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Principles of Economics: Macroeconomics - Econ101 Deficits and Debt Chapter 12 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Deficits and Debt • The core critique of fiscal stimulus focuses on the budget consequences of government pumppriming – How do deficits arise? – What harm, if any, do deficits cause? – Who will pay off the accumulated national debt? 12-2 Budget Effects of Fiscal Policy • Keynesian theory highlights the potential of fiscal policy to solve macro problems – Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes • Use of the budget to stabilize the economy implies that federal expenditures and receipts won’t always be equal 12-3 Budget Surpluses and Deficits • Deficit spending: The use of borrowed funds to finance government expenditures that exceed tax revenues • Budget deficit: Amount by which government spending exceeds government revenue in a given time period Budget government tax – 0 deficit spending revenues 12-4 Budget Surpluses and Deficits • If the government spends less than its tax revenues, a budget surplus is created • Budget surplus: An excess of government revenues over government expenditures in a given time period 12-5 Budget Deficits and Surpluses Budget Total (in billions of dollars) Revenues Outlays Surplus (deficit) 2004 2005 2006 2007 2008 2009 2010 1,880 2,154 2,407 2,568 2,524 2,159 2,289 -2,293 -2,472 -2,655 -2,729 -2,983 -4,004 -3,669 (413) (318) (248) (161) (459) (1,845) (1,380) Source: Congressional Budget Office 12-6 A String of Deficits Budget deficits are overwhelmingly the rule, not the exception. 12-7 Keynesian View • Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy • The goal of macro policy is not to balance the budget but to balance the economy at fullemployment 12-8 Discretionary vs. Automatic Spending • At the beginning of each year, the President and Congress put together a budget blueprint for the next fiscal year • Fiscal year (FY): The 12-month period used for accounting purposes; begins October 1 for the federal government 12-9 Discretionary vs. Automatic Spending • Current revenues and expenditures are largely the result of prior year’s decisions – Only about 20 percent is discretionary spending – Uncontrollables account for roughly 80 percent • Discretionary fiscal spending: Those elements of the federal budget not determined by past legislative or executive commitments 12-10 Discretionary vs. Automatic Spending • Since most of the budget is uncontrollable, fiscal restraint or stimulus is less effective • Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand • Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand 12-11 Automatic Stabilizers • Most uncontrollable line items in the federal budget change with economic conditions • Automatic stabilizer: Federal expenditure or revenue item that automatically responds counter-cyclically to changes in national income, like unemployment benefits, income taxes 12-12 Cyclical Deficits • Cyclical deficit: That portion of the budget balance attributable to short-run changes in economic conditions – The cyclical deficit widens when GDP growth slows or inflation decreases – The cyclical deficit shrinks when GDP growth accelerates or inflation increases 12-13 Structural Deficits • To isolate effects of fiscal policy, the actual budget balance is broken down into cyclical and structural components Total budget cyclical structural balance balance balance 12-14 Structural Deficits • Structural deficit: Federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy • Part of the deficit arises from cyclical changes in the economy; the rest is the result of discretionary fiscal policy 12-15 Cyclical vs. Structural Budget Balances (in billions of dollars) Fiscal Year Budget Balance = Cyclical Component + Structural Component 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 + 236 + 128 - 158 - 378 - 413 - 318 - 248 - 161 - 459 - 1667 + 94 + 19 - 62 - 84 - 46 - 21 -8 - 28 - 76 - 310 + 142 + 109 - 96 - 294 - 367 - 297 - 240 - 133 - 383 - 1357 Source: Congressional Budget Office (June 2009) Changes in the structural component result from policy changes; changes in the cyclical component result from changes in the economy. 12-16 Structural Deficits • Only changes in the structural deficit measure the thrust of fiscal policy – Fiscal stimulus is measured by an increase in the structural deficit (or shrinkage in the structural surplus) – Fiscal restraint is gauged by a decrease in the structural deficit (or increase in the structural surplus) 12-17 Economic Effects of Deficits • Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing • Crowding out reminds us that there is an opportunity cost to government spending • Government borrowing to finance deficits puts upward pressure on interest rates 12-18 The Accumulation of Debt • The U.S. government has had many more years of budget deficits than budget surpluses • National debt: The accumulated debt of the federal government 12-19 Debt Creation • When the Treasury borrows funds it issues treasury bonds • Treasury bonds: Promissory notes (IOUs) issued by the U.S. Treasury • The national debt is a stock of IOUs created by annual deficit flows 12-20 Historical View of the Debt/GDP Ratio 12-21 Who Owns the Debt? • The national debt creates as much wealth for bondholders as liabilities for the government • Liability: An obligation to make future payment; debt • Asset: Anything having exchange value in the marketplace; wealth 12-22 Ownership of Debt Source: U.S. Treasury Department (2008 data) 12-23 Ownership of Debt • 72 percent of the national debt is internal • Internal debt: U.S. government debt (Treasury bonds) held by U.S. households and institutions • External debt: U.S. government debt (Treasury bonds) held by foreign households and institutions 12-24 Burden of the Debt • The debt has historically been refinanced – Refinancing: The issuance of new debt in payment of debt issued earlier • Most debt servicing is simply a redistribution of income from taxpayers to bondholders – Debt service: The interest required to be paid each year on outstanding debt 12-25 Dipping into Social Security • Social Security Trust Fund has been a major source of federal funding for over 20 years • Surpluses have largely resulted from Baby Boomers paying more in payroll taxes than are paid out in benefits to the retired • The Trust Fund balance shifts from surplus to deficit soon after 2014 12-26 Repayment • Foreigners may not be willing to hold bonds forever • External debt must be paid with exports of real goods and services 12-27 Burden of the Debt • Opportunity costs are incurred only when real resources (factors of production) are used • The true burden of the debt is the opportunity costs of the activities financed by the debt 12-28 The Real Trade-Offs • Deficit financing tends to change the mix of output toward more public-sector goods • The burden of the debt is the opportunity cost of deficit-financed government activity • The primary burden is incurred when the debtfinanced activity takes place 12-29 Economic Growth • Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment • The whole debate about the burden of debt is really an argument over the optimal mix of output 12-30 Repayment • Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future 12-31