evil nor good. He condemned the
classicists for ignoring the beneficial aspect of public expenditure. As he puts it, "a loan
will be useful or harmful to the society, in general, depending on whether the State
preserves and usefully employs the proceeds or wastes or destroys the capital which the
rentiers have given up." He criticized the view held by the earlier Classists. A nation
could remain ultimately indifferent as rentier receives returns from the taxpayers. There
is a transfer of resources from one hand to another. In the absence of loan, say for an
example, the creditors instead of lending to the government would have lent to business,
entrepreneurs or invested themselves and would receive an interest exactly like in the
case of amount lent to the government. The taxpayer would retain the increased tax.
Therefore, in the case of public debt, the rentiers receive interest on the capital advanced
to the state at the expense of the taxpayers. For the situation where the credit is not made,
the patrons hold the money that they would have to pay in taxes to service the debt. The
rentiers, having invested the capital that otherwise they would have lent to the state are
not denied interest. We can make out the distinction between the two cases: When there
is an advance, one of parties is harmed and when there is no advance, each of the two, the
giver and the rentier, has for his demeanor the aggregate which in the case of debt would
have belonged to only one.
ECONOMICS Paper 7: Theory of Public Finance
Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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Summarizing the view of Paul Leroy – Beaulieu, the impact of public debt on society will
depend on how the government employs the proceeds of the loan/ capital which the
rentier have given up. During the past, the greater part of proceeds of the loan was used
for unproductive purposes leading to a belief among the economists that public debt is
undesirable. However, he condemns this belief saying it is exaggerated as public
expenditure can be productively utilized too.

His ideas were widely acceptable until the world war I. Subsequently, The report of the
Colwyn Committee in 1927 represents the most important work on debt theory made
during the World War I and the Great Depression. According to the report, the burden of
the public debt is faced by the nation as a whole in the form of future taxes for servicing
of the debt as it involves redistribution of wealth within the nation.
The following points summarize the dominant views held by the Classical on public debt:

 Public debt leads to a reduction of resources for productive private employment.

 Deficits were considered less harmful compared to current taxes and unbalanced
budgets lead to irresponsible government action and unnecessary expansion its
activity.

 Future financing gets more troublesome due to public debt as more funds out of
the budget have to be spared for fixed charges and by increasing the amount of
taxes which must be paid to service the debt.

 Currency depreciation and rise in inflationary expectation are caused by a rise in

public debt.

 Public debt financing requires funds for interest payment and amortization, hence
a double burden for the exchequer.

Overall the Classists believed that increase in fiscal deficit leading to government

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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dissaving will have a detrimental impact on economic growth if rise in government

dissaving is not fully matched rise in private savings. In this scenario, overall savings in
the economy gets reduced exerting pressure on interest rates. The Classists were the
proponents of no government intervention and markets clear automatically so there is the
full employment of resources. This in return leads to a tax burden on future generations
and rise of future consumption. Increased consumption means lesser savings in a closed
economy; external borrowings to finance national debt in case of open economy. External
borrowing involves currency appreciation and fall in export earnings. Thus according to
Classical debt theory, public debt leads to declining national savings, investment, exports
but rise in consumption. A recent estimate by Gale and Orszag on US economy suggests
that rise in fiscal deficit by one percent of GDP will lead to 50-100 basis point increase in
long-term interest rates. Thus, countries must ensure fiscal discipline to achieve long-run
growth objectives.

5. Compensatory aspect of Debt policy

Over the period of time, government borrowing as an instrument of fiscal policy has
gained greater significance. It is used in a wider perspective from financing war
expenditure to the mobilization of savings for economic growth and for aiding monetary
policy in fighting inflation. It is a tool used for containing fluctuations in the business
cycle. Keynesian theory advocates public borrowing as an effective tool for fighting
economic depression when aggregate demand fails to accelerate employment and output.
He has well explained the compensatory aspect of debt. Government borrowing enables
the creation of effective demand through government’s expenditure on infrastructure,
social development, and economic activities.
The government through its fiscal policy aims for three-development objectives namely-
growth, poverty reduction, social inclusion and equity and economic stabilization.

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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Musgrave (1959) has identified three rationales for fiscal policy: Achievement of
Macroeconomic stabilization, improvement of resource allocation and address of
distributional disparities. In this light, there are three principles of fiscal policy:
 High employment and price stability require sufficient expenditure and demand to
take high output off the market.
 However, it is difficult to achieve, given the fluctuations in demand and an
economy prone to inflation or deflation.
 And compensatory budget policy is one of the tools for stimulating aggregate
demand. Stimulating private investment through increased public expenditure can
counteract deflationary tendencies. Inflation can be ceased through deterring
private expenditures.
The government can aid in stimulating economic growth during the period of recession
and depression by increasing its expenditure and thus achieving higher income and
employment growth through the multiplier process. It can also control inflationary and
deflationary pressures in the economy.
The government borrows to compensate for shortfall of private savings in the economy. It
borrows to undertake expenditure on productive infrastructure and social programs to
make up for the decline in private investment. During depression, marginal efficiency of
capital and aggregate demand is low and economy will not move automatically to full
employment level as propounded by the Classists. In the absence of any compensatory
action by the government the economy may move to under-employment.
There are two variants of public expenditure:
 Pump Priming
It refers to initial push provided to the economy through enhanced government
expenditure. The aim is to revive the depressed economy and stimulate economic activity
through an increase in investment.

 Compensatory spending

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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It refers to government borrowing to finance expenditure with the aim to compensate for
the decline in private investment. Growing public expenditure due to the massive
increase in government activity has meant growing gap between revenues and
expenditure. This shortfall is met through raising public debt. Through deficit financing
government creates additional money supply. Deficit financing takes place when the
government borrows from the public or from the central bank. Hence deficit financing is
a particular manner of financing income-creating expenditures. Such expenditures will
increase the national income and out of the enlarged income, savings will increase by an
amount equal to deficit.

An economy under depression faces low marginal efficiency of capital, low confidence in
the economy, low aggregate demand and thus low private investment. The government
stimulates investment in the economy stimulating the process of income generation
through the multiplier process. In order to have an expansionary impact, the public
expenditure must be financed through borrowings or through both increased borrowings
and cut in tax rates rather than through increased taxes only. Increased taxes merely leads
to a transfer of resources from one party to the other i.e. reduction in disposable income
and private spending and increase in public expenditures. Government borrowing will
fight depression better through an increase in overall investment and corresponding
multiple increases in income. The aim is to put idle resources into productive uses. The
corresponding increase in aggregate demand leads to rise in the price level and generates
optimism in the investors and businesses. Increased prices lead to increase in profits and
create an incentive to invest more. This pushes the economy back onto the growth path
through increased employment, output and income.
Expansionary effect of budget deficit can be explained through an example. The
government deficit represents the net government expenditure which increases national
income by the multiplier times the increase in net expenditure. Suppose the MPC is 1/4,

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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the multiplier will be 4; and if the government expenditure is increased by Rs.200 crores,
the national income will increase by Rs. 800 crores (= 200 x 4).

The expansionary effect of a budget deficit is shown diagrammatically in Figure 1. C is

the consumption function. C + I+G represent consumption, investment and government
expenditure (the aggregate demand function) before the budget is introduced.
Equilibrium is at point A corresponding to income level Y. Suppose government
expenditure is increased by ∆G (E1B) and taxes are kept intact.

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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As a result, the aggregate demand function shifts upward to C +1 + G1. Equilibrium

Income increases from OY to OY, when the equilibrium position moves Income from
E to E1 .We can see that the increase in income YY1 is greater than the increase in
government expenditure E1B. BA (E1A – E1B) represents increase in consumption
expenditure. Thus the rise in national income being (YY1) is greater than the increase in
government expenditure (∆G = E1B).
We can also analyze the effect of tax reduction without any increase in government
expenses. Reduction in taxes tends to increase disposable income in the hands of the
people and thus stimulates consumption expenditure. This, in turn, would lead to increase
in aggregate demand output, income, and employment. In Figure 2, where С is the
original consumption function. Consumption function shifts upwards to C1 as a result of
fall in taxes by ET. Equilibrium income rises from OY to OY1.

However, reduction in taxes is not so expansionary compared to the effect of the increase
in government expenditure as increased consumption expenditure because the tax
reduction may be saved and not spent on consumption. Therefore, in the event of an
ECONOMICS Paper 7: Theory of Public Finance
Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
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economic downturn the government should follow the policy of tax reduction along with
increased government spending. The corresponding multiplier effect will be much higher.

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy
____________________________________________________________________________________________________

6. Summary

 Public debt refers to all type of government borrowing from internal and external
sources.
 The Classists were the proponents of no government intervention and argued that
the markets clear automatically so there is always a full employment of resources.
 According to Classical debt theory, public debt leads to fall in national savings,
investment and exports but a rise in consumption. Public debt leads to reduction
of resources available for productive private employment
 Deficit Financing refers to borrowings by the government to cover up its
budgetary deficit. The government raises funds either from the public or through
creation of additional money.
 To revive an economy out of depression, the government adopts a policy of
deficit financing. The government stimulates investment and aggregate demand in
the economy stimulating the process of income generation through the multiplier
process.

ECONOMICS Paper 7: Theory of Public Finance

Module 38: Public Debt- Classical view of public debt; Compensatory aspect
of debt policy