Question

What are the three sources of funding a national debt? Why are they all problematic? Why is foreign debt far more problematic for a country than domestic debt?

Answer 1

Below are three sources of funding national debt and their problems-

1. Taxes - By means of taxes, the government can fund national debt. Taxes can be problematic because they reduce the overall disposable income of the consumer. Hence, they also negatively affect the overall consumption spending in the economy.

2.Borrowing - Government may also choose to borrow from citizens by issuing bonds. However, this only means that the government is caught in a cycle of debt. To retire past debt, it only creates fresh debt and in effect the debt is never written off.

3. Printing more money - This is another option that the government can explore. But, printing more money will imply that there will be more inflation as the government will have to print extravagantly on paying off national debt. The inflation problem can be particularly detrimental to economy. And, it may have to pay a higher return on fresh debt to compensate for the higher inflation in future.

Foreign debt involves borrowing from a foreign nation in foreign currency. The overall obligation of foreign debt can become problematic since the debt often needs to be paid in foreign currency. In case of a depreciated domestic currency, the overall size of foreign debt may become unsustainable and difficult to manage. Servicing foreign debt reduces the overall size of the GDP. Often the terms and conditions of foreign debt may be too harsh with really high interest rate to compensate for the risk involved. Additionally, there may be geopolitical consequences of a foreign debt. For e.g. - China recently took control of a Hambantota port from Sri Lanka after the latter failed to make its debt payments on time.