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Deficits And Debt
Chapter 19
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Laugher Curve
How many neoclassical economists
does it take to change a lightbulb?
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Laugher Curve
How many neoclassical economists
does it take to change a lightbulb?
It depends on the wage rate.
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Chapter Objectives
 Define
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the terms deficit and debt.
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Chapter Objectives
 Define
the terms deficit and debt.
 State why economists focus on financial
health rather than on deficits.
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Chapter Objectives
 Explain
why, in an expanding economy,
a government can run a limited, but
continual, deficit without serious
concern about the consequences.
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Chapter Objectives
 Differentiate
between a real deficit and
a nominal deficit.
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Chapter Objectives
 Explain
why, even though the real
budget deficit of the United States is
much lower than the nominal deficit,
there is still reason for concern about
the deficit.
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Chapter Objectives
 Explain
why there are alternative
reasonable views about the deficit.
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U.S. Government Deficits
and Debt
 Introductory
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Definitions
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U.S. Government Deficits
and Debt
 Introductory

Definitions
A deficit is a shortfall of incoming revenues
under outgoing payments—it is a flow
concept.
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U.S. Government Deficits
and Debt
 Introductory

Definitions
If revenues exceed payment, you are
running a surplus.
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U.S. Government Deficits
and Debt
 Introductory
Definitions
If revenues exceed payment, you are
running a surplus.
 If the opposite happens, you are running a
deficit.

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U.S. Government Deficits
and Debt
 Introductory

Definitions
Debt is accumulated deficits minus
accumulated surpluses—it is a stock
concept.
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U.S. Government Deficits
and Debt
 Introductory

Definitions
As debt accumulates, governments must
borrow to pay the interest.
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U.S. Government Deficits
and Debt
 Why
has the U.S. consistently run
deficits since World War II?
Irwin/McGraw-Hill
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U.S. Government Deficits
and Debt
 Why
has the U.S. consistently run
deficits since World War II?

The reason is a change in macroeconomic
policy regimes—the general set of rules
that governs the monetary and fiscal
policies that a nation follows.
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U.S. Government Deficits
and Debt
 Why
has the U.S. consistently run
deficits since World War II?

Keynesians, in arguing in favor of deficit
spending, removed its stigma.
Irwin/McGraw-Hill
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U.S. Government Deficits
and Debt
 Why
has the U.S. consistently run
deficits since World War II?

As deficits grew, they were blamed for its
growth.
Irwin/McGraw-Hill
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U.S. Government Deficits
and Debt
 Why
has the U.S. consistently run
deficits since World War II?

The modern Classical supply-side regime
of the 1980s, resulted in even greater
deficits than those run up by the
Keynesians.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

The Gramm-Rudman-Hollings Act of 1985
established mandatory deficit targets for
the U.S. in an effort to meet public
demands for their elimination.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

Since the law proved ineffective, the
Budget Enforcement Act of 1990 was
enacted.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

The Budget Enforcement Act of 1990 put
caps on certain aspects of federal spending,
and established a pay-as-you-go test for
new spending or tax cuts.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

Up until 1996, any new legislation, except
for emergencies, must be accompanied by
offsetting tax increases or spending cuts.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

As these laws, and others proved weak,
some politicians demanded a balanced
budget amendment to the Constitution.
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U.S. Government Deficits
and Debt
 The
public dislikes both deficits and
debt.

It was felt that without the amendment,
American politics lacks the political will to
prevent deficit spending.
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U. S. Budget Deficits
$300
Dollars (in billions)
Dollars (in billions)
200
100
Surplus
0
Deficit
–100
–200
–300
–400
1950
1960
1970
1980
1990
2000
2010
Years
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U. S. Government Debt
$5,500
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1950
1960
1970
1980
1990
2000
2010
Years
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness
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in Defining Deficits
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Deficits
How one defines a revenue and an
expenditure is crucial.
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Deficits
Should capital equipment be charged off
completely the year it was bought or be
depreciated over its useful life?
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Deficits
Should the gain in the market value of an
issued U.S. government obligation be
counted as additional revenue or ignored?
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Deficits
Putting aside the issue of “cooking the
books,” reasonable people can disagree on
how to handle government revenue and
expenditures.
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Economists’ Way of Looking
at Deficits and Debt
 Deficits As
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a Summary Measure
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Economists’ Way of Looking
at Deficits and Debt
 Deficits As

a Summary Measure
The deficit is a summary measure of the
financial health of the economy—a single
figure.
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Economists’ Way of Looking
at Deficits and Debt
 Deficits As

a Summary Measure
Therefore, to understand the summary,
you must understand the logic used to
calculate it.
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Economists’ Way of Looking
at Deficits and Debt
 The
Need to Judge Deficits Relative to
Assets
Irwin/McGraw-Hill
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Economists’ Way of Looking
at Deficits and Debt
 The
Need to Judge Deficits Relative to
Assets

Debt, being a summary measure of a
nation’s accumulated deficits, has even
more problems than deficits.
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Economists’ Way of Looking
at Deficits and Debt
 The
Need to Judge Deficits Relative to
Assets

Debt is only half the picture—the other half
being assets.
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Economists’ Way of Looking
at Deficits and Debt
 The
Need to Judge Deficits Relative to
Assets

Debt must be judged in its relation to
assets.
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness
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in Defining Debt
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Debt
Assets and debt are subject to varying
definitions.
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Economists’ Way of Looking
at Deficits and Debt
 Arbitrariness

in Defining Debt
There is no perfectly objective and
universal way of defining how debt and
assets should be valued.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Government debt is different than an
individual’s debt.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Since government is ongoing, it never has
to settle its accounts as when an individual
dies.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Governments can pay off debt by creating
money.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Much of government debt is internal
government debt, debt owed to its own
citizens.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

This means that the government must
collect taxes to pay the debt which is giving
to the debt holders as income.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Not counting the distribution effects (the
same people may not be involved) the
nation is neither richer nor poorer.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

External government debt on the other
hand is debt owed individuals in foreign
nations.
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Economists’ Way of Looking
at Deficits and Debt
 Difference
Between Individual and
Government Debt

Paying interest on it means a net reduction
in domestic income.
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Economists’ Way of Looking
at Deficits and Debt
 Deficits,
Debt, and Debt Service
Relative to GDP
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Economists’ Way of Looking
at Deficits and Debt
 Deficits,
Debt, and Debt Service
Relative to GDP

Government deficits and debt relative to
GDP is less alarming compared to
government deficits and debt in absolute
terms.
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Economists’ Way of Looking
at Deficits and Debt
 Deficits,
Debt, and Debt Service
Relative to GDP

Measuring deficits and debt relative to
GDP highlights a nation’s productive
capacity relative to debt management.
Irwin/McGraw-Hill
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Economists’ Way of Looking
at Deficits and Debt
 Deficits,
Debt, and Debt Service
Relative to GDP

Although the absolute size of the deficits
and debt have grown since World War II,
their importance relative to GDP have not.
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Deficits as percentage of GDP
Budget Deficits as a Percentage
of GDP
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10
0
–10
–20
–30
19001910 1920 1930 1940 1950 1960 1970 1980 1990
Years
© The McGraw-Hill Companies, Inc., 1998
Debt as a Percentage of GDP
Debt as percentage of GDP
100
75
50
25
0
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Years
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Economists’ Way of Looking
at Deficits and Debt
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Economists’ Way of Looking
at Deficits and Debt
 Economists
are also concerned about
the interest rate paid on debt.
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Economists’ Way of Looking
at Deficits and Debt
 Economists
are also concerned about
the interest rate paid on debt.

Debt service is the interest rate on debt
times the total debt.
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Economists’ Way of Looking
at Deficits and Debt
 Economists
are also concerned about
the interest rate paid on debt.

Debt service as payment for past
expenditures puts a burden on future
generations.
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Economists’ Way of Looking
at Deficits and Debt
 Economists
are also concerned about
the interest rate paid on debt.

Debt service payments relative to GDP
suggests that it is a greater problem than
the debt/GDP measure, but less of a
problem than absolute debt.
Irwin/McGraw-Hill
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Economists’ Way of Looking
at Deficits and Debt
 Economists
are also concerned about
the interest rate paid on debt.

The U.S. can actually afford more debt
since U.S. government securities are
considered the safest in the world.
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Federal Interest Payments
Relative to GDP
3.5%
Interest payments as
percentage of GDP
3.0
2.5
2.0
1.5
1.0
0.5
0
1945
1955
1965
1975
1985
1995
2005
Years
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GDP Growth Reduces
Problems Posed by Deficits
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GDP Growth Reduces
Problems Posed by Deficits
 Structural
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Deficits, Cycles and Growth
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GDP Growth Reduces
Problems Posed by Deficits
 Structural

Deficits, Cycles and Growth
As aggregate income increases, tax
revenues increase and the deficit declines.
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GDP Growth Reduces
Problems Posed by Deficits
 Structural
Deficits, Cycles and Growth
As aggregate income increases, tax
revenues increase and the deficit declines.
 The opposite occurs as aggregate income
falls.

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GDP Growth Reduces
Problems Posed by Deficits
 Structural

Deficits, Cycles and Growth
The structural deficit is the deficit that
would remain when these cyclical elements
have been netted out.
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GDP Growth Reduces
Problems Posed by Deficits
 Structural
Deficits, Cycles and Growth
The structural deficit is the deficit that
would remain when these cyclical elements
have been netted out.
 This would result in an economy at its
potential income.

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GDP Growth Reduces
Problems Posed by Deficits
 Real
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Growth and the Deficit
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GDP Growth Reduces
Problems Posed by Deficits
 Real
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Growth and the Deficit
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GDP Growth Reduces
Problems Posed by Deficits
 Real

Growth and the Deficit
Some argue that as long as the economy is
growing in real terms, and the debt/GDP
ratio is maintained, the debt can grow
without deleterious effects.
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GDP Growth Reduces
Problems Posed by Deficits
 Real

Growth and the Deficit
Others argue that the debt-GDP ratio is
already too high and should be brought
down.
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,
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Debt, and the Real Deficit
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
Inflation wipes out debt.
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
The larger the debt and the larger the
inflation, the more debt will be eliminated
with inflation.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
If inflation is wiping out debt, and the
deficit is equal to the increases in debt from
one year to the next, inflation also affects
the deficit.
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
A nominal deficit is the deficit determined
by looking at the difference between
expenditures and receipts.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
A real deficit is the nominal deficit
adjusted for inflation’s effect on the debt.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and the Real Deficit
A real deficit is the nominal deficit
adjusted for inflation’s effect on the debt.
real deficit = nominal deficit - (inflation x total debt)
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,
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Debt, and Nominal Deficits
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and Nominal Deficits
Inflation wipes out debt, and that fact must
be considered when evaluating the effect of
a deficit.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and Nominal Deficits
Inflation is not a costless answer to
eliminating debt.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Inflation,

Debt, and Nominal Deficits
The government’s gain from an inflation is
the private bond holder’s loss from
inflation.
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GDP Growth Reduces
Problems Posed by Deficits
 Nominal
and Real Interest Rates and
Deficits
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Nominal
and Real Interest Rates and
Deficits

Expectations of inflation push up the
nominal interest rate and cause bond
holders to demand an inflation premium
on their bonds.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Nominal
and Real Interest Rates and
Deficits

Future expectations of inflation causes the
real interest rate to be different form the
nominal interest rate.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Nominal
and Real Interest Rates and
Deficits

If bond holders don’t lose when they make
a full adjustment for expected inflation,
government cannot win.
Irwin/McGraw-Hill
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GDP Growth Reduces
Problems Posed by Deficits
 Nominal
and Real Interest Rates and
Deficits

With full adjustments in expectations,
creditors don’t lose. See numerical
example on page 473 of the textbook.
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Summary to This Point
 Deficits
are summary measures of the
state of the economy.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Summary to This Point
 Deficits
are summary measures of the
state of the economy.
 They are dependent on the accounting
procedures used.
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© The McGraw-Hill Companies, Inc., 1998
Summary to This Point
 It
is the financial health of the economy,
not the deficit, with which we should be
concerned.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Summary to This Point
 Deficits
and debt should be viewed
relative to GDP to determine their
importance.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Summary to This Point
 The
real deficit is the nominal deficit
adjusted for the inflation reduction in the
real debt.
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Reasons for Concern About
Budget Deficits
 The
U.S. does not include many
government obligations.
Irwin/McGraw-Hill
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Reasons for Concern About
Budget Deficits
 The
U.S. does not include many
government obligations.

The U.S. uses a cash flow accounting
system—an accounting system entering
expenses and revenues only when cash is
received or paid out.
Irwin/McGraw-Hill
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Reasons for Concern About
Budget Deficits
 The
U.S. does not include many
government obligations.

The cash flow accounting system leads to a
number of distortions in the budget and
deficit.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Reasons for Concern About
Budget Deficits
 The
U.S. does not include many
government obligations.

A number of government obligations do
not show up as part of the deficit.
Irwin/McGraw-Hill
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Reasons for Concern About
Budget Deficits
 The
government uses accounting tricks
to make the deficit look smaller.
Irwin/McGraw-Hill
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Reasons for Concern About
Budget Deficits
 The
government uses accounting tricks
to make the deficit look smaller.

In the S&L bailout, the government
increased insurance fees on member
institutions and counted them as revenue.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Reasons for Concern About
Budget Deficits
 The
government uses accounting tricks
to make the deficit look smaller.

Since they were not nearly enough to cover
the costs, the government sold special
bonds which were not counted as
expenditures.
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Reasons for Concern About
Budget Deficits
 The
government uses accounting tricks
to make the deficit look smaller.

These are called off-budget expenditures,
expenditures of money that are not
counted as expenditures in the budget.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Funded
and Unfunded Retirement
Systems
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Funded
and Unfunded Retirement
Systems

A funded pension system is one in which
money is collected and invested in a special
fund from which pension payments are
made.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Funded
and Unfunded Retirement
Systems

An unfunded pension system is one in
which pensions are paid from current
revenues.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Funded
and Unfunded Retirement
Systems

The social security system is largely an
unfunded pension system.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Funded
and Unfunded Retirement
Systems

The problem with this is that there is no
trust fund of assets earning interest to
cover future payments.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems

The potential problem is that the amount
paid out exceeds the amount paid in.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems

As long as each succeeding generation
remains about the same size, the process
works.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems


If there is a baby boom generation, followed by
normal-sized generations, when the baby boomers
begin to retire, there is not enough money being
paid into the system to sustain them.
There are a number of ways to deal with this.
 Partially fund the system.
 Raise the retirement age.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 Social

Security and the Budget Deficit
The government responded to the
unfunded social security system by raising
the retirement age slightly and legislating a
large increase in the rate of social security
contributions.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems

The tax increase was to fund a large trust
fund.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 A Potential
Problem With Unfunded
Systems

Unfortunately, deficit spending grew apace
so the government was forced to finance
the trust fund by issuing bonds as a
promise to pay for funding the trust fund.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 An Alternative
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 An Alternative

Raise the eligibility age so that by 2010, it
will stand at 70 years.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 An Alternative

Lower the current social security tax rates
by 10 percent.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Social Security
Retirement System
 An Alternative

The effect would be an increase in the
current budget deficit accompanied by an
increase in U.S. financial strength.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative
Irwin/McGraw-Hill
Views of the Deficit
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative

Views of the Deficit
The wolf-at-the-door group believes that
the deficit will bring about imminent
doom.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative
Views of the Deficit
The wolf-at-the-door group believes that
the deficit will bring about imminent
doom.
 Few economists belong to this group.

Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative

Views of the Deficit
The domesticated-pussycat group believes
that the deficit does not matter.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative
Views of the Deficit
The domesticated-pussycat group believes
that the deficit does not matter.
 A small but vocal group belong to this
group.

Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative

Views of the Deficit
The termites-in-the-basement group
believes that continuing deficits will cause
serious problems in the long run.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Three Alternative
Views of the Deficit
The termites-in-the-basement group
believes that continuing deficits will cause
serious problems in the long run.
 The largest number of economists belong
to this group.

Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s
Irwin/McGraw-Hill
Right?
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s
Irwin/McGraw-Hill
Right?
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s

Right?
The Proxmire letter mirrors the views of
most lay people’s views of the deficit.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s

Right?
Eisner’s response represents the views of
liberal Keynesian economists, of which he
is one.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s

Right?
Some Classical economists believe deficits
don’t matter because people are rational
and fully discount future tax payments
deficits would entail.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s

Right?
The Modigliani/Solow response to Eisner
argues that the deficits are gnawing away
at the structure of the economy.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Deficit Debate: Wolves,
Pussycats, or Termites
 Who’s

Right?
The economy is fundamentally sick and
using slick accounting Band-Aids will not
cure the illness.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Comparisons of Government
Debt to GDP
A pproximate ratios of government debt to GDP
120%
Italy
100%
Canada
92%
Japan
67%
United States
60%
Germany
50%
United Kingdom
Sw itzerland
15%
A ustralia
15%
Source: World Economic Outlook, 1996
(International Monetary Fund).
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998