title: National debt, public capital, and welfare in developing economies
Creators: name: Ahmed, Abdul-Mumin
Publisher: name: University of Glasgow
Year: 2022

description: The economic effects of public debt remains one of few subjects that evoke controversy among academics and policy makers, despite being a subject of intense scrutiny for prolonged periods. Earlier literature examined national debt in neoclassical growth models, and focused on its effects on steady state equilibrium. The general finding was that debt issuance by the state reduces factor accumulation in the long run. By the fundamental welfare theorem, the competitive equilibrium is pareto-optimal, and thus, state intervention distorts market-driven outcomes and interferes with optimal allocations in equilibrium. Later research contributions established conditions under which the competitive market environment may reach equilibrium that is not optimal. In this case, the issuance of debt by the government is capable of generating pareto improvements over market equilibrium. Thus far, the theoretical neoclassical literature have limited the positive welfare effect of government debt to the perverse case in which the competitive equilibrium is suboptimal. Recent strands in the literature have explored conditions under which public debt may be invested in infrastructure and other forms of public capital in endogenous growth models. These have been much less rigorous, but have shown that contrary to the result from neoclassical theory, debt issuance for investment may increase equilibrium growth rate in a socially planned economy where the state dictates private saving and consumption decisions. But this is a very restrictive requirement. In addition, even though the recent literature addresses an important aspect of government spending, namely that governments issue debt to provide key infrastructure and public services, no existing work (to best knowledge) has examined the welfare effects of such purposeful government borrowing in a decentralized environment. This dissertation aims to contribute to filling the gap by exploring the effects of debt issuance for investment in public capital using a production structure that is widely used in endogenous growth models, but dispenses with the usual assumptions of a socially planned economy. In other words, we need not require the government to internalize and/or dictate private consumption and savings behaviour for equilibrium to exist. In doing so, a competitive framework is used to examine the role of government debt in a growing economy where public capital is essential to private sector production. We will see first, that the long-run equilibrium of the planning problem elaborated in endogenous growth theory can be supported as competitive equilibrium outcome with lump-sum transfers by government. However, the growth maximizing capital ratio in the planning problem may not yield efficient allocations. Secondly, we will see that in a simple analytic environment, debt-financed public investment can enhance both private wealth and welfare in general equilibrium. This is a novel finding that compares favourably with the Diamond result where debt may increase welfare in the dynamically inefficient equilibrium, but always reduces capital labour ratio in the long-run. Similarly, as opposed to Blanchard result where government expenditure does not benefit individual’s utility but imposes a debt-service burden and hence reduces capital and consumption at steady state, debt-financed public investment directly affects agents utility by increasing not only the prevailing interest rate, but in general the rate of return to investment in the economy. As no known existing work has explored the welfare effects of government expenditure in public capital formation through issuance of debt, this is the crux of my contribution to the literature in this dissertation. The analytic results generally show that debt-financed public expenditure that increases the public capital stock does not only improve efficiency where the equilibrium is sub-optimal, it can increase economic efficiency and welfare of agents in the long-run. The data for a large section of developing and advanced economies seem to check out the necessary condition for debt-financed public investment to be welfare improving. I conclude the research with policy discussions on the implications of the analytic and empirical insights on the future of developing country borrowing in the wake of the high debt levels occasioned by the COVID-19 pandemic.