Chapter 14

ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 14:

Deficit Spending and The Public Debt

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Introduction

Since 2007, the ratio of the official real net public debt to real

GDP has increased dramatically to more than 67 percent

The real net public debt is the inflation-adjusted amount that the

U.S. government owes to U.S. residents and others around the world

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Public Deficits and Debts:

Flows versus Stocks

• Government Budget Deficit

– Exists if the government spends more than it receives in taxes during a given period of time

– Is financed by the selling of government securities

(bonds)

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Flows versus Stocks (cont'd)

• The federal deficit is a flow variable, one defined for a specific period of time, usually one year

• If spending equals receipts, the budget is balanced

• If receipts exceed spending, the government is running a budget surplus

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• Balanced Budget

– A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time

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• Government Budget Surplus

– An excess of government revenues over government spending during a given period of time

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• Public Debt

– A stock variable

– The total value of all outstanding federal government securities

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Government Finance: Spending

More than Tax Collections

• Since 1940, the U.S. federal government has operated with a budget surplus in 13 years

• In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing

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Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

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Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

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Government Finance: Spending More than Tax Collections

(cont'd)

• Question

– Why has the government’s budget recently slipped from a surplus of 2.5% of GDP into a deficit?

• Answer

– Spending has increased at a faster page since the early 2000s than during any other decade since

WWII

– Recent income, capital gains, and estate tax cuts

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Evaluating the Rising Public Debt

• Gross Public Debt

– All federal government debt irrespective of who owns it

• Net Public Debt

– Gross public debt minus all government interagency borrowing

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Evaluating the Rising

Public Debt (cont'd)

• Some government bonds are held by government agencies

– In this case, the funds are owed from one branch of the federal government to another

– To arrive at the net public debt, we subtract interagency borrowings from the gross public debt

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• Tax revenues tend to be stagnant during times of slow economic growth

• Tax revenues grow more quickly when overall growth enhances incomes

• As long as spending exceeds revenues, the budget deficit will persist

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Table 14-1 The Federal Deficit, Our Public Debt, and the

Interest We Pay on It

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Evaluating the Rising Public Debt (cont’d)

• During World War II, the net public debt grew dramatically

• After the war

– It fell until the 1970s

– Started rising in the 1980s

– Declined once more in the 1990s

– And recently has been increasing again

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Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP

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• The government must pay interest on the public debt outstanding

• The level of these payments depends on the market interest rate

• Interest payments as a percentage of GDP are likely to rise in the future

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• As more of the public debt is held by foreigners, the amount of interest to be paid outside the

United States increases

• Foreign residents, businesses and governments hold nearly 50% of the net public debt

• Thus, we do not owe the debt just to ourselves

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• If the economy is already at full employment, then further provision of government goods will

crowd out some private goods

• Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector

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International Policy Example: Why the British Government

Must Pay More Interest on Its Debt

• Since the spring of 2009, a key bond-rating agency, Standard &

Poor’s (S&P) Rating Service, has placed British bonds into what it calls the “negative” category among highest-rated bonds

• The negative rating had an immediate effect on the interest rate that the British government was required to offer to induce individuals and companies to continue buying its bonds

• Indeed, the British government has had to pay almost $500,000 more in interest for each additional $1 billion that it has borrowed

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• Crowding-out may place a burden on future generations

– Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth

– Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt

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• Paying off the public debt in the future

– If the debt becomes larger, each person’s share would increase

– Taxes would be levied, and may not be assessed equally

– A special tax could be levied based on a person’s ability to pay

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• Our debt to foreign residents

– We do not owe all the debt to ourselves—what about the nearly 50% owned by foreign residents?

– Future U.S. residents will be taxed to repay principal and interest

– Portions of U.S. incomes will be transferred abroad

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• If deficits lead to slower growth rates, then future generations will be poorer

• Both present and future generations will be economically better off if…

– Government expenditures are really investments

– The rate of return on such public investments exceeds the interest rate paid on the bonds

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Policy Example: How a Special “Contribution” Increased the U.S. Debt

Burden without Changing the Official Budget Deficit

• Recently, President Obama sought to contribute an additional $108 billion to the International Monetary Fund, which in turn would lend to countries hit hard by the worldwide recession

• To prevent the IMF contribution from adding to the rapidly increasing federal government budget deficit, Obama asked Congress to classify the funds as a

“loan” instead of expenditures, thereby leaving the official budget deficit unaffected

• Why do you suppose economists argue that the best measure of the U.S. government’s actual indebtedness is equal to the total net amount that it has borrowed?

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Federal Budget Deficits in an Open Economy

• Question

– Is there a connection between the U.S. trade deficit and the federal government budget deficit?

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Federal Budget Deficits in an Open Economy (cont'd)

• We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports

• Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two

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Figure 14-4 The Related U.S. Deficits

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• As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners

• The interest rate paid on bonds will need to be high enough to attract foreign investors

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• If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports

• This shows that a U.S. budget deficit can contribute to a trade deficit

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Growing U.S. Government Deficits: Implications for U.S.

Economic Performance (cont'd)

• Which government deficit is the true deficit?

– The government may report distorted measures of its own budget

• Government has not adopted a business-like approach to tracking its expenditures and receipts

• Official government “measures” yield lowest possible deficits and highest reported surpluses

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• An operating budget includes current outlays for on-going expenses, such as salaries and interest payments

• A capital budget, includes expenditures on investment items, such as machines, buildings, roads, and dams

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• Capital budgeting theory

– For years, many economists have recommended

Congress create a capital budget and remove investment outlays from the operating budget

– Opponents point out that this would allow the government to grow even faster than at present

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• Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure

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• Pick a deficit, any deficit: deficit estimates are produced both by

– The Office of Management and Budget

– The Congressional Budget Office

• They have different names

– “Baseline deficit”

– “Policy deficit”

– “On-budget deficit”

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• There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers

• Keep in mind that any one specific deficit measure you hear is based on a definition and a set of assumptions with which others may disagree

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• Question

– How do higher deficits affect the economy in the short run?

• Answers

– If the economy is below full-employment, the deficit can close the recessionary gap

– If the economy is already at full-employment, the deficit can create an inflationary gap

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• In the long run, higher government budget deficits have no effect on equilibrium real GDP

• Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services

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• Thus, if the government operates with higher deficits over an extended period

– The ultimate result is a shrinkage in the share of privately produced goods and services

– By continually spending more than it collects, the government takes up a larger portion of economic activity

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Policy Example: What Is the Outlook for the U.S. Government’s

Share of GDP?

• Each year, the Office of Management and Budget makes a projection of federal government deficits for the following 10 years

• At the beginning of 2009, the OMB projected that the average annual budget deficit from 2010 to 2019 would be nearly $712 billion, or an extra $186billion-per-year slice of GDP

• Seven months later, the OMB redid its projection, which implied that the federal government’s share of GDP would be about $188 billion higher over the following 10-year period

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• How could the government reduce all its red ink?

– Increasing taxes for everyone

– Taxing only the rich

– Reducing expenditures

– Whittling away at entitlements

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• In considering how expenditures might be reduced, it is important to look at entitlements

• These are federal government payments that are legislated obligations and cannot be reduced or eliminated

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• Entitlements

– Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid

• Noncontrollable Expenditures

– Government spending that changes automatically without action by Congress

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Figure 14-5 Components of Federal Expenditures as

Percentages of Total Federal Spending

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• Entitlements are the largest component of the

U.S. federal budget

• To make a significant cut in expenditures, entitlement programs would have to be revised

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• Question

– What are the political costs of reducing entitlement payments for Social Security, Medicare, and

Medicaid?

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Policy Example: Medicare Is Contributing to a Higher Federal

Budget Deficit

• Since 2008, the Medicare entitlement program has officially operated at a deficit. Congress responded by passing a law several years ago that cut allowed payments to Medicare providers by more than 20 percent

• Each year since, however, Congress has passed one-year amendments canceling the payment reductions while boosting Medicare costs by expanding the scope of its coverage

• Congress has also established an annual trust fund for Medicare entitlement, but each year it has borrowed the trust fund to spend. Medicare’s trustees have determined that accumulated annual Medicare deficits will wipe out the trust fund by 2017

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Issues and Applications: How Much of U.S. GDP Would Be

Required to Pay Off the Net Public Debt?

• A measure of the burdens associated with the net public debt is the share of real GDP that would be required to pay off the inflation-adjusted net public debt

• Figure 14-6 shows that this share has nearly doubled since 2007, to more than 67 percent

• Yet, some observers suggest that the true share is much higher than this once government guarantees of housing-related debts are taken into account

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Figure 14-6 The Rapidly Expanding Ratio of the Inflation-

Adjusted Net Public Debt to Real GDP

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ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 14:

Deficit Spending and The Public Debt

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Chapter 14

Introduction

Evaluating the Rising Public Debt

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Introduction

Evaluating the Rising Public Debt

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