Budget Deficits in the Short run and in the long run

Gene H Chang

University of Toledo

Econ 1150

Government budget deficitGovernment budget deficit

Government budget deficit: Government budget deficit: • BDF= G-TBDF= G-T

the government’s expenditures the government’s expenditures exceed its receipts within a fiscal exceed its receipts within a fiscal yearyear

It is a concept of flowIt is a concept of flow

Deficit and debtDeficit and debt

National Debt National Debt the government’s total indebtedness the government’s total indebtedness

at a particular momentat a particular moment Debt is the sum of the previous Debt is the sum of the previous

deficits. deficits. It is a concept of stockIt is a concept of stock

U.S. NATIONALU.S. NATIONAL DEBTDEBT CLOCKCLOCK

The Outstanding Public Debt as of The Outstanding Public Debt as of Oct. 12Oct. 12, , 2011 is: 2011 is: 14,800,000,000,00014,800,000,000,000

It is about 95% of the U.S. GDPIt is about 95% of the U.S. GDP The estimated population of the The estimated population of the

United States is United States is 311,311,000000,,000000so each citizen's share of this debt is so each citizen's share of this debt is

$47,731$47,731. .

Public Debt to GDP ratio, 2010 Public Debt to GDP ratio, 2010 Debt to GDP ratioDebt to GDP ratio

(CIA)(CIA)Debt to GDP ratioDebt to GDP ratio

(IMF)(IMF)

JapanJapan 197.5197.5 225.9225.9

ItalyItaly 119.5119.5 118.4118.4

BelgiumBelgium 100.9100.9 100.2100.2

SingaporeSingapore 105.8105.8 98.998.9

U.S.U.S. 63.363.3 92.792.7

FranceFrance 82.482.4 84.284.2

CanadaCanada 8484 81.781.7

SpainSpain 60.160.1 64.564.5

NigeriaNigeria 11.911.9 16.316.3

http://en.wikipedia.org/wiki/List_of_sovereign_states_by_public_debt

Difference between public debt and Difference between public debt and external debtexternal debt

Public debt: government’s liability Public debt: government’s liability including domestic and foreign onesincluding domestic and foreign ones

External debt: foreign currency liability External debt: foreign currency liability U.S. external debt = U.S. debt owned U.S. external debt = U.S. debt owned

by foreign countries - dollar liability by foreign countries - dollar liability = ?= ?

Debt change during … Debt change during …

Does the U.S. have too much Does the U.S. have too much spending or too much tax? spending or too much tax?

2010 2010 Tax burden % of Tax burden % of GDP (all levels)GDP (all levels)

Government Government expenditure % of expenditure % of GDPGDP

FranceFrance 59.859.8 52.852.8

SwedenSweden 47.947.9 52.552.5

U.K.U.K. 38.938.9 47.347.3

GermanyGermany 40.640.6 43.743.7

NorwayNorway 42.142.1 40.240.2

CanadaCanada 32.232.2 39.739.7

U.S.U.S. 26.926.9 38.938.9

JapanJapan 28.328.3 37.137.1

AustraliaAustralia 30.830.8 34.334.3http://en.wikipedia.org/wiki/Government_spending

Debt and deficitsDebt and deficits

The National Debt has continued to The National Debt has continued to increase an average ofincrease an average of$$44.19 billion per day since .19 billion per day since September 28, 2007 September 28, 2007

Since 2005, the ceiling has been Since 2005, the ceiling has been broken and lifted again and againbroken and lifted again and again

Now congress Sets New Federal Debt Now congress Sets New Federal Debt Limit: $Limit: $1515 Trillion Trillion??

Not always.Not always.• Attempts to achieve balance during a Attempts to achieve balance during a

recession or an inflationary episode recession or an inflationary episode would destabilize the economy.would destabilize the economy.

Should the Budget be Should the Budget be Balanced? The Short RunBalanced? The Short Run

Should the budget be Should the budget be balanced?balanced?

To balance the budget in the To balance the budget in the recession would deepen and prolong recession would deepen and prolong the recessionthe recession

In recession, tax revenue is lower In recession, tax revenue is lower because GDP is lower.because GDP is lower.

Then, to balance to budget, the Then, to balance to budget, the government has to cut the spendinggovernment has to cut the spending

Will prolong the recessionWill prolong the recession

Should the budget be Should the budget be balanced?balanced?

To balance the budget in the full To balance the budget in the full employment state would accelerate employment state would accelerate inflationinflation

When economy is overheating, the When economy is overheating, the tax revenue is hightax revenue is high

Then, if balance the budget, the Then, if balance the budget, the government has to spend moregovernment has to spend more

Accelerate inflationAccelerate inflation

Should the budget be Should the budget be balanced?balanced?

Balance the budget not in the short Balance the budget not in the short run, but in the long runrun, but in the long run

On average in the long run, the On average in the long run, the budget is roughly balancedbudget is roughly balanced

SummarySummary

In the short run: depends on if the In the short run: depends on if the deficit will help the objectives of full deficit will help the objectives of full employment and stable price. employment and stable price.

In the long run: promote or impede In the long run: promote or impede economic growth.economic growth.

Should the budget be Should the budget be balanced?balanced?

What is the current situationWhat is the current situation Our real concern now is: structural Our real concern now is: structural

deficits, and the ratio of deficit to deficits, and the ratio of deficit to GDP is growingGDP is growing

What implications of the current What implications of the current deficits and debt are?deficits and debt are?

More deficits produce higher real More deficits produce higher real interest rates and therefore lower interest rates and therefore lower investment, slowing economic investment, slowing economic growth.growth.

More restrictive fiscal policy should More restrictive fiscal policy should reduce real interest rates and hence reduce real interest rates and hence increase investment and spur increase investment and spur economic growth.economic growth.

Surpluses and Deficits: The Surpluses and Deficits: The Long RunLong Run

Growth and Investment in 24 Countries

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32 30 28 26 24 22

Japan

Norway Portugal

Finland

Austria

Luxembourg

Italy

Spain

Iceland

Ireland

Canada Greece

Germany France

Australia

Switzerland

New Zealand

Netherlands Sweden

Denmark U.S.

Turkey

Belgium

U.K.

20 18

Average Investment as Percent of GDP, 1970–1990

Ave

rag

e A

nn

ual

Gro

wth

Rat

e o

f p

er

Cap

ita

Rea

l G

DP

, 19

70–

1990

0

1

2

3

4%

Can monetary policy help the Can monetary policy help the deficits? deficits?

The Policy Mix?The Policy Mix?• Under expansionary fiscal policy, if the Under expansionary fiscal policy, if the

Fed does not want interest rates to riseFed does not want interest rates to rise• It can engage in expansionary open-It can engage in expansionary open-

market operationsmarket operations• purchase more government debt.purchase more government debt.

Budget Deficits and InflationBudget Deficits and Inflation

When Fed OMO buy bonds, that is, When Fed OMO buy bonds, that is, purchase more government debt.purchase more government debt.

The money supply will then increase.The money supply will then increase. The portion of the deficit purchased The portion of the deficit purchased

by the Fed has been monetized.by the Fed has been monetized. It is very inflationaryIt is very inflationary

Monetization and Interest Monetization and Interest RatesRates

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M Supply0

Ms0

M Demand

D0

Inte

rest

Rat

e

Expansionary Fed policy

Quantity of Money

MS1

Ms1

Md

D1

C

B

A

Monetized Deficit Spending

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Real GDP

Expansionary monetary policy

Pri

ce

Lev

el

Expansionary fiscal policy

D 0

D0

D1

D 1

D2

D 2

S

S

AB

C

The true burden of the debtThe true burden of the debt

How large is our national debt?How large is our national debt? $7.7 trillion (2005), $7.7 trillion (2005), But quickly added to $8.6 in a year.But quickly added to $8.6 in a year. More than a half of GDP. Around $5 More than a half of GDP. Around $5

trillion owned by public. trillion owned by public. It is a rapid growthIt is a rapid growth

The U.S. National Debt Relative to GDP, 1915-2001

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1915

1993 Budget Agreement

1981–1982 Recession

1981–1984 Tax cuts

1974–1975 Recession

World War II

Great Depression

World War I

1995 1985 1975 1965 1955 1945 1935 1925

1.00

0.67

0.50

Year

Rat

io o

f P

ub

lic

De

bt

to

Gro

ss D

om

esti

c P

rod

uct

0.33

The true burden of the debtThe true burden of the debt

Will the Federal government go Will the Federal government go bankrupt?bankrupt?

Not in the legal sense. The Federal Not in the legal sense. The Federal government has a privilege to print government has a privilege to print money to pay the debt.money to pay the debt.

there this can cause inflation and there this can cause inflation and impede growth.impede growth.

The true burden of the debtThe true burden of the debt

About 30% and more are owned by About 30% and more are owned by local governments.local governments.

If all debts are owned by the U.S. If all debts are owned by the U.S. citizens, then the U.S. debt citizens, then the U.S. debt repayment will be transfer payments repayment will be transfer payments among the Americans if the debt is among the Americans if the debt is owned by Americans, owned by Americans,

The true burden of the debtThe true burden of the debt

But an increasing portion of the debt But an increasing portion of the debt is owned by foreignersis owned by foreigners

The new concern is that an The new concern is that an increasing share of debts are owned increasing share of debts are owned by foreigners.by foreigners.

Then our children need pay goods or Then our children need pay goods or assets to foreigners when they assets to foreigners when they demand to redeem the bonds in their demand to redeem the bonds in their hands.hands.

The true burden of the debtThe true burden of the debt

Which means that the future Which means that the future generations need to produce more generations need to produce more than they consume, in order to give than they consume, in order to give the goods and services to those the goods and services to those foreigners who have the U.S. bonds foreigners who have the U.S. bonds in hands.in hands.

IOU maturesIOU matures

ECONOMY

Struggling U.S. dollar triggers currency concerns

Long-term threat of 'trade chaos' citedBARRIE MCKENNA WASHINGTON -- Renewed fears that the Chinese central bank may be poised

to start liquidating its $1-trillion stash of U.S. dollars briefly drove the greenback to a 20-month low against the euro and a two-year low against the British pound in trading yesterday.

The euro surged to $1.3172 (U.S.) against the greenback and the pound to $1.9469, before losing ground by day's end. The loonie and the yen have also gained on the U.S. dollar in recent days.

The sudden weakness of the U.S. dollar began late last week, soon after Chinese officials suggested that holding a lot of dollars might be a losing investment strategy. Investors read that as a signal that the massive trade and financial imbalances between Asia and the U.S. may be about to unwind.

The chief worry is that if China's central bank -- the largest foreign holder of U.S. dollars -- begins to unload its reserves, the dollar will plunge. With China's yuan effectively pegged to the dollar, other leading currencies would move higher after the realignment.

To judgeTo judge

To judge if the short run borrowing or To judge if the short run borrowing or increase in debt is justified or not, increase in debt is justified or not, depends on if it can promote depends on if it can promote economic growth or not. economic growth or not.

The true burden of the debtThe true burden of the debt

What is the burden of deficits?What is the burden of deficits? InflationInflation Nominal interest rate will go up.Nominal interest rate will go up. Crowding-out effect that adversely Crowding-out effect that adversely

affect the long-run growthaffect the long-run growth

The true burden of the debtThe true burden of the debt

Key to answer the question: Key to answer the question: How would the policy affect the long How would the policy affect the long

term economic growth.term economic growth. Deficits may promote or impede Deficits may promote or impede

economic growtheconomic growth

The true burden of the debtThe true burden of the debt

Growth and productivityGrowth and productivity How can we repay our debt How can we repay our debt

owned by foreigners?owned by foreigners? Investing in human capital and Investing in human capital and

raising productivityraising productivity