1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Deficits, Surpluses, and Debt Chapter 12

2. 2 Budget Effects of Fiscal Policy Keynesian theory highlights the potential of fiscal policy to solve macro problems. Fiscal Policy is the use of government taxes and spending to alter macroeconomic outcomes.

3. 3 Budget Surpluses and Deficits Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.

4. 4 Budget Surpluses and Deficits Budget deficit is the amount by which government spending exceeds government revenue in a given time period. Budget deficit = government spending – tax revenues > 0

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

6. 6 Budget Deficits and Surpluses

7. 7 A String of Deficits

8. 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. LO1

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

10. 10 Discretionary vs. Automatic Spending To a large extent, current revenues and expenditures are the result of decisions made in prior years. Roughly 80 percent of the budget is not discretionary so that only about 20 percent represents discretionary fiscal spending. LO1

11. 11 Discretionary vs. Automatic Spending Discretionary fiscal spending are those elements of the federal budget not determined by past legislative or executive commitments. LO1

12. 12 Discretionary vs. Automatic Spending Since most of the budget is uncontrollable, fiscal restraint or fiscal 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. LO1

13. 13 Automatic Transfers Most of the uncontrollable line items in the federal budget change with economic conditions. Outlays for unemployment compensation and welfare benefits increase when the economy goes into a recession. LO1

14. 14 Automatic Transfers These income transfers act as automatic stabilizers. Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits. LO1

15. 15 Automatic Transfers Automatic stabilizers are federal expenditure or revenue items that automatically respond counter- cyclically to changes in national income.

16. 16 Automatic Transfers Automatic stabilizers also exist on the revenue side of the budget. Income taxes move up and down with the value of spending and output. Being progressive, personal taxes siphon off increasing proportions of purchasing power as incomes rise.

17. 17 Cyclical Deficits The size of the federal deficit or surplus is sensitive to expansion and contraction of the macro economy. Actual budget deficits and surpluses may arise from economic conditions as well as policy. LO1

18. 18 Cyclical Deficits The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation. The cyclical deficit widens when GDP growth slows or inflation decreases. The cyclical deficit shrinks when GDP growth accelerates or inflation increases. LO1

19. 19 Structural Deficits To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components. Structural deficit Cyclical deficit Total budget deficit  LO1

20. 20 Structural Deficits The structural deficit is federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy. LO1

21. 21 Structural Deficits Part of the deficit arises from cyclical changes in the economy. The rest is the result of discretionary fiscal policy. Only changes in the structural deficit measure the thrust of fiscal policy. LO1

22. 22 Structural Deficits Fiscal policy is categorized as follows: Fiscal stimulus is measured by the increase in the structural deficit (or shrinkage in the structural surplus). Fiscal restraint is gauged by the decrease in the structural deficit (or increase in the structural surplus). LO1

23. 23 Economic Effects of Deficits There are a number of consequences of budget deficits. Crowding out. Opportunity cost. Interest-rate movements.

24. 24 Crowding Out Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing. Crowding out implies less private- sector output. LO2

25. 25 Public-sector output (quantity per year) Private-sector output (quantity per year) Crowding Out Increase in government spending... Crowds out private spending b c a g2g2 g1g1 h2h2 h1h1 LO2

26. 26 Opportunity Cost Crowding out reminds us that there is an opportunity cost to government spending. Opportunity cost is the most desired goods or services that are forgone in order to obtain something else.

27. 27 Interest-Rate Movements Rising interest rates are both a symptom and a cause of crowding out.

28. 28 Economic Effects of Surpluses The economic effects of budget surpluses are the mirror image of those for deficits.

29. 29 Crowding In There are four potential uses for a budget surplus: Spend it on goods and services. Cut taxes. Increase income transfers. Pay off old debt (“save it”). LO2

30. 30 Crowding In Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing. LO2

31. 31 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. LO2

32. 32 The Accumulation of Debt The United States has accumulated a large national debt. The national debt is the accumulated debt of the federal government.

33. 33 Debt Creation When the Treasury borrows funds it issues treasury bonds. Treasury bonds are promissory notes (IOUs) issued by the U.S. Treasury. The national debt is a stock of IOUs created by annual deficit flows.

34. 34 Early History, 1776-1900 By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War.

35. 35 Early History, 1776-1900 During the period 1790-1812 the U.S. often incurred debt but typically repaid it quickly. The War of 1812 caused a massive increase in national debt and, by 1816, the national debt was over $129 million.

36. 36 Early History, 1776-1900 1835-36: Debt Free! – The U.S. was completely out of debt by 1835. The Mexican-American War (1846-48) caused a four-fold increase in the debt.

37. 37 Early History, 1776-1900 By the end of the Civil War (1861- 65), the North owed over $2.6 billion, nearly half of its national income. After the South lost, Confederate currency and bonds had no value.

38. 38 The Twentieth Century The Spanish-American War (1898) also increased the national debt. World War I raised the debt from 3% to 41% of the national income.

39. 39 The Twentieth Century National debt declined during the 1920’s but rose again during the Great Depression.

40. 40 World War II The greatest increase in national debt occurred during World War II. Rather than raise taxes, the government rationed consumer goods. U.S. War Bond purchases raised the debt from 45% of GDP to over 125% in 1946.

41. 41 The 1980s During the 1980s, the national debt rose by nearly $2 trillion. The increase was not war-related but as a result of recessions, a military buildup, and massive tax cuts.

42. 42 The 1990s The early 1990s continued the same trend. Discretionary federal spending increased sharply in the first two years of the Bush administration.

43. 43 The 1990s The 1988-92 period saw the national debt increased by another trillion dollars. There was some success in reducing the structural deficit in 1993. Budget deficits for 1993-96 have pushed the national debt to over $5 trillion.

44. 44 2000 - By 2002, the accumulated debt was $5.6 trillion. By 2007, the debt approximated $9 trillion, which works out to nearly $30,000 of debt for every U.S. citizen.

45. 45 Historical View of the Debt/GDP Ratio Great Depression Civil War World War I World War II 1990-91 recession 1990-91 recession Bush tax cuts

46. 46 Who Owns the Debt? Who can ever expect to pay off a debt measured in the trillions of dollars?

47. 47 Liabilities = Assets National debt represents an asset as well as a liability in the form of bonds. Liability – An obligation to make future payment; debt. Asset – Anything having exchange value in the marketplace; wealth.

48. 48 Liabilities = Assets The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).

49. 49 Ownership of Debt Federal agencies hold roughly 50 percent of the outstanding Treasury bonds. State and local governments hold 7 percent of the national debt. U.S. households hold nearly 20% of the national debt, either directly or indirectly.

50. 50 Ownership of Debt Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions. The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.

51. 51 Ownership of Debt Foreigners Foreigners 25% State and local governments 7% Public Sector Social Security 21% Federal agencies 24% Federal Reserve 9% Private Sector Internal debt 14%

52. 52 Burden of the Debt The burden of the debt is not so evident: Refinancing. Debt service. Opportunity cost. LO3

53. 53 Refinancing The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due. Refinancing is the issuance of new debt in payment of debt issued earlier. LO3

54. 54 Debt Service Debt service is the interest required to be paid each year on outstanding debt. Interest payments restrict the government’s ability to balance the budget or fund other public sector activities. LO3

55. 55 Debt Service Most debt servicing is simply a redistribution of income from taxpayers to bondholders. Interest payments themselves have virtually no direct opportunity cost. LO3

56. 56 Opportunity Costs 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. LO3

57. 57 Government Purchases The true burden of the debt is the opportunity cost of the activities financed by the debt. LO3

58. 58 Transfer Payments The only direct cost of transfer payments are the resources involved in the administrative process of making the transfer. LO3

59. 59 The Real Trade-Offs Deficit financing tends to change the mix of output in the direction of more public-sector goods. The burden of the debt is the opportunity costs (crowding out) of deficit-financed government activity. LO3

60. 60 The Real Trade-Offs The primary burden of the debt is incurred when the debt-financed activity takes place. The real burden of the debt cannot be passed on to future generations. LO3

61. 61 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. LO3

62. 62 Repayment Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future. LO3

63. 63 External Debt External debt presents some special opportunities and problems. LO3

64. 64 No Crowding Out External financing allows us to get more public-sector goods without cutting back on private-sector production. As long as foreigners are willing to hold U.S. bonds, external financing imposes no real cost. LO3

65. 65 External Financing Extra output (imports) financed with external debt a bd h2h2 h1h1 g2g2 g1g1 Public-sector Output (units per year) Private-sector Output (units per year) LO3

66. 66 Repayment Foreigners may not be willing to hold bonds forever. External debt must be paid with exports of real goods and services. LO3

67. 67 Deficit and Debt Limits The key policy question is whether and how to limit or reduce the national debt. LO3

68. 68 Deficit Ceilings The only way to stop the growth of the national debt is to eliminate the budget deficit that created it. Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.

69. 69 Deficit Ceilings The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-Rudman-Hollings Act) was the first explicit attempt to force the federal budget into balance.

70. 70 Gramm-Rudman-Hollings Act It set a lower ceiling on each year’s deficit until budget balance was achieved. It called for automatic cutbacks in spending if Congress failed to keep the budget below the ceiling.

71. 71 Debt Ceilings A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt. Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.

72. 72 Dipping into Social Security The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years.

73. 73 Aging Baby Boomers Persistent surpluses in the Trust Fund largely result from Baby Boomers paying lots more payroll taxes than are paid out in benefits to the retired.

74. 74 Social Security Deficits The Trust Fund balance shifts from surplus to deficit soon after 2014. To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs.

75. 75 Changing Worker-Retiree Ratios

76. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Deficits, Surpluses, and Debt End of Chapter 12