Skip to main content

Incentivizing Public Debt

Fannie Mae Reston Facility

Sanghee Park is an assistant professor in the Department of Public Policy and Administration, School of Public Service at Boise State University. Her research efforts include public sector management, diversity and state and local government in relation to political institutions. Her articles have appeared in such journals as Public Organization Review, Journal of Public Policy, Public Performance Management Review, International Public Management Journal, and American Review of Public Administration.

People tend to understand the concept of “public debt” in a one-dimensional way: governments are bloated with politicians wasting money. But actually, public debt is more complicated than that – it is a debt that accumulates based on a series of small chain reactions set off by a complex cast of players and based on the expectations of others. This article will introduce the players that increase debt, why that happens and the mechanisms that could be used to curb it in the future.

Public sector debt is difficult to reduce but easy to grow. There are many explanations from different perspectives on the reasons why debt grows. Historically, expanding expenditure with loans and borrowing money from future generations has been one of the most important tools of government since the influence of the Keynesian economics. This debt financing or deficit spending helps to produce specific goods and services, reallocate financial resources and fund public projects in the long term.

One of the main sources of public debt is the price mechanism for monopolistic providers. Economists explain that public goods and services (e.g. water, electricity, roads and public safety) provided by the public sector are underpriced and often determined by political considerations, which causes losses for the providers. Political scientists see public sector debt as a fiscal common pool resource that is used for compensating public service providers for their losses. Governments often delegate authority to independent agencies and subsidize their losses with taxes.

A study conducted in the context of quasi-independent agencies in Korea over the past two decades (1993–2012) shows that public sector debt is the product of a vicious cycle created by agencies and political principals, such as politicians and bureaucrats, who seek to maximize their interests. In essence, they create a chain reaction that increases the public debt.

Quasi-independent agencies or quasi-autonomous nongovernmental organizations, a.k.a quangos, are a popular form of delivering and providing public services around the world. Operating between the public and the private sector, quangos are subject to political and administrative control but insulated from day-to-day intervention and enjoy some degree of autonomy. While quangos aren’t common in the U.S., they operate much like the Federal National Mortgage Association (Fannie Mae). Historically, quangos in Korea have played a critical role in the economic and social development of the country, and politicians control them through various channels such as regulations, budgets and the appointment of CEOs and board members. There is vast diversity in quangos in terms of size, financial dependence, and legal status.

In understanding why public sector debt grows, it’s vital to know about soft budget constraint, as it is the linchpin to the relationship between governments and quangos. The soft budget constraint, a term coined by Hungarian economist Janos Kornai in 1998, refers to the phenomenon that organizations being bailed out by their government when they’re running on a deficit. It creates the expectation by quangos that they will be rescued or helped by the government, which distorts their behavior away from managerial efforts to improve efficiency and, as a result, increase their risk of economic failure. For example, in 1998 the celebrated economist Paul Krugman posited that the East Asian financial crisis of the late 1990s might have been prompted by these same financial policies that raised hopes of rescue.

Yet politicians cannot help injecting public money into these quangos for many reasons. As buffering agencies, quangos serve their interests by helping them avoid reputational harm and political criticism, as well as mask any failure in managing the government and public sector organizations. This is why governments often use political agents paternalistically, as holders of a metaphorical checkbook, which they open to bail out quangos when necessary.

In this relationship based on bailout expectations, public sector debt is also related to quangos’ morally hazardous behaviors, such as expanding “slack resources” like staff and budget through bargaining with politicians who see quangos as a good place to pursue their own interests. The bargaining between quango managers and politicians leads quangos to hire more people than actually needed. They also trade bribes and subsidies with politicians. In addition to a great deal of anecdotal evidence, the findings of the Korean study support this opportunistic behavior of politicians and bureaucrats: the bigger the size of the agency, the greater the political incentives to avoid risk of failure by passing the buck to quangos.

In general, politicians’ incentives for engaging in this behavior are thought to be threefold: avoiding blame, raising re-election chances, and hiding the true size of government. In order to avoid blame during a worsening economy, politicians often expand fiscal spending and slash interest rates to boost the economy especially when elections are approaching. I theorized that they used quangos as a tool of expansion by making them spend more, but this hypothesis was not supported by the study.

Related to electoral chances, politicians prefer a “spend now!” model that leave debts for future iterations of government to figure out. Interestingly, research suggests that conservative governments tend to rack up more debt in order to be re-elected and to discourage future spending by liberal factions, should they fail to be re-elected. The tension embedded in the relationship between current and succeeding governments becomes more significant in countries with a single-term system of presidency, such as Korea. The study found consistent evidence that public sector debt increases when political competition heats up. In other words, the level of debt is likely to rise when politicians feel less supported by the voters and more challenged by the opposition and are not confident of victory in the next election.

Lastly, by subsidizing quangos, politicians and bureaucrats are able to increase spending without being noticed by the public or interest groups. All organizations inherently seek to expand – governments are no different. But they do not want to be seen as greedy and thus often attempt to hide their true size. In choosing public projects, for example, politicians often adopt inefficient projects as a “disguised transfer mechanism” to reward special interest groups. Interestingly but not surprisingly, the study found consistent evidence of this too. In fact, implementing public projects is a better option for politicians than making cash transfers to interest groups even if the project turns out to be inefficient. This tactic may seem silly and a waste of money, but it stimulates job growth and more importantly benefits interest groups that can provide that politician with campaign contributions, financial benefits, and future job opportunities.

We’ve seen that the cycle of public debt is incentivized and inflated by the relationships between politicians and quangos – but what can be done about it?

The first step is simple as it is: by addressing the soft budget constraint in which they operate. There are various fiscal options for hardening budget constraint including balanced budget requirements, debt limits, voter-approval requirements and tax and expenditure limitation. But, the problem is that politicians are reluctant to tighten fiscal rules and quangos are usually not subject to these restrictions. What we can do, as taxpayers and responsible citizens, is to pay attention to public sector debt as it is related not only to overall performance of the organization but also to intergenerational equity and stability of the economy. If we would like to see more sound and sustainable financial management, it is important to find balance between increasing organizational autonomy, strengthening monitoring, and devising a mechanism for more transparency from the quasi-public sector.