Payne with additions from WN
Don’t miss the video of Chicken Little and the financial crisis at
http://www.youtube.com/watch?v=1IUZCyU1S9I
2
The overall federal budget
26
24
Expenditures
22
Deficit
20
18
Revenues
16
14
60
65
70
75
80
85
90
95
00
05
10
3
Debt bathtub
Spending
Debt (end of year) = Debt (beginning) + deficit
Debt (beginning of year)
Revenues
4
Debt algebra
Basic identity:
Debt (end of t) = Debt (beginning of t) + Deficit (t)
Stable system when debt-GDP ratio is constant.
Define debt-GDP ratio = β
Primary surplus = Π = taxes – noninterest spending.
Given U.S. parameters, stable β when Π = 0.
Algebra of stable debt - GDP ratio.
Assume g = nominal GDP growth. Then, equation for change in debt is:
D/t  iD  
Then debt-GDP ( = D/Y) ratio is constant when
  /t   0    D/t  / D  g     iD    / D  g   (i  g )   / Y
Historically for the U.S., i  g, so a stable financial situation implies that
the primary deficit must be zero (   0).
Primary surplus ratio
Clinton-era
surpluses
.06
Primary surplus/GDP
.04
Recession
and
stimulus
package
.02
.00
-.02
-.04
-.06
-.08
60
65
70
75
80
85
90
95
00
05
10
Structural v Actual Budget
• Actual budget is actual spending and receipts
• Structural budget records spending, taxes, and deficit
that would occur if economy at potential output
• Important because taxes, spending programs respond to
state of economy
7
Structural and Actual Budget
.04
.02
.00
-.02
-.04
A substantial
part of the deficit
is cyclical.
-.06
Govt surplus/GDP
Cyclically adjusted govt surplus/GDP
-.08
-.10
60
65
70
75
80
85
90
95
00
05
10
8
Cyclicality of the federal budget
2
Federal surplus/GDP
0
Unemployment up 1%
point
→
Deficit/GDP up about
1.7%.
-2
-4
-6
The recession to date
has raised the debt-GDP
ratio by 16 percentage
points!
-8
-10
3
4
5
6
7
8
9
10
Unemployment rate
9
Current projection of debt/GDP
10
Long-term projection of debt/GDP
11
What are the sources of the spending growth?
Projected federal spending as % of GDP
14
12
10
8
6
4
Social Security
Health
Everything else
2
0
2010
2015
2020
2025
2030
2035
2040
CBO, The Long-Term Budget Outlook, June 2010
12
Preliminaries on Government Debt
• Fundamental difference between spending on I and spending on C:
- Borrowing for spending on I is not a burden unless MPK of government I <
MRK of private I (e.g., roads, high-speed rail, education, missiles v. private
I).
- Problems arise from borrowing for government consumption
• Don’t forget the “two faces of saving”
- Higher deficits in recessions raise output through AD
- Higher deficits (and therefore lower government saving) lowers investment
and therefore growth in potential output
13
For the moment, assume full-employment
economy.
Come back to “dilemma of the deficit” in
recessions later.
14
Impact of Deficits on Economy
y = f(k)
y*
y**
i = s1f(k)
i = s2f(k)
(I/Y)*
(n+δ)k
k
k**
k*
15
ln K, ln GD
ln K
ln K’
ln GD’
ln GD
time
16
ln Y, ln C
ln Y
ln Y’
ln (C+G)
ln (C+G)’
Note that govt spending first
raises (C+G), but then lowers (C+G)’
time
17
What if deficit spending in an open economy?
• In open economy:
Sp + Sg = I + NX = domestic + foreign investment
• Higher deficit reduces domestic and foreign I
– I.e., some of decline in savings is in foreign assets
• For small open economy, the marginal investment is abroad!
– Therefore, no effect on GDP, but has effect on income from abroad
– Will show up in NNP not in GDP!
(Most macro models get this wrong.)
• Large open economy like US:
– Somewhere in between small open and closed.
– I.e., some decrease in domestic I and some in decrease net foreign
assets
18
Initial position
r = real
interest rate
S0
Initial NX
surplus
r = rw
I(r)
0
I, S, NX
19
With higher saving in small open economy
r = real
interest rate
S1
S0
Higher deficit:
1. Lower savings
2. No change I or Y
3. Lower foreign saving
4. Lower GNP, NNP
Initial NX
surplus
r = rw
Final NX
deficit
I(r)
0
I, S, NX
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American views on the national debt
“The Congress shall have power to lay and collect taxes, duties, imposts
and excises to pay the debts and provide for the common defense and
general welfare of the United States.” [U.S. Constitution]
“A national debt, if it is not excessive, will be to us a national blessing.”
[Alexander Hamilton]
“It’s a public debt… we owe it to ourselves… therefore, we never have to
pay it back.” [F. D. Roosevelt]
“There are myths also about our public debt. Borrowing can lead to overextension and collapse – but it can also lead to expansion and strength.
There is no single, simple slogan in this field that we can trust.” [J. F.
Kennedy, Yale Commencement Address, 1962]
“This debt is like a cancer that will truly destroy this country from
within if we don't fix it,“ [Erskine Bowles, Nov. 29, 2010]
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Seven Important Views on the Debt and Deficit
1. In closed economy, lower public saving lowers growth of potential
output.
- Higher deficit and debt leads to lower saving and capital stock
- Leads to lower potential output (we will review the savings
experiment)
2. In open economy, deficit leads to lower foreign investment (more
foreign debt). This predominates in small open economy.
3. Higher debt forces higher taxes or crowds out other spending
4. Efficiency impacts of higher debt:
- Higher debt means higher interest payments
- These require taxes, and this has a “dead-weight loss”
5. Debt is irrelevant. Only spending matters (Barro’s Ricardian theory)
6. High debt can lead to financial crisis, higher interest rates, higher
deficits, and a death spiral of confidence
7. We should raise the deficit in recessions.
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4. Taxes and debt for a purely internal debt
Assume that we “owe the debt to ourselves”
- Many identical people
- All get benefits and pay taxes to service debt
Suppose that we have program which provides $1 in PV of C; and
finances it by $1 of debt.
Classical case:
- Suppose no change in path of output.
- Higher interest payments with present value of $1.
- Taxes cause efficiency losses with a dead-weight loss (DWL).
- If marginal DWL on taxes is 30%, then have cost of $0.30.
- Net value of government program is minus $0.30.
23
The marginal dead weight loss of debt/taxes
= incremental DWL of higher taxes
P(1+τ2)
~ increase revenues
P(1+τ1)
DWL
P
X2
X1
X0
What do Keynesians say about this?
Keynesian case:
- With multiplier of 1.5, output is 1.5 higher
- With tax rate of 0.3, higher net debt is $1 – (0.3 x 1.5) = $0.55
- If marginal DWL on taxes is 30%, then have additional cost of 0.3
x 0.55 = 0.165
- Net is + 1.5 - 0.165 = + 1.335
This indicates the big difference of view of Keynesians and classical
economists on deficit spending in recessions.
25
5. Do Deficits Matter? The Ricardian Theory of the Debt
1. Robert Barro (Chicago/Harvard) introduced a theory in which
deficits do not affect national saving or output.
2. Chicago view of households: They are "clans" or "dynasties" in
which parents have children’s welfare in utility function:
Ui = ui (ci, Ui+1)
where Ui is utility of generation i and
ci is consumption of generation i
3. This implies by substitution:
Ui = ui (ci, ui+1(ci+1, Ui+2)) = vi(ci, ci+1, ci+2, ...)
which is just like an infinitely lived person!
4. Important result: Barro consumers are like a life-cycle model with
infinitely lived agents with perfect foresight:
There will be no impact of anticipated taxes (or deficits) on consumption or on
aggregate demand, but there is impact of government spending.
5. My take: An interesting theory, but does not hold in empirical
studies.
26
6. Debt and financial crises
“Political incentives for additional borrowing could change quickly if financial
markets began to penalize the United States for failing to put its fiscal house
in order.
If investors become less certain of full repayment or believe that the country is
pursuing an inflationary course that would allow it to repay the debt with
devalued dollars, they could begin to charge a “risk premium” on U.S.
Treasury securities. That could happen suddenly in a confidence crisis and
ensuing financial shock.
There is precedent for a financial disruption first contributing to large, chronic
deficits and then in some cases contributing to the loss of investor
confidence and even to a default on a nation’s debt.
[However,] the unique position of the United States—because of its economic
dominance and the dominant role of the dollar internationally—make it
difficult to extrapolate from the experience of other nations in estimating
the risk or timing of a financial crisis arising from failure to address the
projected U.S. fiscal imbalance.
[National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009]
27
A less nuanced view
“When the markets lose confidence in a country, they act swiftly
and they act decisively. Look at Greece, look at Portugal, look
at Ireland, look at Spain. If they markets lose confidence in
this country and we continue to build up these enormous
deficits and debt, they will act swiftly and decisively.”
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Country crises as bank runs
Problem with financial crisis is that have an additional risk element, where
i
risky
 i
riskfree

where  = risk premium on country debt. New stable debt is
  / t   0  (i riskfree    g )   / Y
So again assuming that i  g , now primary surplus ( ) must be higher:
 / Y  
Problem arises because have an unstable equilibrium where country’s liquid
liabilities >> its liquid assets.
A higher debt → higher probability of default → higher δ → requires more
budget cuts and less likely to pay → higher δ → eventually the country
decides to default or restructure.
Examples:
• Greece β=1.4. If markets put δ=5%, primary surplus ratio must be 7% of
GDP. If Greeks start revolting, δ=10%, then required surplus goes to 14% of
GDP. So have a good and bad equilibrium like bank runs.
29
Probability of default (from credit default swaps*)
970
373
40
* Interpretation: a “100 basis point” = “1 percent per year” = 1 percent per year implicit
probability that the bond will fail or default.
Two
Views
the Great
(I):
7. The
two
faces of
of saving
andUnraveling
the deficit dilemma
Soft Landing
What is the effect of deficit reduction on the economy?
1. In short run:
• Higher savings is contractionary
• Mechanism: lower S, lower AD, lower Y (straight Keynesian
effect)
2. In long-run, neoclassical growth model
• Higher savings leads to higher potential output
• Mechanism: higher I, K, Y, w, etc. (through neoclassical growth
model)
Dilemma of the deficit: Should we raise G today or lower G?
32
Impact of fiscal stimulus
AS’
AS
Price (P)
?
AD’
AD
Real output (Y)
The dilemma of the deficit
Compare (1) a full employment deficit spending program with
(2) a balanced budget program
This numerical example combines our AS-AD and Solow models:
Output ratios for two programs:
fiscal stimulus v balanced budget
1.15
1.10
1.05
Notes:
1. Actual output is
higher for the entire
period
2. Potential output is
lower for Keynesian
program
1.00
Ratio actual outputs
0.95
Ratio potential outputs
0.90
2010
2015
2020
34
The dilemma of the deficit
But have higher debt-GDP ratio for long time
Debt-GDP ratios
fiscal stimulus v balanced budget
0.90
0.80
0.70
0.60
0.50
0.40
0.30
Debt-GDP FE
0.20
Debt-GDP Balanced budget
0.10
0.00
2010
2015
2020
2025
35
Conclusions on Fiscal Policy
• Central impact of fiscal policy is on potential economic
growth through impact on national savings rate.
• Insolvency and Irish crisis probably not a genuine risk
for the US in the near term.
• But in recessions, need to remember that country needs
less saving, not more saving, in the short run.
36