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Chapter 14
Deficit Spending
and The Public
Debt
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Since 2007, the U.S. government’s average annual
budget deficit—its flow of spending in excess of its flow
of tax collections—has increased by about 400 percent.
During the same period, the government’s net public
debt—accumulated indebtedness—as a percentage U.S.
GDP has risen by more than 100 percent.
Why have U.S. government budget deficits and the net
public debt increased so quickly?
Reading this chapter will help you answer this question.
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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
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14-3
Learning Objectives (cont'd)
• Analyze the macroeconomic effects of
government budget deficits
• Describe possible ways to reduce the
government budget deficit
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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
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Did You Know That ...
• The typical baby born somewhere in the United
States during the next few minutes already owes
about $45,000 as the baby’s share of the U.S.
government’s debt obligations?
• The rapidly accumulating debts is associated with
the fact that the U.S. government has spent more
than it collected in taxes.
• In this chapter, you will learn what the
government does when it spends more than it
receives.
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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)
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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
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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
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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
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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
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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
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Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
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Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
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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 of nearly 13% of GDP?
• Answer
– Spending has increased at a faster page since the
early 2000s
– Recent income, capital gains, and estate tax cuts
– Declines in economic activity in late 2000s reduced
tax collections and raised federal expenditures
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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
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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
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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
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Table 14-1 The Federal Deficit, Our Public Debt, and
the Interest We Pay on It
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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
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Figure 14-3 The Official Net U.S. Public
Debt as a Percentage of GDP
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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
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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
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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
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14-24
International Policy Example: Why European
Governments Are Paying More Interest on Debt
• Since 2009, bonds issued by several European
governments, including those of Greece, Ireland,
Italy, Portugal, Spain, and the United Kingdom,
have received lower ratings from bond-rating
agencies such as Standard & Poor’s.
• The lower ratings have raised the interest rates
that governments of these nations have been
required to pay to induce individuals and
companies to continue buying their bonds.
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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
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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
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14-27
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
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14-28
Evaluating the Rising
Public Debt (cont'd)
• If deficits lead to slower growth rates, then
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
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14-29
International Policy Example: How Do U.S.
Residents’ Foreign Debt Obligations Compare?
• Today, a typical U.S. resident owes about twice as
much as is owed abroad by a typical Hungarian or
Japanese resident and about three times as much
as the typical resident of Israel or Slovenia owes
to people in other nations.
• At the same time, the foreign debt obligations of
an average U.S. resident are less than those owed
by residents of a number of other industrialized
nations, including Austria, Belgium, Finland,
France, Germany, Ireland, and the Netherlands.
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Federal Budget Deficits
in an Open Economy
• Question
– Is there a relationship between the U.S. trade
deficit and the federal government budget
deficit?
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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
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Figure 14-4 The Related U.S. Deficits
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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
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14-34
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
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14-35
Growing U.S. Government Deficits: Implications
for U.S. Economic Performance
• 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 can create an inflationary gap
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14-36
Growing U.S. Government Deficits: Implications
for U.S. Economic Performance (cont’d)
• What are the long run macroeconomic
effects of higher budget deficits?
– In the long run, higher government budget
deficits have no effect on equilibrium real GDP
per year
– Ultimately, therefore, government spending in
excess of government receipts simply
redistributes a larger share of real GDP per
year to government-provided goods and
services
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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
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Why Not … eliminate deficits and the debt by
taxing the richest 1 percent more?
• Confiscated the incomes of the richest 1 percent
of U.S. residents would cover at most the typical
budget deficit of a single year during the 2010s.
• Thus, temporarily raising taxes on the richest 1
percent of U.S. residents could not possibly
eliminate all federal budget deficits or come close
to paying off the net public debt.
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14-39
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
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14-40
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
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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
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Figure 14-5 Components of Federal Expenditures as
Percentages of Total Federal Spending
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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
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14-44
You Are There: Facing the Good News and the
Bad
• By the time your graduation day arrives (good
news), the federal government’s share of
economic activity will have risen to more than 25
percent, up from a historical average of about
20.5 percent.
• This means that about 25 cents of each dollar of
pretax earnings you will receive will be put to use
by the federal government—rather than you, the
income earner.
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14-45
Issues & Applications: The United States Is
Vying for the “Lead” in Deficits and Debt
• The U.S. budget deficit has risen so fast that the
U.S. deficit-GDP ratio now “beats” the ratios of
other nations.
• The government budget deficit as a percentage of
GDP is now twice as high in the United States as
in the euro area.
• The U.S. net public debt–GDP ratio is also
“gaining.”
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Figure 14-6 Government Budget Deficit and Net
Public Debt as Percentages of GDP in Selected Nations
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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
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14-48
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
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14-49
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
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14-50
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
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