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Chapter 12:
Deficits and Debt
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Fiscal Stimulus and the Deficit
• A fiscal stimulus package is designed to move
the economy out of recession toward fullemployment GDP.
• Tax cuts or increased government spending, or
a combination of the two, increases the size of
the budget deficit.
• Borrowed funds to finance the stimulus must
be paid for in the future by increased taxes or
reduced spending, both fiscal restraint tools.
12-2
Learning Objectives
• 12-01. Know the origins of cyclical and
structural debt.
• 12-02. Know how the national debt has
accumulated.
• 12-03. Know how and when “crowding out”
occurs.
• 12-04. Know what the real burden of the
national debt is.
12-3
Budget Effects of Fiscal Policy
• Using fiscal policy to solve macro problems
implies that federal expenditures and
federal receipts won’t always be equal.
– In fiscal stimulus, G increases or T decreases.
– In fiscal restraint, G decreases or T increases.
• Budget deficit: amount by which G exceeds T
in a given time period.
Budget deficit = Government spending – Tax revenues > 0
12-4
Keynes’s View on Budget Deficits
• Budget deficits are a routine by-product of
fiscal policy, caused by a fiscal stimulus to
increase AD.
• The goal of macro policy is not to balance
the budget but to move the economy to fullemployment GDP.
• Keynes: Full employment first, then worry
about the deficit.
12-5
Discretionary vs.
Automatic Spending
• Discretionary spending: those elements of
the budget not determined by past
legislative or executive commitments.
• Automatic spending: those elements of the
budget that are a result of decisions made in
prior years; said to be “uncontrollable.”
• Make up of the budget:
– Automatic (uncontrollable): about 80 percent.
– Discretionary (controllable ): about 20 percent.
12-6
Uncontrollable?
• The president and Congress can repudiate
prior commitments and enact new legislation.
–
–
–
–
Reduce Social Security benefits.
Refuse to pay interest on the accumulated debt.
Terminate projects approved in prior years.
Reduce payouts for other social welfare programs.
• They would face political consequences in
doing so.
12-7
Automatic Stabilizers
• Automatic stabilizer: federal expenditure or
revenue item that automatically responds
countercyclically to changes in national income
(GDP).
– As a recession begins, unemployment
compensation and welfare payments increase and
income tax collections decrease, each stimulating
economic growth in a small way.
– As economic growth returns, the opposite happens,
which puts a small restraint on economic growth.
12-8
Cyclical Deficits
• Cyclical deficit: that portion
of the budget deficit
attributable to short-run
changes in economic
conditions.
• The cyclical deficit
– Widens when GDP growth
slows or inflation increases.
– Shrinks when GDP growth
accelerates or inflation
decreases.
• As the economy slows
– Tax revenues decline.
– Unemployment benefits
rise.
– Other transfer payments
rise.
• As the economy grows
–
–
–
–
Tax revenues rise.
Unemployment benefits fall.
Other transfer payments fall.
Interest rates could rise,
increasing debt payments.
12-9
Structural Deficits
• Structural deficit: federal revenues at full
employment minus expenditures at full
employment under prevailing fiscal policy.
• The structural deficit reflects fiscal policy
decisions – that is, discretionary fiscal policy.
• Therefore, part of the deficit arises from
cyclical changes in the economy; the rest is a
result of discretionary fiscal policy.
12-10
Who Is to “Blame” for Deficit Increases?
• The impact of cyclical components
(automatic stabilizers) and policy initiatives
affect the budget at the same time.
• According to the CBO, in 2009 the trilliondollar budget deficit increase was due in
part to the recession ($278 billion) and the
rest to discretionary fiscal policy ($675
billion).
12-11
Measuring the Impact of Fiscal Policy
• We must focus on changes in the structural
deficit, not the total deficit.
– Fiscal stimulus is measured by an increase in
the structural deficit (or shrinkage in the
structural surplus).
– Fiscal restraint is measured by a decrease in the
structural deficit (or increase in the structural
surplus).
12-12
Economic Effects of Deficits
• Crowding out can occur, especially as the
economy closes in on full employment.
– Increased government borrowing to finance a
growing deficit reduces the availability of funds for
private sector spending.
– Thus any increase in government expenditures will
be offset by reductions in consumption and
investment spending.
– Tax cuts will increase consumer spending, but near
full employment may force cutbacks in investment
or government services.
12-13
Economic Effects of Deficits
• Interest rate movements:
– An increase in demand for funds will cause the
price of borrowing – the interest rate – to rise.
– Rising interest rates make it more costly for
consumers or businesses to borrow, and they
may cut back.
– Rising interest rates also increase the
borrowing costs of government, leaving less
room in government budgets for financing new
projects.
12-14
Economic Effects of Surpluses
• If the government runs a surplus – that is, tax
revenues are greater than government
expenditure - it is a leakage to the circular flow.
It is a drag on the economy.
• Potential uses for a budget surplus:
–
–
–
–
Spend it on goods and services.
Cut taxes.
Increase income transfers.
Pay off old debt (“save it”).
12-15
Economic Effects of Surpluses
• Spending a surplus increases the size of the
public sector.
• Cutting taxes or increasing income transfers
puts money in the peoples’ hands and enlarges
the private sector.
• Paying off some accumulated debt puts money
in the hands of the debt holders:
– They buy more goods and services.
– Expands the private sector.
– Lowers the demand for funds and the interest rates.
12-16
The Accumulation of Debt
• The national debt is the accumulation of many
more years of running budget deficits than
budget surpluses.
– The U.S. Treasury borrows by issuing Treasury
bonds to lenders who want a safe investment
paying out interest.
– When there is a deficit, the national debt increases.
– When there is a surplus, the national debt can be
pared down.
12-17
The National Debt
• In 2011 the national debt was nearing $15
trillion.
• That is an average of more than $50,000 for
every U.S. citizen.
• A better indicator is the debt-to-GDP ratio.
– Except for the Civil War, this ratio was about 10
percent from 1790 to 1917.
– During World War II, it rose to 130 percent.
– In 2000 it was about 35 percent.
– By 2012 it will rise above 100 percent.
12-18
Who Owns the Debt?
• The national debt creates as much wealth for
bondholders as it does liabilities for the U.S.
Treasury.
• Who are the bondholders (owners)?
– Federal agencies (such as the Federal Reserve and
the Social Security Administration) hold 40 percent
of all outstanding Treasury bonds.
– State and local governments hold 5 percent.
– The private sector holds 24 percent.
– Foreigners hold 31 percent.
12-19
Why Hold U.S. Government Debt?
• Relative to other investments:
– They are safe.
– There is no question of the debt being repaid.
– They pay interest.
– Dollar-denominated assets are generally
acceptable in world trade.
12-20
The Burden of the Debt
• Refinancing: the issuance of new debt in
payment of debt issued earlier.
– When a Treasury bond matures, new funds are
borrowed to pay it off.
– So the debt remains debt. There is no addition
to the debt. Only another deficit adds to the
debt.
12-21
The Burden of the Debt
• Debt service: the interest required to be
paid each year on outstanding debt.
– Increased interest payments use up funds that
cannot be used for other government
expenditures.
– Debt servicing is a redistribution of income
from taxpayers to bondholders.
12-22
The Burden of the Debt
• Opportunity cost:
– The true burden of the debt is the opportunity cost
of the activities financed by the debt.
– Funds spent on government expenditures cannot be
used for other (public or private) expenditures.
– Resources consumed by a government expenditure
cannot be used to produce other goods and
services.
– The value placed on these forgone goods and
services is the opportunity cost, however financed.
12-23
The Real Trade-Offs
• Deficit spending changes the mix of output
in the direction of more public sector goods.
• The burden of the debt is really the
opportunity cost (crowding out) of deficitfinanced government activity.
12-24
The Debt and Economic Growth
• If deficit-financed government spending
crowds out private investment, future
generations will bear some of the debt burden.
– We will have smaller-than-anticipated productive
capacity.
– There will be some question about achieving an
optimal mix of output.
• The public sector grows at the expense of the private
sector.
12-25
Repayment
• If the U.S. Treasury pays off maturing bonds
with taxes, it is a redistribution of income
from taxpayers to bondholders.
– The heirs of current bondholders receive the
payout.
– The taxpayers in the future are hit with the
taxes to pay off the maturing bonds.
12-26
External Debt
• Borrowing from foreigners eliminates
crowding out.
– We get more public sector goods without cutting
back on private sector production.
– Foreigners get the dollars by selling us more
imports than they buy of our exports.
– We can consume an amount greater than the
domestic-only PPC would allow us to consume.
• As long as foreigners are willing to hold U.S.
debt, external financing imposes no real cost.
12-27
External Debt
• If foreigners no longer want to hold U.S.
debt, they will sell their bonds and hold
dollars, which they can use to buy dollardenominated goods and services, mainly
U.S. exports.
• External debt will be repaid with exports of
real goods and services.
12-28
Deficit and Debt Limits
• The only way to stop the growth of the debt is
to eliminate budget deficits.
– One way is to balance the budget (G = T).
– A gradual way is to impose a debt ceiling that is
decreased each year until it reaches zero.
• Debt ceiling: an explicit, legislated limit on the
amount of outstanding national debt.
– This leads to compromises on how best to use
budget deficits.
– Usually, when the debt ceiling is reached, Congress
simply increases it.
12-29