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Chapter 12
DEFICITS AND DEBT
WHAT IS THIS CHAPTER ABOUT?
This chapter looks at the downside of expansionary fiscal policy: deficits and debt. The federal debt is
now over $5 trillion and annual deficits often exceed $200 billion. Long-term growth could be
negatively affected as private investment is crowded out by fiscal policies. Eight out of ten voters
support a constitutional amendment to require the federal government to balance the budget. The focus
of this chapter is on the following questions:
1. How do deficits arise?
2. What harm, if any, do deficits cause?
3. Who will pay off the national debt?
KEY TERMS
Fiscal Policy
Deficit Spending
Budget Deficit
Budget Surplus
Fiscal Year (FY)
Discretionary Fiscal
Spending
Income Transfers
Automatic Stabilizers
Cyclical Deficit
Structural Deficit
Crowding Out
Opportunity Cost
Treasury Bonds
National Debt
Liability
Asset
Internal Debt
External Debt
Refinancing
Debt Service
Debt Ceiling
Debt Ceiling
Optimal Mix Of Output
OUTLINE
I. Introduction
A. This chapter looks at the deficits and debt that occur when the government uses its tax and
spending powers to boost AD, focusing on the following questions:
1. How do deficits arise?
2. What harm, if any, do deficits cause?
3. Who will pay off the national debt?
II. Budget Effects of Fiscal Policy
A. Keynesian theory highlights the potential of fiscal policy to solve macro problems.
1. Use fiscal stimulus to eliminate unemployment and fiscal restraint to control inflation.
2. The federal budget is a key policy lever for controlling the economy.
B. Budget surpluses and deficits.
1. By reducing tax revenues and increasing spending the federal government throws its
budget out of balance.
 Called deficit spending and results in a budget deficit.
 Budget deficit = government spending - tax revenues.
2. If the government spends less than its tax revenues, a budget surplus is created.
 Might arise from fiscal restraint or rapid growth of the economy.
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 Can be used to pay back deficits.
3. A string of deficits.
 From a Keynesian perspective, budget deficits and surpluses are a routine feature of
fiscal policy.
 Practice of fiscal policy has produced few budget surpluses. (See Figure 12.1.)
C. Discretionary vs. automatic spending
1. At the beginning of each year the President and Congress put together a budget blueprint
for next fiscal year.
2. Most current revenues and expenditures are a result of decisions made in prior years so
most of the budget is “uncontrollable”.
 Uncontrollables account for approximately 80% of the federal budget.
 Leaves 20% for discretionary fiscal spending.
3. Automatic transfers.
 Most uncontrollable line items’ value also changes with economic conditions.
 Outlays for unemployment compensation and welfare increase during recessions,
acting as automatic stabilizers.
 Also exist on the revenue side of the budget.
D. Cyclical deficits.
1. The size of the federal deficit is sensitive to expansion and contraction of the macro
economy. (See Table 12.2.)
2. Social Security is automatically adjusted to inflation and federal outlays increase but is
offset by inflation-swollen tax receipts.
 Offsetting expenditure and revenue almost cancel each other out. (See Table 12.2.)
3. Cyclical deficit widens when unemployment or inflation increases and shrinks when
unemployment or inflation decreases.
E. Structural deficits
1. To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural
components.
 Total budget deficit = cyclical deficit + structural deficit.
2. Structural deficit reflects fiscal policy decisions.
3. Only changes in the structural deficit measure the thrust of fiscal policy.
4. Fiscal policy is categorized as follows:
 Discretionary fiscal policy is stimulative if the structural deficit is increasing.
 Discretionary fiscal policy is restrictive if the structural deficit is shrinking.
III. Economic Effects of Deficits
A. Crowding Out.
1. If government borrows funds to finance deficits, the availability of funds for private
sector spending may be reduced.
2. Is complete only if economy is at full employment.
B. Opportunity cost.
1. Crowding out reminds us there is an opportunity cost to government spending.
2. Deficits are only desirable if the resulting change in the mix of output is desired.
IV. The Accumulation of Debt
A. Debt creation.
1. When the Treasury borrows funds it issues treasury bonds.
2. Total of all outstanding bonds represents the national debt.
B. Early history 1776-1900.
1. By 1783 had borrowed over $8 million from France and $250,000 from Spain to finance
the Revolutionary War.
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2. 1790-1812 the U.S often incurred debt but typically repaid it quickly.
3. War of 1812 caused a massive increase in national debt.
 By 1816, the national debt was over $129 million.
4. The U.S. was completely out of debt by 1835.
5. The Mexican-American War (1846-48) caused a four-fold increase in the debt.
6. By the end of the Civil War (1861-65), the North owed over $2.6 billion and after the
South lost, Confederate currency and bonds had no value.
C. The twentieth century.
1. Spanish-American War (1898) also increased the national debt.
2. All prior debt was dwarfed by World War I which raised the debt from 3% to 41% of the
national income.
3. National debt declined during the 1920’s but rose again during the Great Depression.
4. Greatest increase occurred during World War II, rather than raise taxes, the government
rationed consumer goods.
 U.S War Bond purchases raised the debt from 45% of GDP to over 125% in 1946.
(See Figure 12.3.)
5. The Korean War (1950-53) added little to the national debt.
6. Vietnam War (1965-72) increased the debt by over $100 billion largely due to the refusal
of the President or Congress to raise taxes.
D. The 1980s.
1. During the 1980s, the national debt rose by nearly $2 trillion.
 Increase was not war-related but as a result of recessions (1980-82 and 1990-91) and
massive tax cuts (1981-84). (See Tables 12.3 and 12.4.)
E. 1990s
1. 1988-92 the national debt had increased by another trillion dollars.
2. Some success in reducing the structural deficit in 1993 however, budget deficits for
1993-96 have pushed the national debt to over $5 trillion.
V. Who Owns the Debt?
A. Liabilities = Assets
1. National debt represents a liability as well as an asset in the form of bonds.
B. Ownership of debt
1. Federal agencies hold roughly one-third of outstanding Treasury bonds. (See Figure
12.4.)
2. Social Security Trust Fund is becoming largest owner of U.S. debt.
3. 13% of the national debt is held by state and local governments.
4. The general public directly owns about 7% in the form of U.S. Savings Bonds or other
treasury bonds and indirectly owns over 36% in banks, insurance companies,
corporations etc., totaling almost half of the national debt.
5. All debt held by U.S. households, institutions and governments is called internal debt
and equals approximately 88% of the total.
6. The other 12% is external debt and is held by foreign households and institutions.
VI. Burden of the Debt
A. Refinancing
1. There has been no reduction of the national debt since 1957.
2. New bonds are issued to replace old bonds that have become due.
B. Debt service
1. Interest payments restrict the government’s ability to balance the budget or find other
public sector activities.
2. Most debt servicing is a redistribution of income from taxpayers to bondholders.
3. Interest payments themselves have virtually no opportunity cost.
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C. Opportunity costs
1. The process of debt servicing uses few resources, and has negligible opportunity costs.
2. True burden of the debt is the opportunity costs of the activities financed by the debt.
3. Government purchases.
 The opportunity cost of government purchases is the true burden of government
activity, however financed.
4. Transfer payments.
 Only direct cost is the land, labor and capital involved in the administrative process
of making the transfer.
 Changes in output or prices occurring because of income transfers result from
indirect behavior responses and should be distinguished from the direct costs of the
transfer.
 The amount of income transferred is not a meaningful measure of economic burden.
D. The real tradeoffs.
1. The national debt poses no special burden to the economy, but the transactions it
finances have a substantial impact on the question of WHAT, HOW, and FOR WHOM
to produce.
2. Deficit financing tends to change the mix of output in the direction of more public-sector
goods.
3. The burden of the debt is really the opportunity costs (crowding out) of deficit-financed
government activity.
VII. External Debt
A. No crowding out.
1. External financing allows us to get more public-sector goods without cutting back on
private-sector production. (See Figure 12.5.)
2. So long as foreigners are willing to hold U.S. bonds, external financing has no real cost.
B. Repayment
1. Foreigners may not be willing to hold bonds forever.
2. External debt must be paid with exports of real goods and services.
VIII. Deficit and Debt Limits
A. Deficit ceilings
1. Only way to stop the growth of the debt is to eliminate the budget deficit that created it.
2. Deficit ceilings are explicit limitations on the size of the annual budget deficit.
3. The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-RudmanHollings Act) was the first explicit attempt to force the federal budget into balance.
 It set a lower ceiling on each year’s deficit until budget balance was achieved.
 Called for automatic cutbacks in spending if Congress failed to keep the budget
below the ceiling.
 Required Congress to pare the deficit from over $200 billion in FY1985 to zero
(balanced) by 1991.
 Congress refused to cut spending and raise taxes enough to meet the targets, and the
Supreme Court declared the “automatic” mechanisms unconstitutional.
4. The Gramm-Rudman-Hollings Act was amended by Congress in 1987.
 Immediate effect of the revision postponed the balanced-budget ceiling until 1993.
 The opposing forces of President Reagan and Congress left little room for deficit
reduction.
5. In 1990, President Bush and Congress developed a new set of rules for reducing the
deficit.
 Acknowledged they had lack of total control of the deficit but could close the
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structural deficit by limiting discretionary spending or raising taxes.
The Budget Enforcement Act (BEA) of 1990 laid out a plan for doing this by setting
separate limits on defense system, discretionary domestic spending, and international
spending; also required any new spending initiative be offset by increased taxes or
cutbacks in other programs.
 Republican Party’s 1994 Contract With America included promises to balance the
budget by the year 2002, but did not set deficit ceilings.
 In 1995, a new call for a constitutional amendment for a balanced budget was voted
down by the U.S. Senate.
B. Debt ceiling
1. Another mechanism for curbing the national debt.
2. Once the debt ceiling is reached, all government activities must cease.
 This disruption typically lasts less than 24 hours and is often averted completely
when Congress raises the ceiling.
3. Is intended to force political compromises on specific issues.

IX. The Economy Tomorrow: Our Grandchildren’s Burden?
A. What burden?
1. The burden is the opportunity costs of goods and services forgone.
2. The primary burden is incurred when the debt-financed activity takes place.
B. Economic growth.
1. If debt-financed government spending crowds out private investment, then future
generations may be left with less productive capacity.
2. The debate over the burden of the debt is really over the optimal mix of output.
C. Repayment
1. Future interest payments entail a redistribution of income from taxpayers and
bondholders
living in the future.
D. External debt.
1. Is the exception to the case of passing the debt on to future generations.
2. If foreign bondholders want to collect on their bonds and they use the dollars they
receive to purchase U.S. exports, there will be less output for domestic use.
3. No certainty that the bonds will be redeemed or they may choose to reinvest in the U.S.
rather than purchase exports.
4. As inflation drives U.S. prices up, foreign bonds have less purchasing power, and
reduces the potential real cost.
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