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POLITICS, DEFICITS, AND DEBT
Deficits
Laugher Curve
When Albert Einstein died, he met three
New Zealanders in the queue outside the
pearly gates.
 To pass the time, he asked what were their
IQs.

Laugher Curve

The first replied 190.

"Wonderful," exclaimed Einstein, "We can
discuss the contribution made by Earnest
Rutherford to atomic physics and my
theory of general relativity.”
Laugher Curve

The second answered 150.

"Good," said Einstein, "I look forward to
discussing the role of New Zealand's
nuclear-free legislation in the quest for
world peace.”
Laugher Curve

The third New Zealander mumbled 50.

Einstein paused, and then asked, "So what
is your forecast for the budget deficit next
year?"
This chapter will:
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Define the terms deficit, surplus, and debt.
Distinguish between a passive deficit and a
structural deficit.
Differentiate between real and nominal deficits and
surpluses.
Explain why the debt needs to be judged relative to
assets.
Describe the historical record for the U.S. deficit
and debt.
Summarize the current debate about Social
Security and Medicare and identify the real problem
and the real solution.
Introduction

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In 2005 the U.S. had a large budget deficit (a
shortfall of revenues over payments), as it had
for the past three years.
The current deficits are a substantial change
from the surpluses from 1998 to 2001.
In the long run, deficits are bad because they
reduce saving and growth.
Long-run surpluses (excesses of revenues
over payments) are good because they provide
saving for investment.
Introduction
In the short run, if the economy is below
potential, deficits are good and surpluses
are bad because deficits increase
expenditures moving output closer to
potential.
 Combining the two frameworks gives the
following policy directive:

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Whenever possible, run surpluses, or at least a
balanced budget to help stimulate long-run
growth.
Expansionary Fiscal Policy
Price
level
• If the economy is at
LAS
equilibrium at point A,
there is a recessionary
gap Y0 – YP.
• The appropriate
B
SAS
P1
P0
AD1
A
• AD increases to AD1
AD0
Y0
fiscal policy is to
increase government
spending and/or
decrease taxes.
YP
Real output
and output returns to
potential output YP and
prices increase
slightly to P1.
Defining Surpluses and Debt
A surplus is an excess of revenues over
payments.
 A deficit is a shortfall of revenues over
payments.

Financing the Deficit
The government finances its deficit by
selling bonds to private individuals and to
the central bank.
 Bonds – promises to pay back the money
in the future.

Financing the Deficit

A central bank is able to print money to
buy its government’s bonds.
Potentially, the central bank can print an
unlimited amount of money to buy bonds.
 Printing too much money means inflation
which can have a negative effect on the
economy.

Arbitrariness in Defining
Surpluses and Deficits
Whether a nation has a deficit depends on
what is included as a revenue and what is
included as an expenditure.
 This accounting issue is central to the
debate about whether we should be
concerned about a deficit.

Arbitrariness in Defining
Surpluses and Deficits

How the Social Security system is
accounted for plays an important role in
the size of the budget deficit.

Social Security System - a social insurance
program that provides financial benefits to the
elderly and disabled and to their eligible
dependents and/or survivors.
Many Right Definitions
There are many ways to measure
expenditures and receipts.
 There are many ways to measure deficits
and surpluses.
 All definitions are not necessarily correct.

Deficits and Surpluses as
Summary Measures
Deficits and surplus figures are simply
summary measures of the financial health
of the economy.
 To understand the summary, you must
understand the methods that were used to
calculate it.

Deficits and Surpluses as
Summary Measures

What is important is not whether a budget
is in surplus or deficit; what is important is
the economic health of the economy.
Structural and Passive Surpluses
and Deficits
Not all government expenditures are
independent of the level of income in the
economy.
 The budget deficit could result from
policies designed to affect the economy or
from income deviating from its potential.

Structural and Passive Surpluses
and Deficits

A structural deficit or surplus – the part
of the budget deficit or surplus that would
exist even if the economy were at its
potential level of income.
Structural and Passive Surpluses
and Deficits

A passive deficit or surplus is the part of
the deficit or surplus that exists because
the economy is operating below or above
its potential level of output.
Structural and Passive Surpluses
and Deficits

When an economy is operating above its
potential, it has a passive surplus.

If the economy is operating below its
potential, the actual deficit would be larger
than the structural deficit.
Structural and Passive Surpluses
and Deficits
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There is a significant debate about what is
an economy’s potential income level.
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There is disagreement about what
percentage of a deficit is structural and
what part is passive.
Structural and Passive Deficits
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There is disagreement about what percentage of
a deficit is structural and what part is passive.
Actual deficit = structural deficit +
passive deficit
Passive deficit = tax rate x
(potential output – actual output)
Structural deficit = actual deficit – passive deficit
Budget Deficits and Surpluses:
Actual, Passive, and Structural
(–) Deficit or
(+) Surplus
1980
1990
2000
2001
2002
Passive
-61
-100
+137
+47
-5
Plus structural
-13
-121
+99
+80
-153
Equals actual
-74
-221
+236
+127
-158