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? 2

Learning Objectives n Explain how federal government budget deficits occur n Define the public debt and understand alternative measures of the public debt n Evaluate circumstances under which the public debt could be a burden to future generations 3

Learning Objectives n Discuss why the federal budget deficit might be measured incorrectly n Analyze the macroeconomic effects of government budget deficits n Describe possible ways to reduce the government budget deficit 4

Chapter Outline n Public Deficits and Debts n Government Finance n Evaluating the Rising Public Debt n Federal Budget Deficits in An Open Economy n Growing U. S. Government Deficits 5

Did You Know That. . . n Throughout the rest of this decade, the U. S. federal government expects to run annual budget deficits? n The relationship between budget deficits and macroeconomic performance is somewhat elusive? 6

Public Deficits and Debts n 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) 7

Public Deficits and Debts n The federal deficit is a flow variable, one defined for a specific period of time, usually one year 8

Public Deficits and Debts n If spending equals receipts, the budget is balanced. n If receipts exceed spending, the government is running a budget surplus. 9

Public Deficits and Debts n The public debt – A stock variable – The total value of all outstanding government securities 10

Government Finance n Since 1940, the U. S. federal government has operated with a budget surplus in 13 years. n In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing. 11

Government Finance Figure 14 -1 12

Evaluating the Rising Public Debt n 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 n Tax revenues tend to be stagnant during times of slow economic growth. n Tax revenues grow more quickly when overall growth enhances incomes. n As long as spending exceeds revenues, the budget deficit will persist. 14

Evaluating the Rising Public Debt Table 14 -1 15

Evaluating the Rising Public Debt n The government must pay interest on the public debt outstanding. n The level of these payments depends on the market interest rate. n Interest payments as a percentage of GDP are likely to rise in the future. 16

Evaluating the Rising Public Debt n As more of the public debt is held by foreigners, then the amount of interest to be paid outside the U. S. increases. n The presence of the debt may place a burden on future generations. 17

Evaluating the Rising Public Debt n If the economy is already at full employment, then further provision of government goods will crowd out some private goods. n Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector. 18

Evaluating the Rising Public Debt n 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 19

Policy Example: Jefferson and Hamilton on the Public Debt n Jefferson argued that it was unfair to place the burden of public debt on future generations. n He favored an annually balanced government budget. 20

Policy Example: Jefferson and Hamilton on the Public Debt n Alexander Hamilton, the first U. S. Treasury Secretary, argued that a nation which handled a debt responsibly could build a reputation for creditworthiness. n He concluded that there could be a blessing in a national debt that was not excessive and was repaid on time. 21

Evaluating the Rising Public Debt n 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. 22

Federal Budget Deficits in An Open Economy n Is there a connection between the U. S. trade deficit and the federal government budget deficit? n A trade deficit exists when the value of imports exceeds the value of exports. n There is a statistical correlation between the two. 23

Federal Budget Deficits in An Open Economy Figure 14 -4 24

Federal Budget Deficits in An Open Economy n 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. n The interest rate paid on bonds will need to be high enough to attract foreign investors. 25

Federal Budget Deficits in An Open Economy n 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. n This shows that a U. S. budget deficit can contribute to a trade deficit. 26

Growing U. S. Government Deficits n There is some debate among economists and policymakers as to what should be considered the best measure of the deficit. 27

Growing U. S. Government Deficits n Most businesses use two budgets: – An operating budget – A capital budget 28

Growing U. S. Government Deficits n An operating budget includes current outlays for on-going expenses, such as salaries, supplies, utilities, etc. 29

Growing U. S. Government Deficits n A capital budget includes expenditures on investment items, such as a new building or implementation of new technology. n These are generally items that are expected to have a life of many years. 30

Growing U. S. Government Deficits n 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. 31

Growing U. S. Government Deficits n 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. 32

Growing U. S. Government Deficits n Some economists argue that Congress should establish a separate capital budget which would include investment expenditures. n This might give a more accurate reflection of the deficit. 33

Growing U. S. Government Deficits n Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure. 34

Growing U. S. Government Deficits n Deficit estimates are produced both by the Office of Management and Budget and by the Congressional Budget Office. n 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. 35

Growing U. S. Government Deficits n There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers. n 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. 36

Growing U. S. Government Deficits n 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. 37

Growing U. S. Government Deficits n 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. 38

Growing U. S. Government Deficits n How could the deficit be reduced? – Either by increasing taxes or by reducing government spending – Both of these solutions involve political realities 39

E-Commerce Example: Internet Taxes n Some state governments have considered imposing taxes on internet transactions as a means of supplementing their budget revenues. n Estimates show that, at best, this would cover about 25 percent of deficits experienced at the state level. 40

Growing U. S. Government Deficits n In considering how expenditures might be reduced, it is important to look at entitlements. n These are federal government payments that are legislated obligations, and cannot be reduced or eliminated. n Entitlements include Social Security, Medicare, and Medicaid. 41

International Policy Example: Unrealized Public Debts n 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. n 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. 42

Growing U. S. Government Deficits n Entitlements are the largest component of the U. S. federal budget. n To make a significant cut in expenditures, entitlement programs would have to be revised. n What are the political costs of reducing Social Security and Medicare benefits? 43

Issues and Applications: International Cycles in Deficits n 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. n In part, this is because the business cycles of all these economies are closely aligned. 44

Issues and Applications: International Cycles in Deficits n 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. n And further, stock market trends that are internationally correlated affect the amount of capital gains tax that can be collected by each federal treasury. 45

Summary Discussion of Learning Objectives n 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. n The public debt: – Total value of all government bonds outstanding – Net public debt as a share of GDP is 35 percent 46

Summary Discussion of Learning Objectives n How the public debt might prove a burden to future generations: – Higher taxes will reduce private consumption – Crowding out could reduce economic growth n 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 47

Summary Discussion of Learning Objectives n 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. 48

Summary Discussion of Learning Objectives n Possible ways to reduce the government budget deficit: – Increase taxes – Reduce expenditures by revising the terms of entitlement programs 49

End of Chapter 14 Deficit Spending and The Public Debt