McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Deficits, Surpluses, and...

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McGraw-Hill/Irwin

Deficits, Surpluses, and Debt

Chapter 12 Chapter 12

Budget Effects of Fiscal Policy

Keynesian theory highlights the potential of fiscal policy to solve macro problems.

Fiscal Policy is the use of government taxes and spending to alter macroeconomic outcomes.

Budget Surpluses and Deficits

Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.

Budget deficit is the amount by which government spending exceeds government revenue in a given time period.

Budget deficit = government spending – tax revenues > 0

If the government spends less than its tax revenues, a budget surplus is created.

Budget surplus is an excess of government revenues over government expenditures in a given time period.

Budget Deficits and Surpluses

Budget Totals (billions of dollars)

2000 2001 2002 2003

Revenues 2,025 1,991 1,853 1,782

Outlays -1,789 -1,864 -2,011 -2,157

Surplus (deficit) 236 127 (158) (375)

2004 2005 2006

Revenues 1,880 2,154 2,407

Outlays -2,293 -2,472 -2,654

Surplus (deficit) (413) (318) (247)

A String of Deficits

Keynesian View

Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy.

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

Discretionary vs. Automatic Spending

At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.

Fiscal year (FY) is the twelve-month period used for accounting purposes – begins on October 1 for the federal government.

To a large extent, current revenues and expenditures are the result of decisions made in prior years.Roughly 80 percent of the budget is not discretionary so that only about 20 percent represents discretionary fiscal spending.

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

Since most of the budget is uncontrollable, fiscal restraint or fiscal stimulus is less effective.

Fiscal restraint – tax hikes or spending cuts intended to reduce (shift) aggregate demand.

Fiscal stimulus – tax cuts or spending hikes intended to increase (shift) aggregate demand.

Automatic Transfers

Most of the uncontrollable line items in the federal budget change with economic conditions.

Outlays for unemployment compensation and welfare benefits increase when the economy goes into a recession.

Automatic Transfers

These income transfers act as automatic stabilizers.

Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits.

Automatic Transfers

Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.

Automatic Transfers

Automatic stabilizers also exist on the revenue side of the budget.

Income taxes move up and down with the value of spending and output.

Being progressive, personal taxes siphon off increasing proportions of purchasing power as incomes rise.

Cyclical Deficits

The size of the federal deficit or surplus is sensitive to expansion and contraction of the macro economy.

Actual budget deficits and surpluses may arise from economic conditions as well as policy.

Cyclical Deficits

The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation.

The cyclical deficit widens when GDP growth slows or inflation decreases.

The cyclical deficit shrinks when GDP growth accelerates or inflation increases.

Structural Deficits

To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.

Structural deficit

Cyclical deficit

Total budget deficit

Structural Deficits

The structural deficit is federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.

Structural Deficits

Part of the deficit arises from cyclical changes in the economy.

The rest is the result of discretionary fiscal policy.

Only changes in the structural deficit measure the thrust of fiscal policy.

Structural Deficits

Fiscal policy is categorized as follows:

Fiscal stimulus is measured by the increase in the structural deficit (or shrinkage in the structural surplus).

Fiscal restraint is gauged by the decrease in the structural deficit (or increase in the structural surplus).

Economic Effects of Deficits

There are a number of consequences of budget deficits.

Crowding out.

Opportunity cost.

Interest-rate movements.

Crowding Out

Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing.

Crowding out implies less private-sector output.

Private-sector output (quantity per year)

Crowding Out

Increase in government spending . . .

Crowds out private spending

Opportunity Cost

Crowding out reminds us that there is an opportunity cost to government spending.

Opportunity cost is the most desired goods or services that are forgone in order to obtain something else.

Interest-Rate Movements

Rising interest rates are both a symptom and a cause of crowding out.

Economic Effects of Surpluses

The economic effects of budget surpluses are the mirror image of those for deficits.

Crowding In

There are four potential uses for a budget surplus:

Spend it on goods and services.

Cut taxes.

Increase income transfers.

Pay off old debt (“save it”).

Crowding In

Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing.

Cyclical Sensitivity

Crowding in depends on the state of the economy.

In a recession, a decline in interest rates is not likely to stimulate much spending if consumer and investor confidence is low.

The Accumulation of Debt

The United States has accumulated a large national debt.

The national debt is the accumulated debt of the federal government.

Debt Creation

When the Treasury borrows funds it issues treasury bonds.

Treasury bonds are promissory notes (IOUs) issued by the U.S. Treasury.

The national debt is a stock of IOUs created by annual deficit flows.

Early History, 1776-1900

By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War.

During the period 1790-1812 the U.S. often incurred debt but typically repaid it quickly.

The War of 1812 caused a massive increase in national debt and, by 1816, the national debt was over $129 million.

1835-36: Debt Free! – The U.S. was completely out of debt by 1835.

The Mexican-American War (1846-48) caused a four-fold increase in the debt.

By the end of the Civil War (1861-65), the North owed over $2.6 billion, nearly half of its national income.

After the South lost, Confederate currency and bonds had no value.

The Twentieth Century

The Spanish-American War (1898) also increased the national debt.

World War I raised the debt from 3% to 41% of the national income.

The Twentieth Century

National debt declined during the 1920’s but rose again during the Great Depression.

World War II

The greatest increase in national debt occurred during World War II.

Rather than raise taxes, the government rationed consumer goods.

U.S. War Bond purchases raised the debt from 45% of GDP to over 125% in 1946.

The 1980s

During the 1980s, the national debt rose by nearly $2 trillion.

The increase was not war-related but as a result of recessions, a military buildup, and massive tax cuts.

The 1990s

The early 1990s continued the same trend.

Discretionary federal spending increased sharply in the first two years of the Bush administration.

The 1990s

The 1988-92 period saw the national debt increased by another trillion dollars.There was some success in reducing the structural deficit in 1993.

Budget deficits for 1993-96 have pushed the national debt to over $5 trillion.

2000 -

By 2002, the accumulated debt was $5.6 trillion.

By 2007, the debt approximated $9 trillion, which works out to nearly $30,000 of debt for every U.S. citizen.

Historical View of the Debt/GDP Ratio

Great Depression

Civil War World War I

World War II

1990-91 recession

1990-91recession

Bush tax cuts

Who Owns the Debt?

Who can ever expect to pay off a debt measured in the trillions of dollars?

Liabilities = Assets

National debt represents an asset as well as a liability in the form of bonds.

Liability – An obligation to make future payment; debt.

Asset – Anything having exchange value in the marketplace; wealth.

Liabilities = Assets

The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).

Ownership of Debt

Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.

State and local governments hold 7 percent of the national debt.

U.S. households hold nearly 20% of the national debt, either directly or indirectly.

Ownership of Debt

Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions.The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.

Ownership of Debt

Foreigners

Foreigners 25%

State and localgovernments 7%

Public SectorSocial Security21%

Federal agencies

24%Federal Reserve 9%

Private Sector

Internal debt14%

Burden of the Debt

The burden of the debt is not so evident:

Refinancing.

Debt service.

Opportunity cost.

Refinancing

The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due.

Refinancing is the issuance of new debt in payment of debt issued earlier.

Debt Service

Debt service is the interest required to be paid each year on outstanding debt.

Interest payments restrict the government’s ability to balance the budget or fund other public sector activities.

Debt Service

Most debt servicing is simply a redistribution of income from taxpayers to bondholders.

Interest payments themselves have virtually no direct opportunity cost.

Opportunity Costs

Opportunity costs are incurred only when real resources (factors of production) are used.

The true burden of the debt is the opportunity costs of the activities financed by the debt.

Government Purchases

The true burden of the debt is the opportunity cost of the activities financed by the debt.

Transfer Payments

The only direct cost of transfer payments are the resources involved in the administrative process of making the transfer.

The Real Trade-Offs

Deficit financing tends to change the mix of output in the direction of more public-sector goods.

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

The Real Trade-Offs

The primary burden of the debt is incurred when the debt-financed activity takes place.

The real burden of the debt cannot be passed on to future generations.

Economic Growth

Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment.

The whole debate about the burden of debt is really an argument over the optimal mix of output.

Repayment

Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future.

External Debt

External debt presents some special opportunities and problems.

No Crowding Out

External financing allows us to get more public-sector goods without cutting back on private-sector production.

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

External Financing

Extra output (imports)

financed with external debt

Private-sector Output (units per year)

Repayment

Foreigners may not be willing to hold bonds forever.

External debt must be paid with exports of real goods and services.

Deficit and Debt Limits

The key policy question is whether and how to limit or reduce the national debt.

Deficit Ceilings

The only way to stop the growth of the national debt is to eliminate the budget deficit that created it.

Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.

Deficit Ceilings

The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-Rudman-Hollings Act) was the first explicit attempt to force the federal budget into balance.

Gramm-Rudman-Hollings Act

It set a lower ceiling on each year’s deficit until budget balance was achieved.

It called for automatic cutbacks in spending if Congress failed to keep the budget below the ceiling.

Debt Ceilings

A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt.

Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.

Dipping into Social Security

The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years.

Aging Baby Boomers

Persistent surpluses in the Trust Fund largely result from Baby Boomers paying lots more payroll taxes than are paid out in benefits to the retired.

Social Security Deficits

The Trust Fund balance shifts from surplus to deficit soon after 2014.

To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs.

Changing Worker-Retiree Ratios

McGraw-Hill/Irwin

Deficits, Surpluses, and Debt

End of Chapter 12 End of Chapter 12

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Deficits, Surpluses, and...

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