Explanation

Correct Answer: B - Most of the borrowing is owed internally to local citizens.

Why Option B is Correct:

1. Internal vs. External Debt: When government borrowing is owed internally (to domestic citizens and institutions), it represents a transfer of resources within the economy rather than a drain on national resources.
2. No Foreign Exchange Risk: Internal debt doesn't create foreign exchange risk or require foreign currency payments that could strain the balance of payments.
3. Wealth Transfer: The interest payments on internal debt are transfers from taxpayers to domestic bondholders, keeping the money within the national economy.
4. Less Sovereign Risk: Countries with high levels of internal debt typically face less sovereign risk pressure compared to those with high external debt.

Why Option A is Incorrect:

• When the private sector decreases savings to offset government debt, this actually increases concern because:
  • It reduces private investment capacity
  • It may indicate crowding out effects
  • It suggests the government is competing with the private sector for limited savings

Why Option C is Incorrect:

• Crowding out occurs when government borrowing raises interest rates, making it harder for the private sector to borrow and invest. This is a significant concern because:
  • It reduces private sector investment
  • It slows economic growth
  • It indicates inefficient allocation of resources

Key Economic Concept:

The Ricardian equivalence theory suggests that when governments borrow, rational citizens will increase savings to pay for future tax increases. However, in reality, substantial government borrowing is less problematic when:

• The debt is denominated in domestic currency
• The debt is held domestically
• The country has strong institutions and growth prospects
• The borrowing is for productive investment rather than consumption

Bottom Line: Internal debt is generally less concerning than external debt because it doesn't create the same vulnerabilities to foreign investor sentiment, currency crises, or balance of payments problems.