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Views of American leaders on the national debt “A national debt, if it is not excessive, will be to us a national blessing.” [Alexander Hamilton, 1781] “It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F. D. Roosevelt] “There are myths also about our public debt. Borrowing can lead to overextension and collapse – but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [John F. Kennedy, Yale Commencement Address, 1962] “It is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now.” [B. Obama, 2010] 1 Five Genuine Concerns about Government Debt 1. Impact on growth of potential output - Higher deficit and debt leads to lower saving and capital stock - Leads to lower potential output (we will review the savings experiment) 2. Efficiency impacts of higher debt: - Higher debt means higher interest payments - These require higher taxes, and this has a “dead-weight loss” 3. In open economy, some of debt will be held abroad - To extent that have net foreign borrowing (trade deficit), this requires net exports to pay. - If debt is in foreign currency, can lead to financial crisis, higher interest rates, higher deficits, and a death spiral of confidence, and eventual default 4. Higher debt forces higher taxes or crowds out other critical spending 2 The overall federal budget 26 Spending/GDP Deficit 24 22 20 18 Revenues/GDP 16 14 1960 1970 1980 1990 2000 2010 3 Current projections of debt/GDP “Extended Alternative” = continuation of certain policies (war, Bush era tax cuts, Medicare, etc.). “Extended Baseline” = cliff Long-term projection of debt/GDP CBO, The Long-Term Budget Outlook, June 2010 5 What are the sources of the spending growth? Projected federal spending as % of GDP 14 12 10 8 6 4 Social Security Health Everything else 2 0 2010 2015 2020 2025 2030 2035 2040 CBO, The Long-Term Budget Outlook, June 2010/ 6 Debt bathtub Spending Debt (end of year) = Debt (beginning) + deficit Debt (beginning of year) Revenues 7 Debt algebra Basic identity: Debt (end of t) = Debt (beginning of t) + Deficit (t) Stable system when debt-GDP ratio is constant. Define debt-GDP ratio = β Primary surplus = PS = taxes – noninterest spending. Given U.S. parameters, stable β when PS = 0. Algebra of stable debt - GDP ratio. Assume g = nominal GDP growth. Then, equation for change in debt is: D/t iD PS Then debt-GDP ( = D/Y) ratio is constant when /t / 0 D/t / D g [ iD PS / D] g ( i g ) PS / D Historically for the U.S., i g, so a stable financial situation implies that the primary deficit must be zero PS 0). Primary surplus ratio Recession and stimulus package 6% Clinton-era surpluses 4% 2% 0% 1981 1986 1991 1996 2001 2006 2011 2016 -2% -4% Cliff fiscal policy -6% Extended baseline (current law) -8% Actual -10% CBO Forecast 2021 Case 1. Closed classical economy • Fundamental difference between spending on I and spending on C: - Borrowing for spending on productive I does not lower long-run C - Growth lowered from borrowing for government or private C • Two problems from domestic debt (or closed economy debt) - Internal debt requires taxation to service and leads to inefficiency - Debt crowds out capital and reduces the growth/level of potential output 10 The marginal dead weight loss of debt/taxes Empirical estimates: 20 – 40 cents of DWL per $ of taxes from higher tax rates = incremental DWL of higher taxes P(1+τ2) ~ increase revenues P(1+τ1) DWL P X2 X1 X0 Taxes and debt for a purely internal debt Assume that we “owe the debt to ourselves” - Many identical people - All get benefits and pay taxes to service debt - Suppose that we have program which provides $1 in PV of C; and finances it by $1 of debt. Classical case: - Suppose no change in path of output. - Higher interest payments with present value of $1. - Taxes cause efficiency losses with a dead-weight loss (DWL). - If marginal DWL on taxes is 30%, then have cost of $0.30. - Net value of government program is minus $0.30. 12 Debt in neoclassical growth model National investment = national saving = private saving + government saving NS = PS + GS If PS unchanged, then higher deficit leads to lower saving and investment. Then follow through standard Solow neoclassical growth model, with lower s. 13 Impact of Deficits on Economy y = f(k) y* y** i = s1f(k) i = s2f(k) (I/Y)* (n+δ)k k k** k* 14 ln K, ln GD ln K ln K’ ln GD’ ln GD time 15 ln Y, ln C ln Y ln Y’ ln (C+G) ln (C+G)’ Note that govt spending first raises (C+G), but then lowers (C+G)’ time 16 Case 2. Impact of government debt in an open economy (assuming borrowing in own currency) • In open economy: K + NFA = Wealth = Private wealth – Government Debt W/L = v = (K + NFA)/L = k +nfa, where nfa=NFA/L • For small open economy, the marginal investment is abroad! – With r = rw, no change in domestic capital stock! – Therefore, no effect on GDP, but has effect on income from abroad – Will show up in national income (NNP) not in GDP! (Most macro models get this wrong.) • Large open economy like US: – Somewhere in between small open and closed. – I.e., some decrease in domestic I and some in decrease net foreign assets • But results on changes in W and C are same in open as closed economy. 17 Solow model for open economy with net foreign borrowing y=NNP/L; v = per capita wealth v= k + nfa; (n+δ)k Show how: ↓s → ↓v → ↓nfa but no change k → ↓y nfa* k, v v* k* 18 The fiscal cliff Everything goes poof on December 31, 2012. Tax cuts expire, doctors don’t get paid, unemployed lose insurance, military and government programs slashed, rich get big tax increase. The actual details… 19 Fiscal Cliff [billions of dollars at annual rate] Bush era tax cuts High income and estate "Middle class" Payroll tax Other expiring provisions Taxes included in the Affordable Care Act Other misc taxes TOTAL, Revenues Calendar year 2013 295 66 229 127 87 24 105 637 Changes in Specified Spending Policies Budget Control Act Unemployment insurance Medicare "doc fix" Other 87 35 15 35 TOTAL, Expenditures 171 Total Change in Deficit As % of GDP 808 4.9% Source: CBO, May 2012 20 Fiscal Cliff [billions of dollars at annual rate] Bush era tax cuts High income and estate "Middle class" Payroll tax Other expiring provisions Taxes included in the Affordable Care Act Other misc taxes TOTAL, Revenues Calendar year 2013 295 66 229 127 87 24 105 = contentious. 637 Changes in Specified Spending Policies Budget Control Act Unemployment insurance Medicare "doc fix" Other 87 35 15 35 TOTAL, Expenditures 171 Total Change in Deficit As % of GDP 808 4.9% Source: CBO, May 2012 21 Game of chicken and the cliff R’s concede R’s hang tough D’s concede • No recession. • Everyone one looks good. • Politically neutral. • No recession. • Obama loses face early in second term. • Repubs get overconfident. D’s hang tough • No recession. • Repubs lose face. • Dems get overconfident. • Deep recession. • Everyone looks equally bad politically. *** *** Nash equilibrium if prisoners’ dilemma zero-sum structure.