POLITICS, DEFICITS, AND DEBT

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POLITICS, DEFICITS, AND DEBT

• Deficits

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Laugher Curve

• When Albert Einstein died, he met three New
  Zealanders in the queue outside the pearly gates.
• To pass the time, he asked what were their IQs.

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Laugher Curve

• The first replied 190.

• "Wonderful," exclaimed Einstein, "We can discuss
  the contribution made by Earnest Rutherford to
  atomic physics and my theory of general
  relativity.

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Laugher Curve

• The second answered 150.

• "Good," said Einstein, "I look forward to
  discussing the role of New Zealand's nuclear-free
  legislation in the quest for world peace.

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Laugher Curve

• The third New Zealander mumbled 50.

• Einstein paused, and then asked, "So what is your
  forecast for the budget deficit next year?"

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This chapter will

• Define the terms deficit, surplus, and debt.
• Distinguish between a passive deficit and a
  structural deficit.
• Differentiate between real and nominal deficits
  and surpluses.
• Explain why the debt needs to be judged relative
  to assets.
• Describe the historical record for the U.S.
  deficit and debt.
• Summarize the current debate about Social
  Security and Medicare and identify the real
  problem and the real solution.

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Introduction

• In 2005 the U.S. had a large budget deficit (a
  shortfall of revenues over payments), as it had
  for the past three years.
• The current deficits are a substantial change
  from the surpluses from 1998 to 2001.
• In the long run, deficits are bad because they
  reduce saving and growth.
• Long-run surpluses (excesses of revenues over
  payments) are good because they provide saving
  for investment.

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Introduction

• In the short run, if the economy is below
  potential, deficits are good and surpluses are
  bad because deficits increase expenditures moving
  output closer to potential.
• Combining the two frameworks gives the following
  policy directive
• Whenever possible, run surpluses, or at least a
  balanced budget to help stimulate long-run
  growth.

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Expansionary Fiscal Policy
Price level

• If the economy is at equilibrium at point A,
  there is a recessionary gap Y0 YP.

LAS

• The appropriate fiscal policy is to increase
  government spending and/or decrease taxes.

SAS
P0
A
A

• AD increases to AD1 and output returns to
  potential output YP and prices increase slightly
  to P1.

AD0
Real output
Y0
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Defining Surpluses and Debt

• A surplus is an excess of revenues over payments.
• A deficit is a shortfall of revenues over
  payments.

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Financing the Deficit

• The government finances its deficit by selling
  bonds to private individuals and to the central
  bank.
• Bonds promises to pay back the money in the
  future.

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Financing the Deficit

• A central bank is able to print money to buy its
  governments bonds.

• Potentially, the central bank can print an
  unlimited amount of money to buy bonds.
• Printing too much money means inflation which can
  have a negative effect on the economy.

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Arbitrariness in Defining Surpluses and Deficits

• Whether a nation has a deficit depends on what is
  included as a revenue and what is included as an
  expenditure.
• This accounting issue is central to the debate
  about whether we should be concerned about a
  deficit.

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Arbitrariness in Defining Surpluses and Deficits

• How the Social Security system is accounted for
  plays an important role in the size of the budget
  deficit.

• Social Security System - a social insurance
  program that provides financial benefits to the
  elderly and disabled and to their eligible
  dependents and/or survivors.

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Many Right Definitions

• There are many ways to measure expenditures and
  receipts.
• There are many ways to measure deficits and
  surpluses.
• All definitions are not necessarily correct.

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Deficits and Surpluses as Summary Measures

• Deficits and surplus figures are simply summary
  measures of the financial health of the economy.
• To understand the summary, you must understand
  the methods that were used to calculate it.

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Deficits and Surpluses as Summary Measures

• What is important is not whether a budget is in
  surplus or deficit what is important is the
  economic health of the economy.

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Structural and Passive Surpluses and Deficits

• Not all government expenditures are independent
  of the level of income in the economy.
• The budget deficit could result from policies
  designed to affect the economy or from income
  deviating from its potential.

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Structural and Passive Surpluses and Deficits

• A structural deficit or surplus the part of the
  budget deficit or surplus that would exist even
  if the economy were at its potential level of
  income.

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Structural and Passive Surpluses and Deficits

• A passive deficit or surplus is the part of the
  deficit or surplus that exists because the
  economy is operating below or above its potential
  level of output.

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Structural and Passive Surpluses and Deficits

• When an economy is operating above its potential,
  it has a passive surplus.

• If the economy is operating below its potential,
  the actual deficit would be larger than the
  structural deficit.

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Structural and Passive Surpluses and Deficits

• There is a significant debate about what is an
  economys potential income level.

• There is disagreement about what percentage of a
  deficit is structural and what part is passive.

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Structural and Passive Deficits

• There is disagreement about what percentage of a
  deficit is structural and what part is passive.
• Actual deficit structural deficit
• 
  passive deficit
• Passive deficit tax rate x
• (potential output actual output)
• Structural deficit actual deficit passive
  deficit

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Budget Deficits and Surpluses Actual, Passive,
and Structural