Module 9: Budget Deficits and the National Debt

National Debt is Divided into Two Types

*Federal debt*: debt owned by various sectors of the government. The two government groups that own federal debt are the Social Security Trust Fund and the Federal Reserve (printing money), mostly SS, 5-10% fed reserve aka the US central bank. Can't print too much money or inflation and exchange rates suffer. *Public debt*: debt owned by nongovernment groups. Over 50% of the debt is public debt. // % of GDP is public debt ratio only or else it would be over 100.

Another major debt obligation that is not included in the federal debt is

*unfunded liabilities*. These are promises the government has made for future payments, but that the government does not have the funds available to pay for. Social Security payments and Medicare are unfunded liabilities. When Social Security runs a surplus (more is collected in social security taxes than is paid out in Social Security benefits), it is "loaned" to the rest of the government to pay for other current year expenditures. Depending on the year, unfunded liabilities are between $95 to $119 trillion. Government has been using past contributions to Medicare to fund medical expenses for past retirees. The medical expenses of those who are retiring now must be funded out of money that has not yet been collected.

An increase in the budget deficit is expected to ___ interest rates, so funds will be ___ from abroad. The inflow of funds will cause the demand for U.S. dollars to ___, driving the price of the dollar in terms of foreign currency ___.

An increase in the budget deficit is expected to *INCREASE* interest rates, so funds will be *ATTRACTED* from abroad. The inflow of funds will cause the demand for U.S. dollars to *INCREASE*, driving the price of the dollar in terms of foreign currency *HIGHER*. /// An increase in the budget deficit means government's demand for loans increases, causing the equilibrium interest rate to rise. High interest rates attract foreign money, so foreign investors seek to convert their currencies into dollars. Stronger demand for dollars causes the equilibrium price of the dollar to increase.

Countries that have filed for bankruptcy

Argentina in 2001 and Iceland in 2008. // The difference between a national government and a household, firm, or local government is the *power to tax a broad range of people* in order to raise funds to pay off debts. // For nations, any *threat of bankruptcy comes from abroad*. If a national government finances its spending through foreign loans, then it may be unable to come up with the "hard currency" (acceptable foreign currencies) to repay them.

If most government bondholders are rich, reducing spending on government welfare programs to repay the debt then it would

It would redistribute income from the poor to the rich. // When the government repays its debt, it must raise taxes or cut spending, which changes the amount of a household's income. Taxes or spending cuts will lower poor household's income, while repayment will add to the bondholders, who are mostly rich.

PROS of reducing the national debt

Lower interest rates making consumption and business borrowing easier. Reduce the price of the dollar stimulating exports and curtailing imports. More private spending with less government competition. Less government means more freedoms.

Real Deficit

Measures the federal budget deficit as the change in the real (inflation-adjusted) value of the national debt from one year to the next.

Obstacles to Deficit Reduction

Must raise taxes or spend less. This is a form of contractionary fiscal policy so aggregate demand shifts left. *Politics*: politicians that do either are very unpopular and lose future elections. *Economy*: higher taxes or cutting programs increases unemployment and other problems. Then the automatic stabilizers kick in and transfer payments get bigger and no money was actually saved to pay down the debt.

No balanced budget

Other economists wanted to throw out the whole idea of balancing the budget and simply let a surplus or deficit emerge from the need to stabilize the economy. The problem with this approach was that it ignored the importance of putting some limits on government spending.

In 1983, the Social Security system was reformed because

Policymakers noted that there would have to be increased outlays in the period after the year 2000, as the baby boomers began to reach retirement age.

Difficulties with getting the national budget to match the final deficit

When Congress enacts a budget, it does not legislate a level of revenue but rather *a tax structure* that will yield varying amounts of revenue under varying economic conditions...... *Automatic stabilizers* are hard to predict. Some programs are budgeted based on *estimated eligible participants* so more participants means more money (CHIP, Medicare, Veterans, SS). *Inflation* affects tax revenue through cost of living increases and more people in lower tax brackets. *Output*. *Employment*. *Interest rates* affect how much the government pays in interest.

Ricardian Equivalence

When a country runs a *large debt*, the citizens will *assume that tax rates* will increase in the future and will prepare for it by *increasing their savings rate*. The increase in savings will *decrease private spending*, *offsetting the deficit spending* the government is doing to stimulate the economy. // Keynesian economists do not believe households take future tax rates into consideration when thinking about their current spending.

Internationalizing the debt

When foreigners own another country's debt.

The actual deficit is not known until

after the fiscal year is over.

Currently, interest payments represent __% of the federal budget

between 7%-9% of the federal budget. As the debt grows larger, the share of the budget devoted to interest payments increases. The U.S. taxpayers are responsible for paying this expense.

When economists want to measure the direction of fiscal policy, they look at

changes in the *high-employment* budget surplus or deficit rather than the actual deficit. An expansionary policy would increase the high-employment budget. The adoption of a high-employment balanced budget as a policy goal was a major victory for Keynesian ideas.

In selling bonds, the government

competes for funds in the credit market, possibly driving up interest rates for all borrowers. This is indirect crowding out. Private sector borrowers, such as a corporation seeking to finance a new factory, are less able to borrow when government borrows available funds and causes higher interest rates.

If output falls far below full employment, progressive income taxes and transfer programs will

create a deficit as tax revenues fall and transfer payments rise. But these changes will help increase spending and output. These automatic stabilizers help to smooth out the ups and downs of the business cycle.

During a period of inflation, the real value of the debt

decreases. Inflation causes the value of the currency to fall, so while the amount of money owed has stayed the same, the real value of the money owed has fallen.

An annually balanced budget would

force Congress to collect taxes to pay for spending programs and thus restrict the growth of government. It would not allow the use of any kind of fiscal policy.

The effects, whether they are positive or negative, depend on three factors:

how large the debt is relative to the size of the economy, who owns the debt, and what the money was spent on to create the debt.

What causes a large debt to be *NEGATIVE* for an economy

if the debt is large relative to the size of the economy, if it is owned primarily by foreigners, and if it was spent on current consumption.

Potential output

is another name for the output the economy could produce if all its resources were fully employed. Both structural deficit and cyclical deficit concepts take their meaning from the comparison of potential output to actual output.

If actual output is equal to potential output, the cyclical deficit

is zero.

When the Federal Reserve buys federal debt, it is

monetizing the debt. // The Federal Reserve is able to pay for government bonds using newly created money, which increases the money supply.

When foreign investors lose confidence in a nation's ability to repay the loans, they will

no longer want to hold that country's debt. The currency will *depreciate*; *increased interest rate* on government bonds. This will *increase the interest payments* creating a *larger burden for taxpayers*. It will also *decrease private borrowing*, as the higher interest rates will crowd out the private borrowing. *Inflation will increase* as the *money supply in the nation will also increase* as foreigners no longer want to hold the country's currency.

The current national debt actually understates the financial obligations of the U.S. government because

of *other obligations besides debt repayment* that could prove costly in the near future. The *federal government has guaranteed* not only the safety of deposits in federally insured banks, but also mortgage loans, student loans, and other private-sector borrowing. Because bank failures have been higher than expected throughout the 2000s, these guarantees have been a serious drain on the treasury.

If a deficit exists then there are

other possible explanations other than expansionary fiscal policy. For example, a deficit could be the result of a downturn since reduced income means reduced tax collections. The deficit may simply be the result of automatic stabilizers and recessionary conditions.

If the government must cut spending on welfare programs in order to repay the national debt, then the

people who would benefit from those spending programs will essentially be "taxed" to pay back the debt.

If funds are borrowed by the government during a period when the economy is close to full employment, then

resources may be diverted away from productive investment. Interest rates rise and the consumer and business markets are crowded out.

A trade deficit means

that Americans bought more currently produced goods and services from foreigners than they sold to the rest of the world. A trade deficit also means that net exports are negative, depressing aggregate expenditures and aggregate demand so that output, employment, and prices are lower than they would otherwise be. The budget deficit is also blamed for a higher trade deficit, which means an excess of imports over exports in the balance of payments.

Comparing the size of the debt to the size of

the economy by using the *percentage of GDP* is more meaningful than just looking at the absolute value of the debt because *the capacity to repay the debt grows as the economy grows*.

When the Federal Reserve buys government bonds,

the money supply increases. // The Federal Reserve is able to create new money to pay for bonds, and purchasing bonds puts new money into circulation, so the money supply increases.

During what might be considered the heyday of Keynesian policy—the period from 1960 to 1980—the national debt

tripled from $290.5 billion to $908.5 billion, even though the debt did decline as a share of GDP.

PROS of Running Deficits

Allows for more government spending. Allows for reduced taxes which helps the economy. Funding transfer payments is good for the economy. Higher interest rates, which means, lending funds are attracted from abroad. Inflation causes the debt to fall.

Entities that are truly off-budget

Today there are only two entities that are truly off-budget: Social Security and the U.S. Postal Service. The Federal Reserve System and various government-sponsored enterprises such as Fannie Mae and Freddie Mac have always been off-budget.

The Structural Deficit and the Cyclical Deficit

Transfer payments would automatically adjust during recessions and booms and balance out in the long run. The goal being that if the economy were producing at Y* (full employ), even with no action by Congress, there might not be a deficit. What policy makers need to look at is not the actual deficit but what the deficit would be at Y*.

History of Budget Deficits before 1970

US began with a national debt by printing money it could not take taxes on during the 1978 Revolutionary War. Fully repaid by 1830. // Ran surpluses for much of the 19th century. Deficits before 1930's were small except for the Civil War and WW1 financing. 1929 before the crash $17B, 16% of GDP. 1939 drop in GDP and outbreak of the war $48B, 55%. End of WW2, $260B, 122%. Debt started growing slower than the GDP.

The deficits of the 1970s and 1980s

Were incurred even during years when the economy was booming. // Were largely due to political decisions: the expansion of spending programs and several cuts in taxes. // Not caused by Keynesian policies.

When the debt/GDP ratio is over 90%, there is approximately a

1% decrease in the growth rate. Small differences in growth rates over time lead to large differences in GDP due to compounding.

Federal Budget Deficit

A *flow variable* is measured over a time period (P&L). A deficit is the amount by which the federal government's expenditures exceed its revenues in a given year (the federal fiscal year runs from October 1 to September 30).

National Debt

A *stock variable* is measured at a specific point in time (balance sheet). The cumulative total of all past budget deficits minus all past surpluses. It is the amount owed to lenders by the federal government at any point in time.

Gives policymakers a goal to work toward

A budget that balances at full employment.

A high price for the dollar makes exports ___ and imports ___, resulting in a ___, assuming imports and exports were balanced from the start.

A high price for the dollar makes exports *MORE EXPENSIVE* and imports *CHEAPER*, resulting in a *TRADE DEFICIT*, assuming imports and exports were balanced from the start. /// Domestic firms that export goods and services are paid in dollars, so foreign consumers must pay more for dollars and for U.S. exports. A stronger dollar purchases more foreign currency, effectively reducing the dollar price of goods and services sold in foreign countries. Since exports are more expensive, exports will decrease; since imports are cheaper, imports will increase. Lower exports and higher imports lead to a trade deficit.

PROS of Running a Large Debt

Depending on where the money is spent it could improve the economy, productivity, and standard of living. Paying down the debt can be painful.

CONS of Running Deficits

Higher interest rates, which means, harder to borrow, more imports, less exports, worse exchange rates, higher inflation rate. Higher deficit means more government crowding out.

CONS of Running a Large Debt

If a country already has a large debt, it may be hard to use fiscal policy and run a deficit during a recession / depression. Causes a reduction in growth. Decreased confidence of foreign investors could really hurt the economy. Consumers could reduce spending if they are concerned about it. Burden on this generation by lost consumption and burden on future generations.

What causes a large debt to be *POSITIVE* for an economy

If the debt level is small relative to the size of the economy, if the debt is owned primarily by citizens of the country, and if the debt was spent on items that will improve a country's productivity, the effects will be positive for an economy.

If the government ___ money to ___ the productive capacity of the economy and puts ___ resources to work, then future generations will inherit a ___ capital stock and enjoy a higher output.

If the government BORROWS money to EXPAND the productive capacity of the economy and puts IDLE resources to work, then future generations will inherit a LARGER capital stock and enjoy a higher output. /// The government increases spending by borrowing. Production capacity is expanded by increasing the use of resources. A larger capital stock will produce a higher output.

External Debt

Slightly more than 50% of the public debt owed to individuals is owed to foreigners (individuals and governments). Repaying them is transferring funds and goods out of our economy. Repaying the debt to foreigners is a burden that will fall on future generations.

Business cycle balanced budget / a cyclically balanced budget

Some Keynesian economists suggested, instead, that the budget should be balanced over the course of the business cycle. Surpluses during the expansion phase of the business cycle would offset deficits incurred in the recession phase. A cyclically balanced budget was a nice idea in theory but hard to apply in practice. For example, a prolonged recession followed by a weak and brief expansion would generate a large deficit and then a small surplus.

the largest U.S. city to attempt to file for bankruptcy

Stockton, California, in June 2012.

Cyclical Deficit

That part of a deficit that is due to a downturn in economic activity.

Structural Deficit

The part of a deficit that would persist even if the economy were at the full-employment level. A structural deficit of zero would reflect the goal of policy makers in the 1960s and 1970s, and suggest that fiscal policy is neutral. A deficit greater than zero would imply the direction of fiscal policy is expansionary, while a deficit less than zero would imply that fiscal policy is contractionary.