How the Deficit Causes Problems

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How the Deficit Causes Problems

• Lets turn now to a discussion of the various
  economic problems created by chronic budget
  deficits and a growing government debt.
• The kind of problems the deficit and debt may
  cause is in large part determined by how the
  deficit is financed.
• In this regard, there are three major ways the
  government can finance a deficit raising taxes,
  borrowing money, or printing money.

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Financing the Deficit Through Taxes
GDPC I G

• Suppose the budget is initially in balance, and
  that the government undertakes an expansionary
  fiscal policy to close a recessionary gap.

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The Raise Taxes Option

• The Raise Taxes option is interesting because
  at first glance you might ask
• How can the economy expand if taxes and
  expenditures are going up by the same amount?
• Its a good question, and the answer lies in the
  dynamics of the marginal propensity to consume
  that we discussed in a previous lesson.

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The Raise Taxes Option

• If the government raises taxes by 25 billion to
  cover the increase in government expenditures and
  the marginal propensity to consume is, say, 0.8,
  consumption will only fall by 20 billion--or 0.8
  times 25 billion.

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The Raise Taxes Option

• That means that even after the tax hike, the net
  increase in aggregate expenditures is still 5
  billion.
• Given the marginal propensity to consume is 0.8,
  we also know from a previous lesson that the
  multiplier will be five.
• So if you multiply this 5 billion increase in
  aggregate expenditures by our multiplier of five,
  you get a total economic expansion of 25
  billion--which, perhaps curiously, is exactly
  equal to the original outlay of government
  expenditures.

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The Balance Budget Multiplier

• Macroeconomists refer to this phenomenon as the
  balanced budget multiplier.
• This multiplier has a value of one because when
  you simultaneously increase government
  expenditures and increase taxes by the same
  amount, you get an economic expansion exactly
  equal to the increase in government expenditures.

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The Political Problem

• This approach to financing a deficit may sound
  like a great way to conduct expansionary fiscal
  policy without increasing the budget deficit.
• However, it is rarely used because raising taxes
  is politically unpopular.
• Thus, the government has to resort to one of two
  other means to finance the deficit borrowing
  money or printing money, both of which create
  their own problems.

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The Borrow Money Option
Private Sector
Public Sector
U.S. Treasury
Private Capital Markets
Private Companies
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Crowding Out

• To compete for scarce investment dollars, the
  Treasury must raise its interest rate to attract
  enough funds.
• This is a zero sum game.
• The money used to finance the deficit would
  otherwise be spent on private sector investment.
• In this case, deficit spending is said to crowd
  out private investment.

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The Broader Point

• Crowding out applies only to structural deficits.
  
• If the cyclical deficit rises because of a
  recession, the logic of crowding out simply does
  not apply.

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The Link Between Deficits And Investment

• Because a recession causes a decline in the
  demand for money and leads to lower interest
  rates, and the Federal Reserve tends to loosen
  monetary policy in a recession.
• This point is important because it underscores
  the observation that there is no automatic link
  between deficits and investment.

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The Keynesian Model And Crowding Out

• Can you use the Keynesian model to more fully
  illustrate how the crowding out effect might
  reduce the actual effectiveness of fiscal policy?

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The Crowding Out Effect

• Because the government has had to borrow money
  from the private capital markets to finance these
  expenditures, interest rates rise.
• This reduces investment.

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The Crowding Out Effect
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How Complete Is Crowding Out?

• Critics of discretionary Keynesian fiscal policy
  have argued that it is a very weak policy tool.
• Monetarists tend to take the view that crowding
  out is almost complete so that fiscal policy is
  completely ineffective.
• Keynesians, on the other hand, typically argue
  that crowding out is minimal.

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The Print Money Option

• In theory, it is possible to avoid crowding out
  with the Print Money option.
• In this option, the Fed accommodates the
  Treasurys expansionary fiscal policy.
• It buys the Treasury securities itself and pays
  by printing new money.
• The problem this increase in M can cause
  inflation.
• If such inflation drives interest rates up and
  private investment down, the end result may be a
  crowding out effect as well.

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Deficit Hawks and Doves

• Lets turn now to a discussion of the pros and
  cons of budget deficits as set forth by the two
  major competing camps
• The Deficit Hawks who view deficits and a rising
  national debt as a serious threat.
• The Deficit Doves who take the position that such
  deficits and debt are relatively harmless.

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The Trade Deficit Argument Hawks

• Chronic budget deficits have been responsible for
  Americas huge trade deficits over the last
  several decades.

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Other Policy Implications

• A trade deficit means a nation is not exporting
  enough to pay for its imports.
• The difference can be paid for either by
  borrowing from abroad or by selling U.S. assets.

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Mortgaging America

• In fact, to finance its trade deficit, the United
  States has had to sell off assets such as
  factories, shopping centers, hotels, golf
  courses, and farms to foreign investors.
• Over the longer run, Deficit Hawks warn that this
  mortgaging of America will reduce both the rate
  of economic growth and the level of real income
  of Americans.

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Others Share This Burden

• To the extent that deficits drive up real
  interest rates, heavily indebted countries such
  as Mexico and Brazil also face an increased
  burden.
• This is because many of these debts are
  denominated in dollars so, in effect, when the
  dollar strengthens, these foreign countries must
  use more of their own currencies to pay off their
  debts.

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The Only Good News

• The inflow of foreign funds does help keep U.S.
  real interest rates from rising and diminishes
  the crowding out effect.

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Government Debt and Economic Growth

• To address this issue, we draw the distinction
  between the external and internal debt, discuss
  the inefficiencies of levying taxes to pay
  interest on the debt, and examine the impact of
  the debt on productivity and capital
  accumulation.

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• An internal debt is owed by a nation to its own
  citizens while an external debt is owed by a
  nation to foreigners.

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A Tax On U.S. Citizens

• Paying interest on the external debt acts like a
  tax on U.S. citizens by foreigners.
• Such a debtors tax reduces domestic
  consumption, savings, and investment and thereby
  reduces the economys short and long term growth
  rates.
• The holding of large amounts of Americas debt by
  foreigners exposes American public policy to
  undue political pressures.

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An Historical Case

• Some critics have charged that, in 1989, the
  Japanese government, which at the time held a
  large block of U.S. government securities,
  purposely dumped some of these securities onto
  the capital markets to help trigger the Black
  Monday stock market crash.
• The reason these critics say this was done was to
  warn the U.S. government about adopting overly
  restrictive protectionist trade policies.

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Other Arguments of Deficit Hawks

• Even a large internal debt is unacceptable for
  four reasons.

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The Four Reasons
1

• First, an internal debt requires payments of
  interest to bondholders.
• This, in turn, means higher taxes, and as
  microeconomics teaches us, such taxes inevitably
  distort the allocation of national resources and
  lead to an efficiency loss.

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The Four Reasons
2

• Second, paying interest on the internal debt
  unfairly redistributes income from the poor and
  middle class to the rich.
• This happens because government bondholders as a
  group tend to be wealthier than taxpayers as a
  group.

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The Four Reasons

• Third, paying interest on the debt uses hundreds
  of billions of dollars each year, and this money
  could otherwise be spent on providing taxpayers
  with more education, health care, and other
  government services.
• The Deficit Hawks point out that the size of the
  interest payments to service the debt relative to
  total tax revenues has been steadily rising.
• The Deficit Hawks warn that if this trend
  continues, we will eventually wind up using all
  available tax revenues simply to service the
  debt.

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The Four Reasons
4

• Finally, the Deficit Hawks argue that the
  accumulation of such a large debt places an
  unreasonable burden on future generations which
  must pay this debt off.

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The Deficit Doves Counter

• The facts do not warrant the hysteria and
  hyperbole that typically accompanies the Deficit
  Hawks Cassandra-like laments.
• And the Doves like to point to charts like you
  saw earlier in the lesson that show our national
  debt to be only about half the size that it was
  during World War II as a percentage of GDP.

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The Benefits Of Debt

• The Doves point out any debt incurred now as a
  result of public investment will provide
  benefits--not just a burden--to future
  generations.
• This leads us to our next topic the impact of
  the deficit on investment and productivity.

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Productivity The Doves

• Productivity of the private sector depends
  critically on public investment in a wide variety
  of public goods and services from education,
  training, and basic research to public
  infrastructure such as roads, bridges and even
  the information superhighway.
• Such investment increases the productivity of the
  private sector and thereby boosts both economic
  growth and real national income.

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Productivity The Hawks

• Nonsense Far too many government expenditures
  are made on wasting assets rather than
  productive capital.
• While roads and more education may increase
  productivity, wasting assets such as fighter
  planes and inefficient social welfare programs
  simply do not.

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Public Sector Investment Is Less Productive

• Deficit Hawks point out that there is a wealth of
  empirical evidence suggesting that public sector
  investment is less productive than private sector
  investment.
• Thus, when deficit spending crowds out private
  sector investment, it reduces the rate of long
  term economic growth because it substitutes less
  productive government expenditures for more
  productive private investment.

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A Curb On Discretionary Fiscal Policy

• A large and growing public debt makes it
  politically difficult to use the necessary
  discretionary fiscal policies during a recession.
• For example, in 1991 and 1992, the Federal
  Reserve substantially reduced interest rates to
  stimulate the sluggish economy.
• However, this expansionary monetary policy was
  slow to expand output and reduce unemployment.

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If Public Debt Had Not Been High

• It would have been much more politically feasible
  to engage in expansionary fiscal policy as well
  by reducing taxes or increasing spending.
• But the growing debt problem ruled out this
  stimulus on political grounds.

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A Summary The Deficit Hawks

• Chronic budget deficits increase the trade
  deficit, crowd out private investment and reduce
  economic growth.
• The debt unfairly burdens future generations and
  exposes America to dangerous political pressures
  from foreign governments.
• Servicing the debt redistributes income from the
  poor to the rich.

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A Summary The Deficit Doves

• The deficit is a stimulus to economic growth, and
  Doves reject both the crowding out and trade
  deficit arguments.
• The national debt represents productive
  investment in public goods and infrastructure.
• The debt is manageable relative to GDP.
• Since we owe it largely to ourselves, it is not
  a problem.

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Policy Responses

• As far as what has, and can be done, to address
  the deficit and debt issues, there are several
  policy responses worth noting.

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A Balanced Budget Amendment

• Such a Constitutional amendment would compel
  Congress to annually balance its budget.
• What impact do you think such an amendment might
  have on the use of discretionary fiscal policy?

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Its Effect

• It would make it almost impossible to use
  discretionary fiscal policy.
• The biggest problem is that such an amendment
  would force the government to balance the budget
  during a recession by either increasing taxes or
  cutting spending.
• From a Keynesian perspective, we know, of course,
  that the likely result would be to plunge the
  economy deeper into recession.

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Deficit Reduction Legislation

• A more direct and case-specific response is
  simply to cut the rate of spending and raise
  taxes.
• It was precisely this legislative approach the
  Clinton Administration took back in 1993.

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Cut Spending and Raise Taxes

• On the narrowest of votes, Congress passed the
  Administrations Deficit Reduction Act.
• This Act raised the top marginal tax rate from 31
  to 39.6 perecnt, raised the corporate income tax
  from 34 to 35 percent, and added 4.3 cents per
  gallon to the Federal excise tax on gasoline.

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Other Effects

• It also cut the rate of spending by holding
  discretionary expenditures to their 1993 nominal
  levels.
• Many experts credit this Act with being the
  primary catalyst for the strong economic
  expansion that followed as well as for the
  budget surplus that emerged some six years later
  the first surplus in more than 25 years.

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In The Next Lesson

• We will explore further the interaction of the
  budget deficit and the trade deficit within the
  broader context of a discussion of exchange rates
  and the use of fiscal and monetary policies in a
  global economy.

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End of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female voice-over Ashley West Leonard