1. Deficits and Debt Chapter 12 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 12-2 Deficits and Debt The core critique of fiscal stimulus focuses on the budget consequences of government pump- priming –How do deficits arise? –What harm, if any, do deficits cause? –Who will pay off the accumulated national debt?

3. 12-3 Budget Effects of Fiscal Policy Keynesian theory highlights the potential of fiscal policy to solve macro problems –Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes Use of the budget to stabilize the economy implies that federal expenditures and receipts won’t always be equal

4. 12-4 Budget Surpluses and Deficits Deficit spending: The use of borrowed funds to finance government expenditures that exceed tax revenues Budget deficit: Amount by which government spending exceeds government revenue in a given time period

5. 12-5 Budget Surpluses and Deficits If the government spends less than its tax revenues, a budget surplus is created Budget surplus: An excess of government revenues over government expenditures in a given time period

6. 12-6 Budget Deficits and Surpluses Budget Total (in billions of dollars) 2004 2005 2006 2007 2008 2009 2010 Revenues 1,880 2,154 2,407 2,568 2,524 2,159 2,289 Outlays-2,293-2,472-2,655-2,729-2,983-4,004-3,669 Surplus (deficit) (413) (318) (248) (161) (459) (1,845) (1,380) Source: Congressional Budget Office

7. 12-7 A String of Deficits Budget deficits are overwhelmingly the rule, not the exception.

8. 12-8 Keynesian View Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy The goal of macro policy is not to balance the budget but to balance the economy at full- employment

9. 12-9 Discretionary vs. Automatic Spending At the beginning of each year, the President and Congress put together a budget blueprint for the next fiscal year Fiscal year (FY): The 12-month period used for accounting purposes; begins October 1 for the federal government

10. 12-10 Discretionary vs. Automatic Spending Current revenues and expenditures are largely the result of prior year’s decisions –Only about 20 percent is discretionary spending –Uncontrollables account for roughly 80 percent Discretionary fiscal spending: Those elements of the federal budget not determined by past legislative or executive commitments

11. 12-11 Discretionary vs. Automatic Spending Since most of the budget is uncontrollable, fiscal restraint or stimulus is less effective Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand

12. 12-12 Automatic Stabilizers Most uncontrollable line items in the federal budget change with economic conditions Automatic stabilizer: Federal expenditure or revenue item that automatically responds counter-cyclically to changes in national income, like unemployment benefits, income taxes

13. 12-13 Cyclical Deficits Cyclical deficit: That portion of the budget balance attributable to short-run changes in economic conditions –The cyclical deficit widens when GDP growth slows or inflation decreases –The cyclical deficit shrinks when GDP growth accelerates or inflation increases

14. 12-14 Structural Deficits To isolate effects of fiscal policy, the actual budget balance is broken down into cyclical and structural components

15. 12-15 Structural Deficits Structural deficit: Federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy Part of the deficit arises from cyclical changes in the economy; the rest is the result of discretionary fiscal policy

16. 12-16 Cyclical vs. Structural Budget Balances (in billions of dollars) Fiscal Year Budget Balance= Cyclical Component+ Structural Component 2000+ 236+ 94+ 142 2001+ 128+ 19+ 109 2002 - 158 - 62 - 96 2003 - 378 - 84 - 294 2004 - 413 - 46 - 367 2005 - 318 - 21 - 297 2006 - 248 - 8 - 240 2007 - 161 - 28 - 133 2008 - 459 - 76 - 383 2009 - 1667- 310- 1357 Source: Congressional Budget Office (June 2009) Changes in the structural component result from policy changes; changes in the cyclical component result from changes in the economy.

17. 12-17 Structural Deficits Only changes in the structural deficit measure the thrust of fiscal policy –Fiscal stimulus is measured by an increase in the structural deficit (or shrinkage in the structural surplus) –Fiscal restraint is gauged by a decrease in the structural deficit (or increase in the structural surplus)

18. 12-18 Economic Effects of Deficits Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing Crowding out reminds us that there is an opportunity cost to government spending Government borrowing to finance deficits puts upward pressure on interest rates

19. 12-19 Public-sector output Private-sector output Crowding Out Increase in government spending... Crowds out private spending b c a g2g2 g1g1 h2h2 h1h1

20. 12-20 Economic Effects of Surpluses Four potential uses for a budget surplus: –Spend it on goods and services –Cut taxes –Increase income transfers –Pay off old debt (“save it”) The economic effects are the mirror image of those for deficits

21. 12-21 Crowding In Crowding in: An increase in private-sector borrowing (and spending) caused by decreased government borrowing When the government reduces borrowing, it takes pressure off market interest rates As interest rates drop, consumers will be more willing and able to purchase big-ticket items

22. 12-22 Cyclical Sensitivity Crowding in depends on the state of the economy In a recession, a decline in interest rates is not likely to stimulate much spending if consumer and investor confidence is low

23. 12-23 The Accumulation of Debt The U.S. government has had many more years of budget deficits than budget surpluses National debt: The accumulated debt of the federal government

24. 12-24 Debt Creation When the Treasury borrows funds it issues treasury bonds Treasury bonds: Promissory notes (IOUs) issued by the U.S. Treasury The national debt is a stock of IOUs created by annual deficit flows

25. 12-25 Historical View of the Debt/GDP Ratio

26. 12-26 Who Owns the Debt? The national debt creates as much wealth for bondholders as liabilities for the government Liability: An obligation to make future payment; debt Asset: Anything having exchange value in the marketplace; wealth

27. 12-27 Ownership of Debt Source: U.S. Treasury Department (2008 data)

28. 12-28 Ownership of Debt 72 percent of the national debt is internal Internal debt: U.S. government debt (Treasury bonds) held by U.S. households and institutions External debt: U.S. government debt (Treasury bonds) held by foreign households and institutions

29. 12-29 Burden of the Debt The debt has historically been refinanced –Refinancing: The issuance of new debt in payment of debt issued earlier Most debt servicing is simply a redistribution of income from taxpayers to bondholders –Debt service: The interest required to be paid each year on outstanding debt

30. 12-30 Burden of the Debt Opportunity costs are incurred only when real resources (factors of production) are used The true burden of the debt is the opportunity costs of the activities financed by the debt

31. 12-31 The Real Trade-Offs Deficit financing tends to change the mix of output toward more public-sector goods The burden of the debt is the opportunity cost of deficit-financed government activity The primary burden is incurred when the debt- financed activity takes place

32. 12-32 Economic Growth Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment The whole debate about the burden of debt is really an argument over the optimal mix of output

33. 12-33 Repayment Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future

34. 12-34 External Debt External financing allows us to get more public-sector goods without cutting back on private-sector production (or vice versa) As long as outsiders are willing to hold U.S. bonds, external financing imposes no real cost

35. 12-35 External Financing Extra output (imports) financed with external debt a bd h2h2 h1h1 g2g2 g1g1 Public-sector Output Private-sector Output

36. 12-36 Repayment Foreigners may not be willing to hold bonds forever External debt must be paid with exports of real goods and services

37. 12-37 Deficit and Debt Limits The only way to stop the growth of the national debt is to eliminate the budget deficit that created it Deficit ceiling: An explicit, legislated limitation on the size of the budget deficit Debt ceiling: An explicit, legislated limit on the amount of outstanding national debt

38. 12-38 Dipping into Social Security Social Security Trust Fund has been a major source of federal funding for over 20 years Surpluses have largely resulted from Baby Boomers paying more in payroll taxes than are paid out in benefits to the retired The Trust Fund balance shifts from surplus to deficit soon after 2014

39. Deficits and Debt End of Chapter 12 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin