TEN QUESTIONS (AND ANSWERS) ABOUT GOVERNMENT DEBT AND DEFICITS

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CHAPTER 31

• TEN QUESTIONS (AND ANSWERS) ABOUT GOVERNMENT DEBT
  AND DEFICITS

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1. WHAT EXACTLY ARE DEBTS AND DEFICITS ?
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DEFICIT

• When governments spend more money than they
  currently receive in either taxes or fees.

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SURPLUS

• Occurs when revenues exceed spending.
• BALANCED BUDGET
• Occurs when governments spending equals
  revenues

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GOVERNMENT EXPENDITURE

• Includes both purchases of goods and services
  and transfer payments.

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FISCAL YEAR

• Differs from the normal calendar year
• Fiscal year for a given year begins October 1 of
  the preceding calendar year and ends on August 30
  of the current calendar year

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ESTIMATES OF GOVERNMENT EXPENDITURES, REVENUES
AND DEFICIT BILLIONS OF DOLLARS

• Total 1996 1997 1998 1999 2000 2001 2002 2003
  2004 2005
• Exp 1,572 1,654 1,737 1,828 1,925 2,016
  2,125 2,242 2,365 2,500
• Rev 1,428 1,483 1,544 1,609 1,681 1,758
  1,840 1,931 2,033 2,124
• Deficit 144 171 193 219 244
  258 285 311 342 376
• Total As a percent of GDP
• Exp 21 21.1 21.1 21.2 21.3
  21.3 21.4 21.5 21.6 21.8
• Rev 19.1 18.9 18.8 18.7 18.6
  18.5 18.5 18.5 18.5 18.5
• Deficit 1.9 2.2 2.3 2.5 2.7
  2.8 2.9 3.0 3.1 3.3
• Source Congressional Budget Office, Reducing the
  Deficit Spending and Revenue Options,
  Washington, DC U.S. Government Printing Office

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GOVERNMENTS DEBT

• The total of all deficits
• For example, if the government had a debt of 100
  billion and then ran deficits of 20, 30, and
  50 billion, the governments total debt at the
  end of this period would be 200 billion
• If a government ran a surplus, it would decrease
  the total stock of debt

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BASELINE BUDGETING

• First estimated what would be needed to maintain
  existing programs
• For example, if price of food has increased,
  under baseline budgeting, expenditures for food
  stamps would have to be increased
• If Congress reduced expenditures from this higher
  level, they could claim they were cutting their
  budget
• But if baseline budget increased by 10 and
  expenditures were cut by 5 from the higher
  level, actual expenditures would have increased
  by 5

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2. HOW ARE GOVERNMENT DEFICITS FINANCED ?
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FINANCING GOVERNMENT DEFICITS

• Borrow money from the public in return for
  government bonds (in effect IOUs)
• In the future, the government would have to pay
  back what it borrowed plus any interest on the
  bonds
• An alternative is to print new money
• Government could use a mix of borrowing and
  printing
• government deficit new borrowing from public
  new money created

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MONETIZING THE DEFICIT

• In the U.S., the Treasury Department always
  issues government bonds to finance the deficit
• The Federal Reserve has the option of buying
  existing government debt (including the new
  issues)
• If the Federal Reserve does purchase bonds, it
  takes the government debt out of the hands of the
  public and creates money through its purchase
• This has precisely the same effect as if the
  Treasury had printed money to finance the
  government deficit

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World War II
1980s
Civil War
World War I
Sources Economic Report of the President,
Washington, DC U.S. Government Printing Office
Historical Statistics of the United States,
Berry Production and Population Since 1789,
Washington, DC U.S. Department of Commerce, 1988
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3. WHAT IS THE U.S. HISTORY OF DEBTS AND DEFICITS
?
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HISTORY OF DEBTS AND DEFICITS

• Scholars who have studied deficits and debt
  for the United States and other countries have
  found
• The total level of the debt relative to GDP
  generally rises during and after wars
• The total level of the debt relative to GDP
  generally falls during peacetime
• Starting in the 1980s, however, the United States
  began to run large peacetime deficits
• These deficits resulted from actions taken during
  the first few years during the presidency of
  Ronald Reagan

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FEDERAL OUTLAYS, REVENUES AND ENTITLEMENTS, 1970
- 1995
Source The Economic and Budget Outlook Fiscal
Years 1997 - 2006, Congressional Budget Office,
1996
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4. CAN DEFICITS BE GOOD FOR THE COUNTRY ?
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AUTOMATIC STABILIZERS

• The increase in the deficit during economic
  downturns shows the automatic stabilizers in
  action
• Puts additional income into the hands of the
  public during bad economic times
• The additional income allows people to avoid
  drastic cuts in their consumption spending
• Since total spending doesnt fall as much,
  severity of recessions is decreased

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THE US. DEFICIT AND UNEMPLOYMENT RATE, 1970 - 1995
Unemployment Rate
Deficit as a percent of GDP
Source Data from U.S.. Department of Commerce
Year and Economic Report of the President
(Washington, DC U.S. Government Printing Office,
yearly).
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THE DEFICIT CAN CHANGE

• As incomes fall during a recession so do tax
  payments
• Transfer payments, such as food stamps and
  welfare, rise during a recession
• Since increases in unemployment signal bad
  economic times, the deficit is expected to rise
  and fall with the unemployment rate
• The deficit also changes if the government tries
  to stabilize the economy
• -- Expansionary fiscal policy increases the
  deficit

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5. WHAT IS THE BURDEN OF THE NATIONAL DEBT ?
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NATIONAL DEBT

• Another commonly used term for total government
  debt
• Poses two different burdens for society
• -- A large debt can reduce the amount of
  capital in the economy, thereby reducing future
  incomes and wages
• -- A large national debt will mean future
  generations will have to pay higher taxes to
  finance the interest on the debt (servicing the
  debt)

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RICARDIAN EQUIVALENCE

• Some economists do not believe that government
  deficits or debt impose a burden on society
• Ricardian equivalence is the proposition that it
  does not matter whether government expenditure
  is financed by taxes or issuing debt

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UNDERSTANDING RICARDIAN EQUIVALENCE

• Government initially has a balanced budget
• It cuts taxes and issues new debt to finance the
  deficit
• The public realizes that the government will have
  to raise taxes in the future to service the debt,
  so it increases saving to pay for the taxes that
  will be raised in the future
• If private saving rises sufficiently, the public
  would be able to purchase the new debt without
  reducing funds for investment
• Since investment does not decline, there will be
  no burden of the debt

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6. WHEN DOES A NATIONAL DEBT BECOME TOO LARGE ?
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TWO WARNING SIGNS F EXCESSIVE GOVERNMENT DEBT

• 1. High inflation
• Countries with limited ability to finance
  their deficits through issuing bonds will soon
  find that they must monetize their deficits
• 2. Low National Investment
• When governments run large deficits, savers
  must purchase the new government bonds that are
  issued these bonds displace new investment

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FULL-EMPLOYMENT DEFICIT

• Economists use full-employment deficit to measure
  changes in fiscal policy due to economic policy
• Also known a structural deficit
• It is an estimate of what the deficit would be if
  the economy were operating at full employment
• Isolates the effects of fiscal policy changes
  from movements in GDP that affect the deficit.

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INTERNATIONAL DEBT TO GDP RATIOS, 1992
Percent
1.2
1.17
1.06
1.0
0.8
0.61
0.6
0.51
0.52
0.47
0.35
0.4
0.3
0.07
0.2
0
Belgium
Finland
France
India
Italy
Japan
Korea
Spain
United States
Source International Financial Statistics, 1995
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DEFICITS ARE MORE OF A PROBLEM FOR COUNTRIES WITH
LOW SAVING RATES

• Countries with high saving rates can more easily
  absorb deficits
• A high saving rate allows a country to absorb new
  bonds issued by the government

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7. DOES THE NATIONAL DEBT MEASURE THE TOTAL
BURDEN ON FUTURE GENERATIONS ?
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THE BURDEN OF FUTURE GENERATIONS

• Higher interest payments to service the debt
• Social security and Medicare, programs that
  provide retirement and health benefits to
  retirees in the United States , are financed
  through payroll taxes of current workers, not the
  past contributions of retirees

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GENERATIONAL ACCOUNTING

• Developed by Laurence Kotlikoff, an economist at
  Boston University
• Provides estimates of the burdens on future
  generations from all past actions taken by the
  government
• According to Kotlikoffs estimates, male workers
  born today would have to hand over nearly 80 of
  their income to pay for benefits to future
  retirees
• Kotlikoffs numbers have been criticized because
  they rely on a number of special assumptions

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8. WHY DO STATES USUALLY BALANCE THEIR BUDGETS
BUT THE FEDERAL GOVERNMENT DOES NOT ?
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THREE ANSWERS WHY STATES APPEAR TO BALANCE THEIR
BUDGETS WHILE THE FEDERAL GOVERNMENT DOES NOT

• 1. The states do not always balance their budgets
• 2. The budgets they balance are not the same type
  as the federal governments
• 3. Balanced budget requirements work, but they
  force states to cut spending and raise taxes
  during poor economic times
• Balanced budget requirements apply to
  operating budgets

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STATES HAVE TWO TYPES OF BUDGETS(The Federal
Government has One)

• Operating Budgets
• The day-to-day operations of the government --
  salaries, supplies, maintenance -- are included
• These expenditure are financed by taxes
• Capital Budgets
• Refers to all major investment expenditures, such
  as roads or buildings
• These are financed through long-term borrowing

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9. HOW WELL WOULD A BALANCED BUDGET AMENDMENT
REALLY WORK ?
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PROPONENTS OF THE BALANCED BUDGET CONTEND

• It will finally exert discipline on the federal
  government and prevent it from running large
  deficits in peacetime
• We can avoid adverse effects of deficits, namely
  reduced capital formation and a shift in the
  burden of taxation to future generations
• Good experience of states with balanced budget
  requirements

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CRITICS OF BALANCED BUDGET AMENDMENT POINT TO
MANY DIFFERENT PROBLEMS

• There is not enough flexibility to deal with
  recessions -- limited ability of government to
  use fiscal policy to stabilize the economy
• The Constitution is not the right mechanism to
  enforce complicated budget rules
• Congress could devise special budgets to get
  around the requirement
• Congress could also find other nonbudgetary ways
  to carry out policies it desires

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10. IS THE BUDGET DEFICIT RELATED TO THE TRADE
DEFICIT ?
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TWIN DEFICITS

• Simultaneous rise in budget and trade deficits
  during the 1980s
• The sale of assets or borrowing from abroad
  enabled the economy to provide funds necessary
  for domestic investment despite increased
  borrowing arising from government budget
  deficits
• However, during the 1990s, the trade deficit fell
  while the budget deficit increased
• In the 1990s, the economy was no longer at full
  employment and with the recession, total
  investment fell sharply
• Domestic savings were sufficient to finance the
  budget deficit and reduced level of investment

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Source Data from Economic Report of the
President, (Washington, DC U.S. Government
Printing Office, yearly)