Download Introduction Learning Objectives

Chapter 14
Deficit Spending
and The Public
Debt
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Introduction
The federal budget deficit often has appeared to move in tandem
with the trade deficit. In the past, they were sufficiently closely
related that economists began to call them the “twin deficits.”
In recent years, however, the U.S. trade deficit has increased
even as the U.S. government’s budget deficit has been
decreasing.
Why has this divergence occurred? Are the two deficits no
longer twins?
14-2
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Learning Objectives
• Explain how federal government budget
deficits occur
• Define the public debt and understand
alternative measures of the public debt
• Evaluate circumstances under which the
public debt could be a burden to future
generations
14-3
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Learning Objectives (cont'd)
• Discuss why the federal budget deficit might
be measured incorrectly
• Analyze the macroeconomic effects of
government budget deficits
• Describe possible ways to reduce the
government budget deficit
14-4
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Chapter Outline
• Public Deficits and Debts: Flows
versus Stocks
• Government Finance: Spending More than
Tax Collections
• Evaluating the Rising Public Debt
• Federal Budget Deficits in an Open Economy
• Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
14-5
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Did You Know That...
• The U.S. federal government spends a total
of more than $3 billion per day on Social
Security, Medicare, and Medicaid.
• Each of these guaranteed spending
programs is individually nearly as large as
the entire discretionary portion of the
federal government’s budget.
14-6
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Public Deficits and Debts:
Flows versus Stocks
• 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)
14-7
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Public Deficits and Debts:
Flows versus Stocks (cont'd)
• The federal deficit is a flow variable, one
defined for a specific period of time, usually
one year.
• If spending equals receipts, the budget is
balanced.
• If receipts exceed spending, the
government is running a budget surplus.
14-8
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Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Balanced Budget
– A situation in which the government’s spending
is exactly equal to the total taxes and revenues
it collects during a given period of time
14-9
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Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Government Budget Surplus
– An excess of government revenues over
government spending during a given period of
time
14-10
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Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Public Debt
– A stock variable
– The total value of all outstanding federal
government securities
14-11
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Government Finance: Spending
More than Tax Collections
• Since 1940, the U.S. federal government
has operated with a budget surplus in 13
years.
• In all other years, the shortfall of tax
revenues below expenditures has been
financed with borrowing.
14-12
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Figure 14-1 Federal Budget
Deficits and Surpluses Since 1940
*Budgeted items not including 2008–2009 financial institutions bailout expenditures.
Source: Office of Management and Budget.
14-13
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Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
*Budgeted items not including 2008–2009 financial institutions bailout expenditures.
Sources: Economic Report of the President; Economic Indicators, various issues.
14-14
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Government Finance: Spending More than
Tax Collections (cont'd)
• Question
– Why has the government’s budget recently
slipped from a surplus of 2.5% of GDP into a
deficit?
• Answer
– Spending has increased at a faster page since
the early 2000s than during any other decade
since WWII.
– Recent income, capital gains, and estate tax cuts
14-15
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Evaluating the Rising Public
Debt
• Gross Public Debt
– All federal government debt irrespective of who
owns it
• Net Public Debt
– Gross public debt minus all government
interagency borrowing
14-16
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Evaluating the Rising
Public Debt (cont'd)
• 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.
14-17
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Evaluating the Rising
Public Debt (cont'd)
• Tax revenues tend to be stagnant during
times of slow economic growth.
• Tax revenues grow more quickly when
overall growth enhances incomes.
• As long as spending exceeds revenues, the
budget deficit will persist.
14-18
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Table 14-1 The Federal Deficit, Our Public
Debt, and the Interest We Pay on It
14-19
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Evaluating the Rising Public Debt
(cont’d)
• During World War II, the net public debt
grew dramatically.
• After the war
– It fell until the 1970s
– Started rising in the 1980s
– Declined once more in the 1990s
– And recently has been increasing again
14-20
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Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP
Source: U.S. Department of the Treasury.
14-21
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Evaluating the Rising
Public Debt (cont'd)
• The government must pay interest on the
public debt outstanding.
• The level of these payments depends on the
market interest rate.
• Interest payments as a percentage of GDP
are likely to rise in the future.
14-22
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Evaluating the Rising
Public Debt (cont'd)
• As more of the public debt is held by
foreigners, the amount of interest to be paid
outside the United States increases.
• Foreign residents, businesses and
governments hold nearly 50% of the net
public debt.
• Thus, we do not owe the debt just
to ourselves.
14-23
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Evaluating the Rising
Public Debt (cont'd)
• If the economy is already at full
employment, then further provision of
government goods will crowd out some
private goods.
• Deficit spending may raise interest rates,
which in turn will discourage capital
formation in the private sector.
14-24
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Evaluating the Rising
Public Debt (cont'd)
• Crowding-out may place a burden on future
generations.
– Increased present consumption may crowd out
investment and reduce the growth of capital
goods—which could reduce a future generation’s
wealth.
– Taxes may have to be increased; imposing
higher taxes on future generations in order to
retire the debt.
14-25
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Evaluating the Rising
Public Debt (cont'd)
• Paying off the public debt in the future
– If the debt becomes larger, each person’s share
would increase.
– Taxes would be levied, and may not be assessed
equally.
– A special tax could be levied based on a person’s
ability to pay.
14-26
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Evaluating the Rising
Public Debt (cont'd)
• Our debt to foreign residents
– We do not owe all the debt to ourselves—what
about the nearly 50% owned by foreign
residents?
– Future U.S. residents will be taxed to repay
principal and interest.
– Portions of U.S. incomes will be transferred
abroad.
14-27
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Evaluating the Rising
Public Debt (cont'd)
• If deficits lead to slower growth rates future
generations will be poorer.
• Both present and future generations will be
economically better off if…
– Government expenditures are really investments
– The rate of return on such public investments exceeds the
interest rate paid on the bonds
14-28
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International Example: Who Is Most Likely
to Buy U.S. Government Bonds “Indirectly”?
• The U.S. Treasury typically auctions new
debt securities once or twice per week.
• Most direct bids come from primary dealers
of government securities.
• Indirect bidders include private pension
funds, securities brokers and dealers, and
insurance companies.
14-29
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International Example: Who Is Most Likely
to Buy U.S. Government Bonds “Indirectly”?
(cont'd)
• Many indirect bids, however, come from
international sources.
• Why do you suppose that the U.S. Treasury
does not report each bidder by name?
14-30
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Federal Budget Deficits
in an Open Economy
• Question
– Is there a connection between the U.S. trade
deficit and the federal government budget
deficit?
14-31
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Federal Budget Deficits
in an Open Economy (cont'd)
• We know what a budget deficit is, but a
trade deficit exists when the value of
imports exceeds the value of exports.
• Some say it appears that there is a
relationship between trade and budget
deficits; at least there is a statistical
correlation between the two.
14-32
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Figure 14-4 The Related U.S.
Deficits
Sources: Economic Report of the President; Economic Indicators, various issues;
author’s estimates.
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14-33
Federal Budget Deficits
in an Open Economy (cont'd)
• 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.
• The interest rate paid on bonds will need to
be high enough to attract foreign investors.
14-34
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Federal Budget Deficits
in an Open Economy (cont'd)
• 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.
• This shows that a U.S. budget deficit can
contribute to a trade deficit.
14-35
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Which government deficit is the
true deficit?
– The government may report distorted measures
of its own budget.
• Government has not adopted a
business-like approach to tracking
its expenditures and receipts.
• Official government “measures” yield
lowest possible deficits and highest
reported surpluses.
14-36
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• An operating budget includes current
outlays for on-going expenses, such as
salaries and interest payments.
• A capital budget, includes expenditures on
investment items, such as machines,
buildings, roads, and dams.
14-37
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Capital budgeting theory
– For years, many economists have recommended
Congress create a capital budget and remove
investment outlays from the operating budget.
– Opponents point out this would allow
the government to grow even faster than
at present.
14-38
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Even without a distinction drawn between
the capital and operating budgets, there is a
discrepancy about the true government
deficit measure.
14-39
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Pick a deficit, any deficit: deficit estimates
are produced both by
– The Office of Management and Budget
– The Congressional Budget Office
• They have different names
– “Baseline deficit”
– “Policy deficit”
– “On-budget deficit”
14-40
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• There is also some disagreement as
to whether the Social Security surplus
should be used to reduce current
deficit numbers.
• So 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.
14-41
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Question
– How do higher deficits affect the economy in the
short run?
• Answers
– If the economy is below full-employment, the
deficit can close the recessionary gap.
– If the economy is already at full-employment,
the deficit can create an inflationary gap.
14-42
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• In the long run, higher government
budget deficits have no effect on
equilibrium real GDP.
• Ultimately, spending in excess of
receipts redistributes a larger share of
real GDP to government-provided
goods and services.
14-43
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Thus, if the government operates with
higher deficits over an extended period
– The ultimate result is a shrinkage in
the share of privately produced goods
and services
– By continually spending more than it collects,
the government takes up a larger portion of
economic activity.
14-44
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Policy Example: A Short-Run Deficit
Boosting Stimulus is Set to Give Way to
Deficit-Fighting Tax Increases
• In early 2008, Congress passed the
Economic Stimulus Act in response to
declining GDP growth rate.
• This law provided for $45 billion in
government spending and authorized tax
“rebates” aimed at stimulating
consumptions pending and preventing a
short-run recessionary gap from expanding.
14-45
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Policy Example: A Short-Run Deficit Boosting
Stimulus is Set to Give Way to Deficit-Fighting Tax
Increases (cont'd)
• However, worries over an increasing budget
deficit prompted Congress to authorize a
significant personal income tax increase at
the end of 2010.
• This rate will raise the overall U.S. personal
income tax burden by 25%.
• Higher tax rates could reduce long-run
aggregate supply and dampen future real
GDP growth.
14-46
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• How could the government reduce all its red
ink?
– Increasing taxes for everyone
– Taxing only the rich
– Reducing expenditures
– Whittling away at entitlements
14-47
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• In considering how expenditures
might be reduced, it is important to
look at entitlements.
• These are federal government payments
that are legislated obligations and cannot be
reduced or eliminated.
14-48
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Entitlements
– Guaranteed benefits under a government
program such as Social Security, Medicare, or
Medicaid
• Noncontrollable Expenditures
– Government spending that changes
automatically without action by Congress
14-49
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Figure 14-5 Components of Federal
Expenditures as Percentages of Total Federal
Spending
Source: Office of Management and Budget.
14-50
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Entitlements are the largest component of
the U.S. federal budget.
• To make a significant cut in expenditures,
entitlement programs would have to be
revised.
14-51
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Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
(cont'd)
• Question
– What are the political costs of reducing
entitlement payments for Social Security,
Medicare, and Medicaid?
14-52
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Issues and Applications: Are Budget and
Trade Deficits Twins or Distant Cousins?
• In principle, an increase in the U.S. government
budget deficit should be related to lower U.S.
exports and hence a higher U.S. trade deficit.
• There is not always a direct relationship between
the twin deficits, however, as can be seen in Figure
14-5.
• With all other things being equal, when the U.S.
budget falls deeper into deficit, the U.S. trade
deficit will increase and when the U.S. budget
deficit moves toward a surplus, the U.S. trade
deficit will tend to decline.
14-53
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Issues and Applications: Are Budget and
Trade Deficits Twins or Distant Cousins?
(cont'd)
• In the real world, however, other things are not
always equal.
• A key factor that changed during the 1990s and the
early 2000s was U.S. real GDP.
• Economic expansions during the 1990s and mid2000s brought about declines in the budget deficit,
but at the same time the expansions boosted the
trade deficit. The two deficits diverged.
14-54
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Issues and Applications: Are Budget and
Trade Deficits Twins or Distant Cousins?
(cont'd)
• Other factors can also contribute to this divergence
such as labor and capital productivity increasing
significantly.
• The fact that other factors influencing the two
deficits, such as real GDP and investment
expenditures, change over time explains why there
is not a dollar-for-dollar relationship between the
two deficits.
• Nevertheless, over a long period of time there
should be a tendency for the trade deficit to rise
when the government budget deficit increases, and
vice versa.
14-55
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Summary Discussion
of Learning Objectives
• Federal government budget deficits
– Whenever the flow of government expenditures
exceeds the flow of government revenues a
budget deficit occurs.
• The public debt
– Total value of all government bonds outstanding
– The federal budget deficit is a flow, whereas
accumulated deficits are a stock, called the
public debt.
14-56
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Summary Discussion
of Learning Objectives (cont'd)
• How the public debt might prove a burden
to future generations
– Higher taxes will reduce private consumption.
– Crowding out might reduce economic growth.
• 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.
14-57
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Summary Discussion
of Learning Objectives (cont'd)
• The macroeconomic effects of government
budget deficits
– Because higher government deficits are caused
by increased government spending or tax cuts,
they contribute to a short-run rise in total
planned expenditures and aggregate demand.
– In the long run, increased deficits only
redistribute resources from the private sector
to the public sector.
14-58
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Summary Discussion
of Learning Objectives (cont'd)
• Possible ways to reduce the government
budget deficit
– Increase taxes
– Reduce expenditures by revising the terms of
entitlement programs
14-59
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