Chapter 14

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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.
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
2
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)
3
Public Deficits and Debts:
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
4
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• 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
5
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Government Budget Surplus
– An excess of government revenues over government
spending during a given period of time
6
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Public Debt
– A stock variable
– The total value of all outstanding federal
government securities
7
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
8
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
9
Figure 14-2 The Federal Budget Deficit Expressed as
a Percentage of GDP
10
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
11
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
12
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
13
Evaluating the Rising
Public Debt (cont'd)
• 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
14
Table 14-1 The Federal Deficit, Our Public Debt, and the
Interest We Pay on It
15
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
16
Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP
17
Evaluating the Rising
Public Debt (cont'd)
• 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
18
Evaluating the Rising
Public Debt (cont'd)
• 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
19
Evaluating the Rising
Public Debt (cont'd)
• 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
20
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
21
Evaluating the Rising
Public Debt (cont'd)
• 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
22
Evaluating the Rising
Public Debt (cont'd)
• 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
23
Evaluating the Rising
Public Debt (cont'd)
• 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
24
Evaluating the Rising
Public Debt (cont'd)
• 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
25
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?
26
Federal Budget Deficits
in an Open Economy
• Question
– Is there a connection between the U.S. trade deficit
and the federal government budget deficit?
27
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
28
Figure 14-4 The Related U.S. Deficits
29
Federal Budget Deficits
in an Open Economy (cont'd)
• 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
30
Federal Budget Deficits
in an Open Economy (cont'd)
• 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
31
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
32
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
33
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
34
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• Even without a distinction drawn between the
capital and operating budgets, there is a
discrepancy about the true government deficit
measure
35
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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”
36
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
37
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
38
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
39
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
40
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
41
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• How could the government reduce all its red
ink?
– Increasing taxes for everyone
– Taxing only the rich
– Reducing expenditures
– Whittling away at entitlements
42
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
43
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
44
Figure 14-5 Components of Federal Expenditures as
Percentages of Total Federal Spending
45
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• 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
46
Growing U.S. Government Deficits: Implications for U.S.
Economic Performance (cont'd)
• Question
– What are the political costs of reducing entitlement
payments for Social Security, Medicare, and
Medicaid?
47
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
48
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
49
Figure 14-6 The Rapidly Expanding Ratio of the InflationAdjusted Net Public Debt to Real GDP
50
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.
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