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Chapter 12: Government Debt and Budget Balance J. Bradford DeLong --First Draft-1999-07-27: 4,493 words Measuring the Debt, Measuring the Budget Before we discuss the deficit and debt further, we need to spend a little bit of time on measurement issues. Just what, exactly, is the budget balance? Or, rather, which of the many possible budget balances—totals that produce one final surplus or deficit number—that are calculated should we pay the most attention to? The Cash Balance The budget bottom line that is reported in the newspapers the most often is the so-called “unified cash” balance: the difference between the money that the government actually spends in a year, and the money that it takes in. This balance is called “unified” because it unifies all of the government’s accounts and trust funds (including Social Security). This balance is called “cash” because it doesn’t take account of changes in the value of government-owned assets or of the future liabilities owed by the government: it is just cash in minus cash out. (Unfortunately, the “cash” balance does make a few allowances for future liabilities: when the government guarantees a loan, for example, the reserve set aside in case the borrower defaults and the government actually has to make good on its guarantee is for complicated political reasons counted as a “cash budget” expenditure, even though it isn’t.) It is not even completely clear what the economically-relevant budget balance is. There are a number of adjustments that can be and frequently are made to the budget balance to try to produce a more relevant and useful number than the balance reported for the unified cash budget. Adjustments Cyclical Adjustment The first adjustment often made to the budget balance is to take out the effects of the fiscal automatic stabilizers. A component of the budget deficit (or surplus) is due to the automatic reaction of the deficit to the stage of the business cycle. When unemployment is high, taxes are low and social welfare spending high, so the budget balance tends to swing into deficit. When unemployment is low, taxes are high—and the budget balance tends to swing into surplus. The effect of these automatic stabilizers on the budget balance makes it hard to interpret the budget balance. Is such-and-such a shift in the bottom line the result of a change in policy, or just the result of the phase of the business cycle? To allow themselves and others to concentrate on changes in policy, the government calculates a cyclically-adjusted or high-employment budget balance. It is what the estimated budget balance would be if the current level of GDP were equal to potential output. Almost everyone who analyzes economic and budget policy prefers to make this adjustment, and to work with cyclically-adjusted rather than raw cash budget balances. [Figure: Cyclically adjusted budget balance and actual cash balance, 1960present] Inflation A second adjustment that almost all economists believe is warranted corrects the measured budget balance for inflation. A portion of the debt interest paid out by the government to its bondholders is merely compensation to them for the fact that inflation is eroding the value of their principal. At the end of the year, the debt principal plus this inflation component of debt interest are together equal— in their power to purchase useful goods and services—to what the debt principal was at the start of the year. A good measure of the deficit should be a measure of whether the government is spending more in the way of resources than it is taking in: a measure of the change in the real debt that the government owes. Almost everyone who analyzes economic and budget policy prefers to work with inflation-adjusted budget balance numbers. [Figure: the Inflation-adjusted budget balance] Government Investment Yet a third adjustment corrects for an asymmetry between the treatment of private and public assets. Private spending on long-lived capital goods is called “investment.” A business that has total sales of $100 million, costs of goods sold of $90 million, and spends $20 million on enlarging its capital stock reports a profit of $10 million—not a deficit of $10 million. Standard and sensible accounting treatment of long-lived valuable assets in the private sector is definitely not to count their entire cost as a charge at the time of initial purpose, but instead to spread the cost out—a process called “amortization”—over the useful life of the asset. Shouldn’t the government do its accounting the same way, like a business, and amortize rather than expense its spending on long-lived assets? There are periodic calls that the federal government budget should be reformed, and that the federal government should do capital budgeting. But few people use numbers based on capital budgeting. The principal reason that capital budgeting is resisted is political. Which government expenditures are capital expenditures? Aircraft carriers and nuclear weapons? The interstate highway system? Improvements to trails in the national parks? Headstart expenditures—money spent on educating poor children (after all, it is an investment in their future)? It is hard to see any long-run dividing line between government investment and government consumption expenditures that would be sustainable from a political point of view. Thus critics regard capital budgeting as simply too difficult to implement in a helpful way. Supporters, however, point out that not doing capital budgeting at all is, in a sense, worse than even the least helpful implementation. Liabilities and Generational Accounting All of the issues surrounding capital budgeting appear again whenever the longrun future of the government’s budget is considered. Back when I worked at the Treasury Department, some $10,000 a year was set aside for me in my Treasury pension account. It is as if my income had been $10,000 a year higher, and I had invested that extra $10,000 in U.S. government bonds. But bonds issued by the government appear on the books as part of the government’s debt. But pension fund liabilities that the government owes to ex-workers do not. Thus there is a sense in which the right way to count the government’s debt is to look not just at the bonds that it has issued but at all of the promises to pay money out in the future that it has made. Indeed, a large chunk of the government’s expenditures—those by the Medicare and Social Security Trust Funds, for example—are presented to the public in just this way. The Social Security deficit reported by the Trustees of the Social Security System every spring is not the difference between social security taxes paid in and social security benefits paid out, but is instead the long-run, seventy-five-year balance between the estimated value of the commitments to pay benefits that the Social Security System has made and will make, and the estimated value of the taxes that will be paid into the Social Security Trust Fund. But the Social Security Trustees’ Report covers just one program—albeit a big program. And great confusion is created by the fact that the Social Security systems expenditures and revenues are also included within the unified budget balance. Wouldn’t it be better to bring all of taxation and spending within a longrun system like that currently used by Social Security? Economists like Laurence Kotlikoff and Alan Auerbach say “yes!” They propose—instead of the year-by-year budget balances—that the United States governmetn shift to a system of “generational accounting” that would examine the lifetime impact of taxes and spending programs on individuals born in specific years, and that would come up with a final balance that could be used for long-term planning. It is hard to escape the conclusion that Auerbach and Kotlikoff have a very strong case. Yet few analysts of the budget use their “generational accounting” measures. [Box: U.S. fiscal policy through the lens of alternative deficit measures] To be written… Budget Balances and National Debts Sustainability The first question to ask about a government that is running a perennial deficit is: “Can it go on?” Is it possible for the government to continue running its current deficit indefinitely, or must policy change—possibly for the better, possibly for the worse. The thing to look at to decide whether the government’s fiscal policy is sustainable is the time path of the ratio of the government’s total debt to GDP, the debt-to-GDP ratio, which we will write in symbols as D/Y: “D” for debt, and “Y” for GDP. We would like to know toward what value this debt-to-GDP ratio is heading: what is the long-run steady-state value of D/Y given that the government is running a constant deficit equal to d percent of GDP? As in chapter 4, use the fact that if a ratio like D/Y at its steady state value, then both the numerator and the denominator are growing at the same proportional rate. We know from chapter 4 that the denominator—real GDP, Y—grows in the long run at a proportional annual rate n + g, where n is the annual rate of laborforce growth and g is the annual rate at which the efficiency of labor is augmented. What is the proportional rate at which the real debt, D, is growing? If the real debt this year is equal to Dt, then the real debt next year will be equal to: Dt+1 = (1-π)Dt + d x Yt The real value of the debt shrinks by a proportional amount π as inflation erodes away the real value of the debt principal owed by the government, and grows by an amount equal to the deficit as a percent of GDP d times the current level of GDP, Y. Thus the proportional growth rate of the real debt is: Y Dt 1 Dt d t Dt Dt And the debt-to-GDP ratio will be stable when these two proportional growth rates—of real GDP and of the real debt—are equal to each other: n + g = -π + d(Y/D) Which happens when: D d Y n g This is the level toward which the debt-to-GDP ratio is heading: this is the level consistent with a constant deficit of d percent of GDP in an economy with long run inflation rate π, and with long run real GDP growth rate n+g. So why then do economists talk about deficit levels as being “unsustainable”? It looks as though for any deficit as a share of GDP d, the debt-to-GDP ratio heads for a well-defined steady-state value. But this is only half the story: the debt that the government wants to issue goes to a stable level relative to GDP, but is this an amount of debt that anyone wishes to hold? The higher the debt-to-GDP ratio, the more risky and investment do financiers judge the debt of a country—and the less willing they are to buy and hold that debt. A higher debt-to-GDP ratio makes investments in the debt issued by a government more risky for two reasons. First, revolutions—or other, more peaceful changes of government—happen. One of the first things that any new government must decide is whether it is going to honor the debt issued by the previous governments. Are these debts the commitments of the nation, which as an honorable entity honors its commitments? Or are these debts the reckless mistakes made by and obligations of a gang of thugs, unrepresentative of the nation, to whom investors should have known better than to lend money for them to steal? The higher the debt-to-GDP ratio, the greater the temptation for a new government to repudiate debt issued by its predecessor. Hence the riskier is buying and holding a portion of a country’s national debt. Second, even if there is no change in government, it is still the case that a government can control the real size of the debt it owes through controlling the rate of inflation. The (nominal) interest rate to be paid on government debt is fixed by the terms of the bond issued. The real interest rate paid on the debt is equal to the nominal interest rate minus the rate of inflation—and the government controls the rate of inflation. Thus a government that seeks to redistribute wealth away from its bondholders to its taxpayers can do so by increasing the rate of inflation: the more inflation, the less is the government’s debt worth and the lower are the real taxes that have to be imposed to pay off the interest and principal on the debt. Whether a government is likely to increase the rate of inflation depends on the costs and benefits—and raising the rate of inflation does have significant political costs. But the higher the debt-to-GDP ratio, the greater the benefits to taxpayers of a sudden burst of inflation. When the debt-to-GDP ratio is equal to 2, a sudden 10% rise in the price level reduces the real wealth of the government’s creditors—and increases the real wealth of taxpayers—by an amount equal to 20% of a year’s GDP. By contrast, when the debt-to-GDP ratio is equal to 0.2 the same rise in the price level redistributes wealth equal to only 2% of a year’s GDP. Thus the government’s potential creditors must calculate that the greater the debt-to-GDP ratio, the greater are the benefits to the government of inflation as a way of writing down the value of its debt, the more likely is the government to resort to such inflation, and so the more risky are investments in the government’s debt. Thus a deficit is sustainable only if the associated steady-state debt-to-GDP ratio is low enough that investors judge the debt safe enough to be willing to hold it. Think of each government as having a debt capacity—a maximum debt-to-GDP ratio at which investors are willing to hold the debt issued at reasonable interest rates. If this debt capacity is exceeded then the interest rates that the government must pay on its debt spike upwards—and the government is faced with either a much larger deficit than planned (as a result of higher interest costs), or with resorting to inflation or hyperinflation to write the real value of the debt down. Deficits that lead to steady-state debt-to-GDP ratios higher than the government’s debt capacity are not sustainable—and as economist Herbert Stein said, if something cannot go on forever then at some time it will stop. [Box: Another long-run effect: unpleasant monetarist arithmetic and the incentives for inflation] To be written… Effects of Deficits: The Conventional View Even if a given deficit as a share of GDP is sustainable, it still may have significant effects on the economy, both in the short run and in the long run. In the last chapter we saw that discretionary fiscal policy cannot help moderate the business cycle: laws passed to increase the government deficit and stimulate the economy are likely to take effect long after the phase of the business cycle, and thus the need for stimulus, is passed. What, then, can discretionary fiscal policy do? It can change the level of the government’s debt. Whenever the government spends more than it collects in taxes (and in seigniorage from printing money), it must borrow. It sells the public promises that the government will repay the principal it borrows with interest: threemonth Treasury bills, ten-year Treasury notes, thirty-year Treasury bonds, and other securities. And these accumulated promises to pay make up the government debt. [Figure: U.S. government debt since the Civil War] Usually governments run up large debts during wartime. Their survival, and perhaps the survival of their nation and their civilization, is at stake. So during major wars governments use all the tools they have to gain control of resources for their fleets, armies, and airforces. And one of those tools is a very healthy dose of government borrowing. The great peaks in U.S. government debt as a share of total domestic product all come after the three major wars in which the U.S. has been engaged: the Civil War, World War I, and World War II. Usually during peacetime the size of the government debt as a share of GDP falls. Economic growth raises real GDP and inflation provides an additional boost to nominal GDP. As long as the government’s tax and spending programs are not grossly out of whack—as long as the overall budget is not in enormous deficit—in peacetime government debt tends to fall as a share of GDP. Thus the violation of this empirical regularity in the U.S. in the 1980s—the sudden emergence of peacetime deficits large enough to cause a substantial upward jump in the debt-to-GDP ratio—was a great surprise. [Figure: U.S. government debt to GDP ratio, 1970-present] In part because of higher spending on defense and other programs in the 1980s, in part because of substantial tax cuts, the Reagan presidency set in motion a series of deficits that ended by nearly doubling the burden of the federal government debt as a share of GDP. The rise in the debt was brought to an end by three factors: President Bush’s economic advisors, who persuaded him to go back on his campaign pledge of “read my lips, no new taxes” and to negotiate a serious deficit-reduction program including major reforms in congressional budget procedures in 1990. President Clinton and his economic advisors, who made deficit reduction the highest priority of his administration in 1993. A healthy dose of good macroeconomic luck. A fair but rough assignment of credit would give 40% to those who planned the 1990 deficit-reduction program, 30% to those who planned the 1993 deficitreduction program, and 30% to sheer dumb good luck. The end of the era of deficits was, by the late 1990s, trumpeted as an amazing and important political success, a policy accomplishment that would significnatly improve the lives of Americans. [Figure: Federal spending and tax collections, 1960-present] But how big a burden is a large national debt? How important was the doubling of the debt as a share of GDP that took place in the 1980s and early 1990s? One view—the view held by the majority of economists—is that the emergence of such large government deficits has expansionary effects on the economy in the short run, and contractionary effects on the economy in the long run. Short Run In the short run, the income-expenditure diagram tells us that a deficit produced by a tax cut stimulates consumer spending. A deficit produced by an increase in government spending increases government purchases. Either way, it shifts the IS curve out and to the right: any given interest rate is associated with a higher equilibrium value of production and employment. If monetary policy is unchanged—if the LM curve does not shift—then output and employment rise in response to the tax cut. A deficit is expansionary in the short run. Caveats Of course, the belief that deficits are expansionary—increase production and employment—in the short run hinges on the Federal Reserve’s maintaining monetary policy unchanged in response to the rise in the deficit. If the Federal Reserve does not want inflation to rise, it will respond to the rightward expansionary shift in the IS curve by tightening monetary policy: shifting the LM curve back and to the left, neutralizing the expansionary effect of the deficit. As the discussion in the previous chapter suggested, the decision and policy implementation cycle for monetary policy is significantly shorter than the decision and policy implementation cycle for discretionary fiscal policy. There is little doubt that the central bank can keep legislative actions to change the deficit from affecting the level of production and unemployment. The question is whether it will. The answer is “very probably.” The central bank is presumably trying its best to guide the economy along a narrow path without excess unemployment and without accelerating inflation. It has made its best guess as to what level of aggregate demand leads along that path. In all likelihood its senior officials are uninterested in seeing the economy pushed away from that path by the fiscal policy decisions of legislators. Hence it is very likely that the central bank will act to neutralize any effect of changes in fiscal policy on the level of output and employment. [Figure: central bank neutralizing effects of fiscal policy on output and employment] [Box: Interest rate forecasts and the Clinton deficit reduction program] To be written… Open-Economy Effects Such an increase in the government’s budget deficit also leads to an increase in the trade deficit. The outward shift in the IS curve pushes up interest rates. Higher interest rates mean an appreciated dollar, and so imports rise and exports fall. Up until now we have implicitly assumed that the composition of aggregate demand has no effect on the productivity of industry: businesses have been implicitly assumed to be equally happy and equally productive whether they are producing consumption goods, investment goods for domestic use, goods and services that the government will purchase, or for the export market. Yet this is unlikely to be true. As you will recall from your microeconomics courses, the point of international trade is to export those goods which your economy is especially productive at making for goods which your economy is relatively unproductive at making. As large deficits that increase interest rates raise the value of the exchange rate, export industries—likely to be highly productive—shrink as exports shrink, reducing total productivity. Nobody, however, has a very sound estimate of how large these effects might be. [Figure: Budget Deficits and the International Sector] Long Run Effects In the long run, the increase in the deficit means that more of total product goes for consumption or government purchases, and less remains for investment and capital accumulation. The increase in the deficit reduces the investment share of GDP. Thus the long-run growth path of the economy has a lower capital-output ratio and a lower level of output per worker associated with the current level of labor productivity. But there’s more. A higher deficit means a higher debt, which means that the government owes more in the way of interest payments to bondholders. Over time—even if the level of the deficit is kept constant—the increase in interest payment will require tax increases. And these tax increases will discourage entrepreneurship and economic activity. In addition to the reduction in output per worker resulting from the lower capital-output ratio, there will be an additional reduction in output per worker: the increased taxes needed to finance the interest owed on the national debt will have negative supply-side effects on production. That is the dominant view that economists hold of the effects of large government deficits. But there are serious critiques of this dominant view, the most powerful of which is mounted by Professor Robert Barro of Harvard University. These alternative views are covered in chapter 17. [Box: How large were the effects of the Reagan deficits?] To be written… Chapter summary Main points 1. The standard measure of the budget balance—the one you see in the newspapers and on television—is the “unified cash” balance. It is “unified” in that it pulls together all of the federal government’s revenues and expenditures. It is “cash” in that it counts cash paid out and cash paid in—and does not take account of changes in the value either of assets or of liabilities. 2. The standard measures of the budget balance is not a very good measure of fiscal policy. 3. Most people analyzing the government’s budget adjust the budget balance first to remove the effect of automatic stabilizers and the business cycle on the government’s balance, and second to remove that component of debt interest which merely compensates bondholders for the inflation-driven real reduction in the value of their principal. 4. A few economists go further, and adopt either “capital budgeting” or “generational accounting” approaches to the federal budget. 5. The dominant view in economics is that a spending increase unaccompanied by a tax increase—and thus financed by issuing debt—stimulates consumer spending and raises GDP in the short run, but depresses savings and investment and slows economic growth in the long run. But a challenge to this dominant view comes from Robert Barro, who argues that a spending increase unaccompanied by a contemporaneous tax increase should have no effect on consumer spending or savings and investment. Why should our behavior depend on when our agent happens to submit the bill we owe it? Analytical exercises [To be written] Policy exercises [To be written, and revised for each year within editions]