Chapter 14
Deficit
Spending and
The Public Debt
Introduction
A government budget is in deficit when
spending exceeds receipts.
When the U.S. federal government runs a
budget deficit, other countries tend to
experience deficits as well. Why does
this correlation exist?
Slide 14-2
Learning Objectives
 Explain how federal government
budget deficits occur
 Define the public debt and understand
alternative measures of the public debt
 Evaluate circumstances under which
the public debt could be a burden to
future generations
Slide 14-3
Learning Objectives
 Discuss why the federal budget deficit
might be measured incorrectly
 Analyze the macroeconomic effects of
government budget deficits
 Describe possible ways to reduce the
government budget deficit
Slide 14-4
Chapter Outline
 Public Deficits and Debts
 Government Finance
 Evaluating the Rising Public Debt
 Federal Budget Deficits in An Open
Economy
 Growing U.S. Government Deficits
Slide 14-5
Did You Know That...
 Throughout the rest of this decade, the
U.S. federal government expects to run
annual budget deficits?
 The relationship between budget
deficits and macroeconomic
performance is somewhat elusive?
Slide 14-6
Public Deficits and Debts
 A 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)
Slide 14-7
Public Deficits and Debts
 The federal deficit is a flow variable,
one defined for a specific period of
time, usually one year
Slide 14-8
Public Deficits and Debts
 If spending equals receipts, the budget
is balanced.
 If receipts exceed spending, the
government is running a budget
surplus.
Slide 14-9
Public Deficits and Debts
 The public debt
– A stock variable
– The total value of all outstanding
government securities
Slide 14-10
Government Finance
 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.
Slide 14-11
Government Finance
Figure 14-1
Slide 14-12
Evaluating the Rising Public Debt
 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
Slide 14-13
Evaluating the Rising Public Debt
 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.
Slide 14-14
Evaluating the Rising Public Debt
Table 14-1
Slide 14-15
Evaluating the Rising Public Debt
 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.
Slide 14-16
Evaluating the Rising Public Debt
 As more of the public debt is held by
foreigners, then the amount of interest
to be paid outside the U.S. increases.
 The presence of the debt may place a
burden on future generations.
Slide 14-17
Evaluating the Rising Public Debt
 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.
Slide 14-18
Evaluating the Rising Public Debt
 Burdens on Future Generations:
– Crowding out then may place a burden on
future generations by dampening the rate
of economic growth
– Taxes may be increased in the long term
to retire the debt
Slide 14-19
Policy Example:
Jefferson and Hamilton on the Public Debt
 Jefferson argued that it was unfair to
place the burden of public debt on
future generations.
 He favored an annually balanced
government budget.
Slide 14-20
Policy Example:
Jefferson and Hamilton on the Public Debt
 Alexander Hamilton, the first U.S.
Treasury Secretary, argued that a
nation which handled a debt
responsibly could build a reputation for
creditworthiness.
 He concluded that there could be a
blessing in a national debt that was not
excessive and was repaid on time.
Slide 14-21
Evaluating the Rising Public Debt
 Is there anything positive about the
public debt?
– While the debt in and of itself may not
offer a benefit to our economy, the
government expenditures incurred in
creating it provide goods and services that
are needed.
Slide 14-22
Federal Budget Deficits
in An Open Economy
 Is there a connection between the U.S.
trade deficit and the federal
government budget deficit?
 A trade deficit exists when the value of
imports exceeds the value of exports.
 There is a statistical correlation
between the two.
Slide 14-23
Federal Budget Deficits
in An Open Economy
Figure 14-4
Slide 14-24
Federal Budget Deficits
in An Open Economy
 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.
Slide 14-25
Federal Budget Deficits
in An Open Economy
 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.
Slide 14-26
Growing U.S. Government Deficits
 There is some debate among
economists and policymakers as to
what should be considered the best
measure of the deficit.
Slide 14-27
Growing U.S. Government Deficits
 Most businesses use two budgets:
– An operating budget
– A capital budget
Slide 14-28
Growing U.S. Government Deficits
 An operating budget includes current
outlays for on-going expenses, such as
salaries, supplies, utilities, etc.
Slide 14-29
Growing U.S. Government Deficits
 A capital budget includes expenditures
on investment items, such as a new
building or implementation of new
technology.
 These are generally items that are
expected to have a life of many years.
Slide 14-30
Growing U.S. Government Deficits
 For the federal government, items in
an operating budget would include
Social Security benefits, interest on the
public debt, upkeep of national parks,
salaries of federal employees, and the
costs of operating the IRS.
Slide 14-31
Growing U.S. Government Deficits
 Items in the capital budget would
include a new aircraft carrier or
weapons system, a new federallyfunded highway, construction of a dam,
and the design of new software to
handle the federal payroll.
Slide 14-32
Growing U.S. Government Deficits
 Some economists argue that Congress
should establish a separate capital
budget which would include investment
expenditures.
 This might give a more accurate
reflection of the deficit.
Slide 14-33
Growing U.S. Government Deficits
 Even without a distinction drawn
between the capital and operating
budgets, there is a discrepancy about
the true government deficit measure.
Slide 14-34
Growing U.S. Government Deficits
 Deficit estimates are produced both by
the Office of Management and Budget
and by the Congressional Budget
Office.
 Each estimate is based on a different
set of assumptions, and they have
names such as the baseline deficit,
policy deficit, or on-budget deficit.
Slide 14-35
Growing U.S. Government Deficits
 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.
Slide 14-36
Growing U.S. Government Deficits
 Question
– How do higher deficits affect the economy
in the short run?
– If the economy is below full employment,
the deficit can close the recessionary gap.
– If the economy is already at full
employment, the deficit an create an
inflationary gap.
Slide 14-37
Growing U.S. Government Deficits
 What is the long-run effect?
– In the long run, a higher deficit does not
affect the equilibrium level of real GDP.
– The lasting effect of a persistent deficit is
to redistribute resources from the private
sector to the public sector.
Slide 14-38
Growing U.S. Government Deficits
 How could the deficit be reduced?
– Either by increasing taxes or by reducing
government spending
– Both of these solutions involve political
realities
Slide 14-39
E-Commerce Example:
Internet Taxes
 Some state governments have
considered imposing taxes on internet
transactions as a means of
supplementing their budget revenues.
 Estimates show that, at best, this
would cover about 25 percent of
deficits experienced at the state level.
Slide 14-40
Growing U.S. Government Deficits
 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.
 Entitlements include Social Security,
Medicare, and Medicaid.
Slide 14-41
International Policy Example:
Unrealized Public Debts
 Peter Heller of the International Monetary
Fund has devised a measure intended to
include the implicit future indebtedness of a
country based on its current entitlements.
 The fact that a country’s debt appears larger
when using this measure shows that there
are significant economic burdens ahead in
following through on political promises.
Slide 14-42
Growing U.S. Government Deficits
 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.
 What are the political costs of reducing
Social Security and Medicare benefits?
Slide 14-43
Issues and Applications:
International Cycles in Deficits
 Among the nations of Canada, France,
Germany, the U.K. and the U.S.,
changes in the size of federal budget
deficits seem to be correlated.
 In part, this is because the business
cycles of all these economies are
closely aligned.
Slide 14-44
Issues and Applications:
International Cycles in Deficits
 Also, this correlation occurs because the
need for military spending by each nation is
determined by outside factors that affect all
countries at the same time.
 And further, stock market trends that are
internationally correlated affect the amount
of capital gains tax that can be collected by
each federal treasury.
Slide 14-45
Summary Discussion
of Learning Objectives
 Federal government budget deficits:
– The U.S. federal government operated with
a surplus from 1998 through 2001, but it
returned to a deficit condition in 2002.
 The public debt:
– Total value of all government bonds
outstanding
– Net public debt as a share of GDP is 35
percent
Slide 14-46
Summary Discussion
of Learning Objectives
 How the public debt might prove a burden to
future generations:
– Higher taxes will reduce private consumption
– Crowding out could reduce economic growth
 Why the federal budget deficit might be
incorrectly measured
– No distinction between capital expenses and
operating expenses
– Each estimate is based on a set of assumptions
Slide 14-47
Summary Discussion
of Learning Objectives
 The macroeconomic effects of
government budget deficits:
– In the short run, a deficit can close a
recessionary gap or cause an inflationary
gap.
– The long run effect is to shift resources
from the private sector to the public
sector.
Slide 14-48
Summary Discussion
of Learning Objectives
 Possible ways to reduce the
government budget deficit:
– Increase taxes
– Reduce expenditures by revising the
terms of entitlement programs
Slide 14-49
End of
Chapter 14
Deficit
Spending and
The Public Debt