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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.
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
Learning Objectives (cont'd)
• Analyze the macroeconomic effects of
government budget deficits
• Describe possible ways to reduce the
government budget deficit
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
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.
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)
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
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
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
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Public Debt
– A stock variable
– The total value of all outstanding federal
government securities
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
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
Figure 14-2 The Federal Budget Deficit Expressed as a
Percentage of GDP
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
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
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
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
Table 14-1 The Federal Deficit, Our Public Debt, and the Interest
We Pay on It
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
Figure 14-3 The Official Net U.S. Public
Debt as a Percentage of GDP
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
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
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
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 bondrating 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.
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
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
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
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
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.
Federal Budget Deficits
in an Open Economy
• Question
– Is there a relationship between the U.S. trade
deficit and the federal government budget deficit?
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
Figure 14-4 The Related U.S. Deficits
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
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
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
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 governmentprovided goods and services
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
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.
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
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
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
Figure 14-5 Components of Federal Expenditures as Percentages
of Total Federal Spending
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
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.
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. deficitGDP 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.”
Figure 14-6 Government Budget Deficit and Net Public Debt as
Percentages of GDP in Selected Nations
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
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
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
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