The Power Of Macroeconomics

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The Power Of Macroeconomics
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Budget Deficits And The Public Debt
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The Purpose Of This Lesson

• Is to examine the economic consequences of
  chronic budget deficits and the potential dangers
  of an upward spiraling government debt.

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Historically

• Classical economists have argued that such budget
  deficits are bad and should be avoided except in
  wartime.
• In contrast, Keynesians believe that, at least
  during recessions, budget deficits are a
  necessary byproduct of an expansionary fiscal
  policy.

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Nonetheless

• Both Classical and Keynesian economists agree
  that chronic budget deficits such as the nation
  has been experiencing are undesirable.
• How big a danger are these chronic deficits and a
  collateral soaring national debt?

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Lesson 8 Colander McConnell Samuelson
Schiller Brue Nordhaus 3rd Edition 14th
Edition 16th Edition 8th Edition
Complete Textbook (includes both Micro-and
Macroeconomics) Macroeconomics Text Only
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19 19 17 12
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A Budget In Surplus

• In his second term, President Clinton proclaimed
  that the U.S. Federal budget would be in surplus.
  
• It was the first time the United States had run a
  budget surplus in over 25 years.
• These years of chronic budget deficits had
  swelled the accumulated national debt to over 5
  trillion making the United States the largest
  debtor nation in the world.

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In This Lesson

• In this lesson, we are going to look at the dark
  side of using discretionary fiscal policythe
  deficits and debt that can occur when the
  government uses the fiscal policy lever to boost
  aggregate demand.

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The Keynesian Context

• Keynesian economics focuses on the use of fiscal
  policy to solve our macroeconomic problems.
• Use fiscal stimulus increased government
  spending or tax cuts to fight recession and
  unemployment.
• Use fiscal restraint reduced spending or
  increased taxes to fight inflation.

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A Problem

• It implies that federal expenditures and receipts
  will not always be equal.
• When the government engages in fiscal stimulus,
  it typically is engaging in deficit spending, a
  situation in which the government borrows funds
  to pay for spending that exceeds tax revenues.

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The Deficit Defined
-
Budget Deficit
Government Spending
Tax Revenues

• A budget surplus occurs when all taxes and other
  revenues exceed government expenditures for the
  year.
• When revenues and expenditures are equal--an
  increasingly rare instance--the government has a
  balanced budget.

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The Debt Defined

• Now when the government incurs a budget deficit,
  it must borrow from the public to pay its bills.
• In this case it issues bonds, and the government
  debt--or the national or public debt as it is
  also called--is simply the total dollar value of
  the bonds owned by the public.
• This debt is simply the accumulated budget
  deficits minus the accumulated surpluses, and
  note that this debt is held not only by banks,
  households, and businesses in the U.S., but also
  by foreign investors as well.

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The Punchline

• Whatever the merits of Keynesian economics, the
  practice of using discretionary fiscal policy has
  produced few budget surpluses since the 1930s
  and this has been especially true since the
  1970s.

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• When Reagan supply side tax cuts were passed by
  Congress in the early 1980s, there was little or
  no offsetting reductions in government outlays.

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• This meant that a structural budget deficit was
  built into the Federal budget in the sense that
  the budget would not balance even if the economy
  were operating at full employment.

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The Debt-to-GDP Ratio

• Economists like to compare the debt to the size
  of the nations gross domestic product or GDP.
• The reason is simple In the abstract, a five
  trillion dollar national debt is a very large
  number.
• However, such a debt would pose a far more
  crushing burden to a small nation such as
  Thailand than it does to the United States.

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The Ability To Pay Off The Debt

• Comparing the debt to the GDP gives us a measure
  of a nations ability to produce and therefore
  its ability to pay off its debt.
• When we make such a comparison, the news about
  the national debt is somewhat less grim than the
  popular view might suggest.

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The Debt-to-GDP Ratio Since 1800
The ratio is creeping up, but is still not
significantly higher than at other points in
history
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The Real Versus Nominal Deficit

• A second important way to think about the size of
  the national debt is to distinguish between the
  real and nominal budget deficits.
• This distinction is important because it allows
  us to measure how inflation in any given year
  reduces the effective burden of the debt.

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The Terms Defined

• The real deficit in any given year is the actual
  or nominal deficit adjusted for inflation's
  effect on the debt.
• In particular, the real deficit equals the
  nominal deficit minus the inflation rate times
  the total debt.

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An Example

• If the nominal deficit is 100B, inflation is
  10, and total debt is 5 trillion, whats the
  real deficit?

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An Example

• If the nominal deficit is 100B, inflation is
  10, and total debt is 5 trillion, then the real
  deficit is equal to what?

• Minus 400B
• Heres the math 10 times 5 trillion is 500B.
  
• Subtract this from the nominal deficit of 100B
  and you get a real deficit of minus 400B.

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The Point

• Even though there is a nominal deficit, inflation
  has eroded the actual burden of the total debt.
• This suggests government can lower the burden of
  the debt by increasing inflation.
• This controversial strategy can only work if the
  inflation is unanticipated.
• Otherwise bond holders will demand a higher
  interest rate and thereby drive up the nominal
  deficit through higher interest payments.

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Structural Versus Cyclical Deficits

• A third distinction to make is between the
  structural deficit and the cyclical deficit.
• The structural deficit is that part of the budget
  deficit that would exist even if the economy were
  at full employment.
• It is due to the existing structure of tax and
  spending programs.
• The structural part of the budget is thought of
  as active.
• It is determined by discretionary policies such
  as those covering tax rates, public works
  projects, and education and defense spending.

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The Cyclical Deficit

• The cyclical deficit is that part of the deficit
  attributable to recession.
• It results partly from the governments
  automatic stabilizers increased income
  transfers that kick in during a recession for
  unemployment compensation, food stamps and other
  welfare benefits.
• The cyclical deficit results primarily from the
  shortfall of tax revenues that arises when the
  economys resources are underutilized such as in
  the downward portions of the business cycle.

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The Nature Of Cyclical Deficits

• Lets digress for a moment and talk a little more
  about automatic stabilizers and income
  transfers.

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Income Transfers

• Are payments to individuals by the government for
  which no current goods or services are exchanged.
  
• They include payments for entitlement programs
  like Social Security, welfare, and unemployment
  benefits.

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Automatic Stabilizers

• At least some of these income transfers,
  particularly welfare and unemployment, are part
  of the governments automatic stabilizer system.
• Automatic stablizers are defined as Federal
  revenues or expenditures that automatically
  respond to changes in the GDP in a
  countercyclical way.

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The Broader Point

• Neither the President nor the Congress has
  complete control over the federal deficit and
  thats one major reason why the distinction
  between the structural and cyclical deficits is
  so important.

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Calculating The Deficits

• Suppose the gross domestic product is 10
  trillion, the budget deficit is 100 billion, and
  the unemployment rate is seven percent, or one
  percent above the assumed full employment rate.
• The marginal tax rate is 30 percent, meaning that
  for every additional dollar that the GDP grows,
  the government will collect 30 additional cents
  in taxes.
• How can we calculate which portion of the 100
  billion deficit is structural and which portion
  is cyclical?

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Okuns Law

• Okuns Law says that a one percent fall in the
  unemployment rate will lead to a two percent
  increase in GDP.
• Try using Okuns law to calculate the increase in
  GDP that would result if the unemployment rate
  were to fall from 7 to the full employment rate
  of 6.

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Step One
1

• If the unemployment rate falls by one percent, by
  Okuns law, real GDP must increase by 2 times
  ten trillion dollars for a total of 200 billion.

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Step Two
2

• We have to calculate the additional tax revenues
  the government would collect from this increase
  in GDP (of 200 billion).
• How much is that?

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Step Two
2

• At our assumed marginal tax rate of 30 percent,
  the additional 200 billion of GDP income would
  generate an additional 60 billion in tax
  revenues.
• What part of the total 100 billion deficit is
  structural and what part is cyclical?

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Step Three
3

• The structural deficit clearly is 40 billion
  because thats how much of the deficit that would
  remain at full employment.
• That means that the cyclical deficit must be 60
  billion.

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This Distinction is Important

• It helps provide us with a policy guide to
  tackling the deficit problem.
• For example, since we can grow our way out of a
  cyclical deficit simply by reaching full
  employment, expansionary fiscal or monetary
  policies may well be appropriate in a sluggish
  economy.
• In fact, such a Keynesian policy prescription
  would have been quite appropriate way back in
  1958.

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The Situation in 1958

• In the middle of a recession, the Eisenhower
  Administration was running a purely cyclical
  deficit of 10 B.
• Concerned about the upcoming Presidential
  election, Vice President Richard Nixon advocated
  an expansionary tax cut to stimulate the economy.
• Eisenhower wanted to balance the budget before he
  left office and rejected such a tax cut for fear
  it would balloon the deficit.

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The Result

• The economy limped into 1960, Kennedy campaigned
  to get the country moving again, and Kennedy
  squeaked by Nixon.
• The irony If Eisenhower had listened to Nixon
  and cut taxes, the result would have been strong
  economic growth and a budget surplus of about 5
  billion.
• This is because the additional economic growth
  would have generated billions of dollars of
  additional tax revenues.

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The Bush Cyclical Deficit

• lets fast forward from the 1950s to the 1990s
  and watch as another Republican presidential
  candidate loses to a Democrat because of a
  failure to address a cyclical deficit in a timely
  way.
• The year is 1990, Republican George Bush is
  President, a recession has begun, and the budget
  deficit has soared to over 200 billion.

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The Structural Portion

• Of course, a good portion of this budget deficit
  is purely structural and attributable to the
  supply side policies of Bushs predecessor Ronald
  Reagan.
• However, as the Bush economy sinks further into
  recession, the cyclical portion of this already
  large budget deficit balloons.

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The Policy Implication

• To any red-blooded Keynesian, this onset of
  recession and an increasing cyclical deficit
  would have been a clear signal to engage in
  expansionary policy.
• However, in the Bush White House, Ronald Reagans
  Supply Side advisors had been supplanted not by
  Keynesians but rather by a new breed of
  economists ---the so-called New Classicals.

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Rational Expectations

• If you form your expectations rationally, you
  will take into account all available information
  including the future effects of activist fiscal
  and monetary policies.
• The idea behind rational expectations is that
  such activist policies might be able to fool
  people for a while.

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The Policy Implication

• However, after a while, people will learn from
  their experiences, and then, you cant fool them
  at all.
• The central policy implication of this idea is
  profound rational expectations render activist
  fiscal and monetary policies completely
  ineffective so they should be abandoned.

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Clearly Bad Politics

• Bushs New Classical advisors flatly rejected any
  Keynesian quick fix to reverse the deepening
  recession and reduce the cyclical deficit.
• Instead, they called for more stable and
  systematic policies based on long term goals
  rather than a continued reliance on
  short-sighted discretionary reactions.

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Bush Loses the 1992 Election
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The Clinton Deficit Reduction Plan

• In the 1996 campaign, Clinton proclaimed that
  policies such as his Deficit Reduction Act of
  1993 had been successful in reducing the budget
  deficit by more than half.

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The Clinton Deficit Reduction Plan

• However, Clintons Republican critics argued that
  it was mainly the recovery from recession that
  was responsible for the improvement.
• Some of these critics even claimed that it was
  George Bush who deserved most of the credit since
  the economic recovery began well before Clinton
  ever took office.

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The Facts

• Between 1992 and 1996, the federal deficit
  declined by 146 billionfrom 290 billion to
  144 billionand yes that is a more than a 50
  percent reduction.
• But how much of this deficit reduction was
  structural?

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The CBO Estimates

• According to the CBO, the structural deficit
  declined by 70 billion between 1992 and
  1996from 224 to 154 billion.
• This means that of the 146 billion in deficit
  reduction, about half of that was due to Clinton
  Administration policies and the other half was
  due to improved economic conditions.

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Estimating The Natural Rate

• The calculation of the structural deficit is
  clearly determined by what economists assume the
  full employment, natural rate of unemployment to
  be.
• The structural deficit will be lower if we assume
  the economy can sustain a four percent rate of
  unemployment without increasing inflation as
  opposed to, say, a six percent rate.

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Using Okuns Law

• Assuming a 10 trillion GDP, we can calculate the
  difference in the assumed structural deficit for
  these two different unemployment rate scenarios
  to be 120 billion.

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The Fiscal Policy Problem

• Suppose we believe that the four percent
  unemployment rate is the correct assumption for
  full employment output and that the economy is
  currently at six percent with a budget deficit of
  120 billion.
• Based on that four percent assumption, we must
  conclude that the budget deficit is purely
  cyclical in nature.

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Two Questions

• So what change in fiscal policy would a Keynesian
  economist recommend facing such a large cyclical
  deficit?
• And what would happen if the natural rate of
  unemployment actually turned out to really be 6
  percent?

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The Keynesian Solution

• A Keynesian would argue for an expansionary
  fiscal policy both to close a perceived
  recessionary gap and eliminate the perceived
  purely cyclical deficit.
• If, however, it turns out that the natural rate
  of unemployment was actually six percent, the
  Keynesian expansion would not only not eliminate
  the cyclical deficitwhich, as it turns out, was
  purely structural.
• It would also result in an even bigger deficit
  and a bad case of demand-pull inflation.

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End of Lesson
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