Chapter 12:Deficits and Debt

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Fiscal Stimulus and the Deficit• A fiscal stimulus package is designed to move

the economy out of recession toward full-employment GDP.

• Tax cuts or increased government spending, or a combination of the two, increases the size of the budget deficit.

• Borrowed funds to finance the stimulus must be paid for in the future by increased taxes or reduced spending, both fiscal restraint tools.

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Learning Objectives

• 12-01. Know the origins of cyclical and structural debt.

• 12-02. Know how the national debt has accumulated.

• 12-03. Know how and when “crowding out” occurs.

• 12-04. Know what the real burden of the national debt is.

12-4

Budget Effects of Fiscal Policy

• Using fiscal policy to solve macro problems implies that federal expenditures and federal receipts won’t always be equal.– In fiscal stimulus, G increases or T decreases.– In fiscal restraint, G decreases or T increases.

• Budget deficit: amount by which G exceeds T in a given time period.

Budget deficit = Government spending – Tax revenues > 0

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Keynes’s View on Budget Deficits

• Budget deficits are a routine by-product of fiscal policy, caused by a fiscal stimulus to increase AD.

• The goal of macro policy is not to balance the budget but to move the economy to full-employment GDP.

• Keynes: Full employment first, then worry about the deficit.

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Discretionary vs. Automatic Spending

• Discretionary spending: those elements of the budget not determined by past legislative or executive commitments.

• Automatic spending: those elements of the budget that are a result of decisions made in prior years; said to be “uncontrollable.”

• Make up of the budget:– Automatic (uncontrollable): about 80 percent.– Discretionary (controllable ): about 20 percent.

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Uncontrollable?• The president and Congress can repudiate

prior commitments and enact new legislation.– Reduce Social Security benefits.– Refuse to pay interest on the accumulated debt.– Terminate projects approved in prior years.– Reduce payouts for other social welfare programs.

• They would face political consequences in doing so.

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Automatic Stabilizers• Automatic stabilizer: federal expenditure or

revenue item that automatically responds countercyclically to changes in national income (GDP).– As a recession begins, unemployment

compensation and welfare payments increase and income tax collections decrease, each stimulating economic growth in a small way.

– As economic growth returns, the opposite happens, which puts a small restraint on economic growth.

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Cyclical Deficits

• Cyclical deficit: that portion of the budget deficit attributable to short-run changes in economic conditions.

• The cyclical deficit– Widens when GDP growth

slows or inflation increases.– Shrinks when GDP growth

accelerates or inflation decreases.

• As the economy slows– Tax revenues decline.– Unemployment benefits

rise.– Other transfer payments

rise.• As the economy grows

– Tax revenues rise.– Unemployment benefits fall.– Other transfer payments

fall.– Interest rates could rise,

increasing debt payments.

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Structural Deficits

• Structural deficit: federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy.

• The structural deficit reflects fiscal policy decisions – that is, discretionary fiscal policy.

• Therefore, part of the deficit arises from cyclical changes in the economy; the rest is a result of discretionary fiscal policy.

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Who Is to “Blame” for Deficit Increases?

• The impact of cyclical components (automatic stabilizers) and policy initiatives affect the budget at the same time.

• According to the CBO, in 2009 the trillion- dollar budget deficit increase was due in part to the recession ($278 billion) and the rest to discretionary fiscal policy ($675 billion).

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Measuring the Impact of Fiscal Policy

• We must focus on changes in the structural deficit, not the total deficit.– Fiscal stimulus is measured by an increase in

the structural deficit (or shrinkage in the structural surplus).

– Fiscal restraint is measured by a decrease in the structural deficit (or increase in the structural surplus).

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Economic Effects of Deficits• Crowding out can occur, especially as the

economy closes in on full employment.– Increased government borrowing to finance a

growing deficit reduces the availability of funds for private sector spending.

– Thus any increase in government expenditures will be offset by reductions in consumption and investment spending.

– Tax cuts will increase consumer spending, but near full employment may force cutbacks in investment or government services.

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Economic Effects of Deficits

• Interest rate movements:– An increase in demand for funds will cause the

price of borrowing – the interest rate – to rise.– Rising interest rates make it more costly for

consumers or businesses to borrow, and they may cut back.

– Rising interest rates also increase the borrowing costs of government, leaving less room in government budgets for financing new projects.

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Economic Effects of Surpluses• If the government runs a surplus – that is, tax

revenues are greater than government expenditure - it is a leakage to the circular flow. It is a drag on the economy.

• Potential uses for a budget surplus:– Spend it on goods and services.– Cut taxes.– Increase income transfers.– Pay off old debt (“save it”).

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Economic Effects of Surpluses• Spending a surplus increases the size of the

public sector.• Cutting taxes or increasing income transfers

puts money in the peoples’ hands and enlarges the private sector.

• Paying off some accumulated debt puts money in the hands of the debt holders:– They buy more goods and services.– Expands the private sector.– Lowers the demand for funds and the interest rates.

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The Accumulation of Debt

• The national debt is the accumulation of many more years of running budget deficits than budget surpluses.– The U.S. Treasury borrows by issuing Treasury

bonds to lenders who want a safe investment paying out interest.

– When there is a deficit, the national debt increases.– When there is a surplus, the national debt can be

pared down.

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The National Debt• In 2011 the national debt was nearing $15

trillion.• That is an average of more than $50,000 for

every U.S. citizen.• A better indicator is the debt-to-GDP ratio. – Except for the Civil War, this ratio was about 10

percent from 1790 to 1917.– During World War II, it rose to 130 percent.– In 2000 it was about 35 percent.– By 2012 it will rise above 100 percent.

12-19

Who Owns the Debt?• The national debt creates as much wealth for

bondholders as it does liabilities for the U.S. Treasury.

• Who are the bondholders (owners)?– Federal agencies (such as the Federal Reserve and

the Social Security Administration) hold 40 percent of all outstanding Treasury bonds.

– State and local governments hold 5 percent.– The private sector holds 24 percent.– Foreigners hold 31 percent.

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Why Hold U.S. Government Debt?

• Relative to other investments:– They are safe.– There is no question of the debt being repaid.– They pay interest.– Dollar-denominated assets are generally

acceptable in world trade.

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The Burden of the Debt

• Refinancing: the issuance of new debt in payment of debt issued earlier.– When a Treasury bond matures, new funds are

borrowed to pay it off.– So the debt remains debt. There is no addition

to the debt. Only another deficit adds to the debt.

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The Burden of the Debt

• Debt service: the interest required to be paid each year on outstanding debt.– Increased interest payments use up funds that

cannot be used for other government expenditures.

– Debt servicing is a redistribution of income from taxpayers to bondholders.

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The Burden of the Debt• Opportunity cost:– The true burden of the debt is the opportunity cost

of the activities financed by the debt.– Funds spent on government expenditures cannot

be used for other (public or private) expenditures.– Resources consumed by a government expenditure

cannot be used to produce other goods and services.

– The value placed on these forgone goods and services is the opportunity cost, however financed.

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The Real Trade-Offs

• Deficit spending changes the mix of output in the direction of more public sector goods.

• The burden of the debt is really the opportunity cost (crowding out) of deficit-financed government activity.

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The Debt and Economic Growth

• If deficit-financed government spending crowds out private investment, future generations will bear some of the debt burden.– We will have smaller-than-anticipated productive

capacity.– There will be some question about achieving an

optimal mix of output.• The public sector grows at the expense of the private

sector.

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Repayment

• If the U.S. Treasury pays off maturing bonds with taxes, it is a redistribution of income from taxpayers to bondholders.– The heirs of current bondholders receive the

payout.– The taxpayers in the future are hit with the

taxes to pay off the maturing bonds.

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External Debt• Borrowing from foreigners eliminates

crowding out.– We get more public sector goods without cutting

back on private sector production.– Foreigners get the dollars by selling us more

imports than they buy of our exports.– We can consume an amount greater than the

domestic-only PPC would allow us to consume.

• As long as foreigners are willing to hold U.S. debt, external financing imposes no real cost.

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External Debt

• If foreigners no longer want to hold U.S. debt, they will sell their bonds and hold dollars, which they can use to buy dollar-denominated goods and services, mainly U.S. exports.

• External debt will be repaid with exports of real goods and services.

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Deficit and Debt Limits• The only way to stop the growth of the debt is

to eliminate budget deficits.– One way is to balance the budget (G = T).– A gradual way is to impose a debt ceiling that is

decreased each year until it reaches zero.• Debt ceiling: an explicit, legislated limit on the

amount of outstanding national debt.– This leads to compromises on how best to use

budget deficits.– Usually, when the debt ceiling is reached, Congress

simply increases it.