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Deficits And Debt Chapter 19 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Laugher Curve How many neoclassical economists does it take to change a lightbulb? Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Laugher Curve How many neoclassical economists does it take to change a lightbulb? It depends on the wage rate. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Define Irwin/McGraw-Hill the terms deficit and debt. © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Define the terms deficit and debt. State why economists focus on financial health rather than on deficits. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Explain why, in an expanding economy, a government can run a limited, but continual, deficit without serious concern about the consequences. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Differentiate between a real deficit and a nominal deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Explain why, even though the real budget deficit of the United States is much lower than the nominal deficit, there is still reason for concern about the deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Chapter Objectives Explain why there are alternative reasonable views about the deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Irwin/McGraw-Hill Definitions © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Definitions A deficit is a shortfall of incoming revenues under outgoing payments—it is a flow concept. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Definitions If revenues exceed payment, you are running a surplus. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Definitions If revenues exceed payment, you are running a surplus. If the opposite happens, you are running a deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Definitions Debt is accumulated deficits minus accumulated surpluses—it is a stock concept. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Introductory Definitions As debt accumulates, governments must borrow to pay the interest. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Why has the U.S. consistently run deficits since World War II? Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Why has the U.S. consistently run deficits since World War II? The reason is a change in macroeconomic policy regimes—the general set of rules that governs the monetary and fiscal policies that a nation follows. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Why has the U.S. consistently run deficits since World War II? Keynesians, in arguing in favor of deficit spending, removed its stigma. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Why has the U.S. consistently run deficits since World War II? As deficits grew, they were blamed for its growth. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt Why has the U.S. consistently run deficits since World War II? The modern Classical supply-side regime of the 1980s, resulted in even greater deficits than those run up by the Keynesians. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. The Gramm-Rudman-Hollings Act of 1985 established mandatory deficit targets for the U.S. in an effort to meet public demands for their elimination. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. Since the law proved ineffective, the Budget Enforcement Act of 1990 was enacted. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. The Budget Enforcement Act of 1990 put caps on certain aspects of federal spending, and established a pay-as-you-go test for new spending or tax cuts. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. Up until 1996, any new legislation, except for emergencies, must be accompanied by offsetting tax increases or spending cuts. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. As these laws, and others proved weak, some politicians demanded a balanced budget amendment to the Constitution. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U.S. Government Deficits and Debt The public dislikes both deficits and debt. It was felt that without the amendment, American politics lacks the political will to prevent deficit spending. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U. S. Budget Deficits $300 Dollars (in billions) Dollars (in billions) 200 100 Surplus 0 Deficit –100 –200 –300 –400 1950 1960 1970 1980 1990 2000 2010 Years Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 U. S. Government Debt $5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1950 1960 1970 1980 1990 2000 2010 Years Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness Irwin/McGraw-Hill in Defining Deficits © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Deficits How one defines a revenue and an expenditure is crucial. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Deficits Should capital equipment be charged off completely the year it was bought or be depreciated over its useful life? Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Deficits Should the gain in the market value of an issued U.S. government obligation be counted as additional revenue or ignored? Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Deficits Putting aside the issue of “cooking the books,” reasonable people can disagree on how to handle government revenue and expenditures. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits As Irwin/McGraw-Hill a Summary Measure © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits As a Summary Measure The deficit is a summary measure of the financial health of the economy—a single figure. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits As a Summary Measure Therefore, to understand the summary, you must understand the logic used to calculate it. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt The Need to Judge Deficits Relative to Assets Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt The Need to Judge Deficits Relative to Assets Debt, being a summary measure of a nation’s accumulated deficits, has even more problems than deficits. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt The Need to Judge Deficits Relative to Assets Debt is only half the picture—the other half being assets. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt The Need to Judge Deficits Relative to Assets Debt must be judged in its relation to assets. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness Irwin/McGraw-Hill in Defining Debt © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Debt Assets and debt are subject to varying definitions. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Arbitrariness in Defining Debt There is no perfectly objective and universal way of defining how debt and assets should be valued. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Government debt is different than an individual’s debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Since government is ongoing, it never has to settle its accounts as when an individual dies. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Governments can pay off debt by creating money. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Much of government debt is internal government debt, debt owed to its own citizens. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt This means that the government must collect taxes to pay the debt which is giving to the debt holders as income. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Not counting the distribution effects (the same people may not be involved) the nation is neither richer nor poorer. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt External government debt on the other hand is debt owed individuals in foreign nations. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Difference Between Individual and Government Debt Paying interest on it means a net reduction in domestic income. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits, Debt, and Debt Service Relative to GDP Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits, Debt, and Debt Service Relative to GDP Government deficits and debt relative to GDP is less alarming compared to government deficits and debt in absolute terms. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits, Debt, and Debt Service Relative to GDP Measuring deficits and debt relative to GDP highlights a nation’s productive capacity relative to debt management. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Deficits, Debt, and Debt Service Relative to GDP Although the absolute size of the deficits and debt have grown since World War II, their importance relative to GDP have not. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Deficits as percentage of GDP Budget Deficits as a Percentage of GDP Irwin/McGraw-Hill 10 0 –10 –20 –30 19001910 1920 1930 1940 1950 1960 1970 1980 1990 Years © The McGraw-Hill Companies, Inc., 1998 Debt as a Percentage of GDP Debt as percentage of GDP 100 75 50 25 0 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 Years Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Economists are also concerned about the interest rate paid on debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Economists are also concerned about the interest rate paid on debt. Debt service is the interest rate on debt times the total debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Economists are also concerned about the interest rate paid on debt. Debt service as payment for past expenditures puts a burden on future generations. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Economists are also concerned about the interest rate paid on debt. Debt service payments relative to GDP suggests that it is a greater problem than the debt/GDP measure, but less of a problem than absolute debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Economists’ Way of Looking at Deficits and Debt Economists are also concerned about the interest rate paid on debt. The U.S. can actually afford more debt since U.S. government securities are considered the safest in the world. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Federal Interest Payments Relative to GDP 3.5% Interest payments as percentage of GDP 3.0 2.5 2.0 1.5 1.0 0.5 0 1945 1955 1965 1975 1985 1995 2005 Years Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Structural Irwin/McGraw-Hill Deficits, Cycles and Growth © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Structural Deficits, Cycles and Growth As aggregate income increases, tax revenues increase and the deficit declines. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Structural Deficits, Cycles and Growth As aggregate income increases, tax revenues increase and the deficit declines. The opposite occurs as aggregate income falls. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Structural Deficits, Cycles and Growth The structural deficit is the deficit that would remain when these cyclical elements have been netted out. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Structural Deficits, Cycles and Growth The structural deficit is the deficit that would remain when these cyclical elements have been netted out. This would result in an economy at its potential income. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Real Irwin/McGraw-Hill Growth and the Deficit © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Real Irwin/McGraw-Hill Growth and the Deficit © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Real Growth and the Deficit Some argue that as long as the economy is growing in real terms, and the debt/GDP ratio is maintained, the debt can grow without deleterious effects. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Real Growth and the Deficit Others argue that the debt-GDP ratio is already too high and should be brought down. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Irwin/McGraw-Hill Debt, and the Real Deficit © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit Inflation wipes out debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit The larger the debt and the larger the inflation, the more debt will be eliminated with inflation. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit If inflation is wiping out debt, and the deficit is equal to the increases in debt from one year to the next, inflation also affects the deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit A nominal deficit is the deficit determined by looking at the difference between expenditures and receipts. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit A real deficit is the nominal deficit adjusted for inflation’s effect on the debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and the Real Deficit A real deficit is the nominal deficit adjusted for inflation’s effect on the debt. real deficit = nominal deficit - (inflation x total debt) Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Irwin/McGraw-Hill Debt, and Nominal Deficits © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and Nominal Deficits Inflation wipes out debt, and that fact must be considered when evaluating the effect of a deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and Nominal Deficits Inflation is not a costless answer to eliminating debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Inflation, Debt, and Nominal Deficits The government’s gain from an inflation is the private bond holder’s loss from inflation. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Nominal and Real Interest Rates and Deficits Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Nominal and Real Interest Rates and Deficits Expectations of inflation push up the nominal interest rate and cause bond holders to demand an inflation premium on their bonds. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Nominal and Real Interest Rates and Deficits Future expectations of inflation causes the real interest rate to be different form the nominal interest rate. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Nominal and Real Interest Rates and Deficits If bond holders don’t lose when they make a full adjustment for expected inflation, government cannot win. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 GDP Growth Reduces Problems Posed by Deficits Nominal and Real Interest Rates and Deficits With full adjustments in expectations, creditors don’t lose. See numerical example on page 473 of the textbook. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Summary to This Point Deficits are summary measures of the state of the economy. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Summary to This Point Deficits are summary measures of the state of the economy. They are dependent on the accounting procedures used. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Summary to This Point It is the financial health of the economy, not the deficit, with which we should be concerned. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Summary to This Point Deficits and debt should be viewed relative to GDP to determine their importance. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Summary to This Point The real deficit is the nominal deficit adjusted for the inflation reduction in the real debt. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The U.S. does not include many government obligations. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The U.S. does not include many government obligations. The U.S. uses a cash flow accounting system—an accounting system entering expenses and revenues only when cash is received or paid out. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The U.S. does not include many government obligations. The cash flow accounting system leads to a number of distortions in the budget and deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The U.S. does not include many government obligations. A number of government obligations do not show up as part of the deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The government uses accounting tricks to make the deficit look smaller. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The government uses accounting tricks to make the deficit look smaller. In the S&L bailout, the government increased insurance fees on member institutions and counted them as revenue. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The government uses accounting tricks to make the deficit look smaller. Since they were not nearly enough to cover the costs, the government sold special bonds which were not counted as expenditures. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Reasons for Concern About Budget Deficits The government uses accounting tricks to make the deficit look smaller. These are called off-budget expenditures, expenditures of money that are not counted as expenditures in the budget. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Funded and Unfunded Retirement Systems Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Funded and Unfunded Retirement Systems A funded pension system is one in which money is collected and invested in a special fund from which pension payments are made. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Funded and Unfunded Retirement Systems An unfunded pension system is one in which pensions are paid from current revenues. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Funded and Unfunded Retirement Systems The social security system is largely an unfunded pension system. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Funded and Unfunded Retirement Systems The problem with this is that there is no trust fund of assets earning interest to cover future payments. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems The potential problem is that the amount paid out exceeds the amount paid in. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems As long as each succeeding generation remains about the same size, the process works. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems If there is a baby boom generation, followed by normal-sized generations, when the baby boomers begin to retire, there is not enough money being paid into the system to sustain them. There are a number of ways to deal with this. Partially fund the system. Raise the retirement age. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System Social Security and the Budget Deficit The government responded to the unfunded social security system by raising the retirement age slightly and legislating a large increase in the rate of social security contributions. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems The tax increase was to fund a large trust fund. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System A Potential Problem With Unfunded Systems Unfortunately, deficit spending grew apace so the government was forced to finance the trust fund by issuing bonds as a promise to pay for funding the trust fund. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System An Alternative Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System An Alternative Raise the eligibility age so that by 2010, it will stand at 70 years. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System An Alternative Lower the current social security tax rates by 10 percent. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Social Security Retirement System An Alternative The effect would be an increase in the current budget deficit accompanied by an increase in U.S. financial strength. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Irwin/McGraw-Hill Views of the Deficit © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The wolf-at-the-door group believes that the deficit will bring about imminent doom. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The wolf-at-the-door group believes that the deficit will bring about imminent doom. Few economists belong to this group. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The domesticated-pussycat group believes that the deficit does not matter. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The domesticated-pussycat group believes that the deficit does not matter. A small but vocal group belong to this group. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The termites-in-the-basement group believes that continuing deficits will cause serious problems in the long run. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Three Alternative Views of the Deficit The termites-in-the-basement group believes that continuing deficits will cause serious problems in the long run. The largest number of economists belong to this group. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Irwin/McGraw-Hill Right? © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Irwin/McGraw-Hill Right? © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Right? The Proxmire letter mirrors the views of most lay people’s views of the deficit. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Right? Eisner’s response represents the views of liberal Keynesian economists, of which he is one. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Right? Some Classical economists believe deficits don’t matter because people are rational and fully discount future tax payments deficits would entail. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Right? The Modigliani/Solow response to Eisner argues that the deficits are gnawing away at the structure of the economy. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 The Deficit Debate: Wolves, Pussycats, or Termites Who’s Right? The economy is fundamentally sick and using slick accounting Band-Aids will not cure the illness. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998 Comparisons of Government Debt to GDP A pproximate ratios of government debt to GDP 120% Italy 100% Canada 92% Japan 67% United States 60% Germany 50% United Kingdom Sw itzerland 15% A ustralia 15% Source: World Economic Outlook, 1996 (International Monetary Fund). Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998