Debts and Deficits Lecture 17 Debts and Deficits

Debts and Deficits Lecture 17

Debts and Deficits • Deficits (or Surpluses) are the difference between government spending (G) and government revenue (T) in a year • The National Debt is the sum of all past deficits and surpluses

Effects of the Debt - Crowding out reduces private investment - Debt finance of public investment or consumption? PART IV Further Macroeconomics Issues - Longer term redistributions - From tax payers to bondholders - From tax payers to foreigners (out of our circular flow - of income and into theirs) © 2012 Pearson Education, Inc. Publishing as Prentice Hall 3 of 24

It’s a Fertile Ground for Misinformation and Paranoia • People hate personal debt • Mistaken analogies between household debt and national debt • Nowhere is hysteria more evident than in graphs of the facts

PART IV Further Macroeconomics Issues © 2012 Pearson Education, Inc. Publishing as Prentice Hall

Use “Emergency” Colors

Scale it so it looks like a rocket taking off

Another

Use the word “DEATH”

Actually, That Last Slide Had Some Good Info • The importance of looking at debt as a percent of GDP • The long historical view and debt peaks in the past • We never did “pay down” the highest debt/GDP ratio of all • You can reduce debt/GDP two ways!

The basic debt dynamic equation • Debt = This year’s deficit plus the sum of ALL past deficits and surpluses • Put another way, Debt this year equals debt last year plus interest on that debt plus/minus any new borrowing/repayment this year (the deficit or surplus)

When is Debt/GDP Growing? • Debt/GDP is the important variable • A million dollar debt is a lot to me but not to Bill Gates • Debt relative to GDP can go down by – Paying down the debt – Increasing GDP faster than the debt

When is Debt/GDP Growing? • So if GDP growth is faster than debt growth, Debt/GDP goes down • If GDP growth rate is the same as the interest rate then debt/GDP remains constant

Some Important Implications • One important way to reduce Debt/GDP is to invest in capital so GDP grows faster • Trying to reduce Debt/GDP by cutting spending (and therefore the deficit) has a built-in problem – When you cut spending the economy slows down and this tends to increase the deficit again.

Government Deficit Issues Deficit Targeting Gramm-Rudman-Hollings Act Passed by the U. S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. FIGURE 15. 6 Deficit Reduction Targets under Gramm-Rudman-Hollings PART IV Further Macroeconomics Issues The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 24

Government Deficit Issues Deficit Targeting Deficit targeting has undesirable macroeconomic consequences. It requires cuts in spending or increases in taxes at times when the economy is already experiencing problems. PART IV Further Macroeconomics Issues Locking in spending cuts or tax increases during periods of negative demand shocks is not a good way to manage the economy. Moving forward, policy makers around the globe will have to devise other methods to control growing structural deficits. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 18 of 24

Government Deficit Issues Deficit Targeting PART IV Further Macroeconomics Issues automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP. automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 24

Government Deficit Issues Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred. PART IV Further Macroeconomics Issues Deficit Targeting FIGURE 15. 7 Deficit Targeting as an Automatic Destabilizer © 2012 Pearson Education, Inc. Publishing as Prentice Hall 20 of 24

PART IV Further Macroeconomics Issues Who Do We Owe it To? © 2012 Pearson

The Importance of the Currency You Borrow In • “If we keep running deficits we will turn into Greece, GREECE!!!! • Greece’s national debt is denominated in Euros which means they do NOT control their own monetary policy • USA’s national debt is denominated in dollars

What Do Greece and the US Have to Do to Pay Off Debt? • Greece has to run a trade surplus and/or engineer a deep enough depression to create a surplus • USA has two options - First is don’t pay off the debt until later (if ever) - Second is to monetize the debt via the Federal Reserve

Consequences of Debt Monetization • In a liquidity trap, not very many consequences. Interest Rates and Prices stuck • Suppose prices DO rise. What then? – Inflation (but we have been trying to get higher inflation for years now) – Depreciation of our currency