POLITICS, DEFICITS, AND DEBT Chapter 15 POLITICS, DEFICITS, AND DEBT

Today’s lecture will: 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 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: Whenever possible, run surpluses, or at least a balanced budget to help stimulate long-run growth.

Financing the Deficit The government finances its deficits by selling bonds to private individuals and the Fed. Bonds – promises to pay back the money in the future. The Fed can print an unlimited amount of money to buy bonds, but printing too much money can cause inflation.

Arbitrariness in Defining Surpluses and Deficits Whether a nation has a deficit or surplus depends on what is included as revenues and expenditures. Social Security system accounting procedures are important in how big the deficit actually is. Social Security system – a social insurance program that provides financial benefits to the elderly and disabled and to their eligible dependents and/or survivors.

Deficits and Surpluses as Summary Measures Deficit and surplus figures are summary measures of the financial health of the economy. To interpret the summary measures, you must understand the accounting procedures used to measure the receipts and expenditures. What’s important is not the surplus or deficit, but whether the economy is healthy.

Structural and Passive Deficits Many government revenues and expenditures depend on the level of income in the economy. Structural deficit – the part of the budget deficit that would exist even if the economy were at its potential income. Passive deficit – the part of the deficit that exists because the economy is operating below its potential level of output.

Structural and Passive Deficits 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

Nominal and Real Surpluses and Deficits A nominal deficit is the difference between expenditures and receipts. A real deficit is the nominal deficit adjusted for inflation. Inflation reduces the value of the debt. Real deficit = Nominal deficit – (Inflation x Total debt) Lowering the real deficit by inflation can be costly because it may build inflation into expectations and cause higher interest rates.

The Definition of Debt and Assets Debt is accumulated deficits minus accumulated surpluses. Debt is a stock, defined at a point in time. Deficits and surpluses are flow concepts, defined for a period of time. The U.S. Treasury must sell new bonds to pay for a deficit and refinance previously issued bonds as they come due.

The Need to Judge Debt Relative to Assets Debt, as a summary measure of a nation’s financial situation, needs to be judged in relation to a nation’s assets. When the government runs a deficit, it might be spending on projects that increase its assets. If the assets are valued at more than their costs, then the deficit is making society better off.

The Need to Judge Debt Relative to Assets For a nation assets include: Its skilled work force. Natural resources. Its housing stock. Holdings of foreign assets. For a government, assets include: The building and land it owns. A portion of the assets of the people, since government gets a portion of all earnings of those assets in tax revenue.

51% of the Debt is Held by Government Agencies Like income and revenues, assets and debt are subject to varying definitions. Around 49% of the U.S. government debt is held by people and organizations outside the government. The other 51% is held by government agencies, so that part of the debt is an asset of one part of the government and a debt to another part.

Arbitrariness in Defining Debt and Assets Federal Reserve (9%) © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign individuals and firms (25%) U.S. individuals and firms (24%) U.S. government agencies (42%)

Differences Between Individual and Government Debt Government debt is ongoing, but individual debt must eventually be repaid. Government, but not individuals, can print money to pay off debt. Most of the government’s debt is internal debt – debt owed to its agencies or to its citizens. External debt – owed to individuals in foreign countries – is more like individual debt. Paying interest on internal debt redistributes income, but does not cause a net reduction in income of the average citizen.

Government Deficits and Debt: the Historical Record The government has run almost continual deficits from World War II until now, except for a few years in the late 1990s. Deficits as a percentage of GDP did not rise significantly in the 1970s and 1980s. Debt relative to GDP has not been continuously increasing. Deficits and debt relative to GDP provide a measure of a country’s ability to pay off a deficit and service its debt.

Budget Deficits as a Percentage of GDP

Debt as a Percentage of GDP 100% 75 50 25 1800 1920 1940 1960 1980 2000 1820 1840 1860 1880 1900

The Debt Burden Most of the decrease in the debt-to-GDP ratio occurred through growth of GDP. Real growth in the U.S. has averaged about 2.5 to 3.5 percent per year. This means that U.S. debt can grow between 2.5 to 3.5 percent a year without increasing debt/GDP ratio.

U.S. Debt Compared to Foreign Countries’ Debt

Interest Rates and Debt Burden The annual debt service is the interest rate on debt times the total debt. A deficit is a burden to future generations because interest payments on the debt take revenue from other government programs. The U.S. can actually afford more debt since U.S. government securities are considered the safest in the world.

Federal Interest Payments Relative to GDP 1945 1955 1965 1975 1985 1995 2005 3.5% 3.0 2.5 2.0 1.5 1.0 0.5

Projections for the Deficit In 2000 projections were for continual surpluses and a paying down of the debt. By 2002, the surplus had turned to deficits due to a significant tax cut in 2001, slower economic growth, and increased government expenditures for the war on terrorism. After more tax cuts in 2003 and 2004 and a longer and costlier war in Iraq than expected, the deficit had grown to $422 billion in 2004. The Congressional Budget Office projects deficits for the next 5-7 years, then a return to surpluses. This forecast assumes that the 2001 tax cuts will expire.

Projections for the Budget Deficit

Social Security and Lockboxes Because the government uses a cash flow accounting system, which enters expenses and revenues only when cash is received or paid out, many government obligations do not show up as part of expenditures. The Social Security system currently has a large surplus. Some politicians advocate the creation of a “lockbox” to protect the surplus for future retirees.

Pay-as-You-Go System The Social Security system was set up as a pay-as-you-go system, in which payments to current beneficiaries are funded through current payroll taxes. An unfunded pension system works smoothly as long as the population’s age distribution, the annual death rate, and the number of people working do not change much.

The Effect of the Baby Boom When baby boomers retire, there will not be enough new entrants into the work force to pay their benefits. Because the elderly use significantly more medical services and require more medication than younger people, the Medicare program will also experience funding problems in the future. Payments per beneficiary must decrease and/or contributions per worker coming in must increase.

Projection of Workers Compared to Retirees

The Social Security Trust Fund In 1983 legislation was passed to aid Social Security: It raised the age of eligibility slightly. Social Security tax rates were increased. Social Security payments became subject to taxation for some beneficiaries. The portion of surpluses held by Social Security is not available for spending – it is saved for the trust fund.

The Real Problem and the Real Solution The trust fund is simply a financial solution, not a real solution. When the baby boomers retire in 2020: Workers must produce enough goods for themselves and their families. They must also produce enough for the retired baby boomers. The real amount baby boomers spend when they retire must be reduced or taxes on those working must be increased.

Politically Unpopular Policies The Social Security problem can be solved by: Increasing taxes in 2020 on those working. Cutting benefits once baby boomers start retiring. Making Social Security means tested. Increasing the retirement age to 72. The proposal to privatize Social Security will not solve the problem because if people leave the system and move to private accounts, there will be even less money available to pay current benefits and the government will have to borrow the shortfall.

Summary A deficit is a shortfall of revenues over payments. A surplus is an excess of revenues over payments. Debt is accumulated deficits minus accumulated surpluses. Deficits and surpluses are summary measures of a budget. Whether a budget is a problem depends on the budgeting procedures that measure it.

Summary A structural deficit is that part of a budget deficit that would exist even if the economy were at its potential income. A passive deficit is the part of the deficit that exists because the economy is below its potential. Structural deficit = Actual deficit – Passive deficit A real deficit is a nominal deficit adjusted for inflation. Real deficit = Nominal deficit – (InflationxDebt)

Summary Government debt and individual debt differ in three major ways: Government is ongoing and never needs to repay its debt. Government can pay off its debt by printing money. Most of the government debt is internal – owed to its own citizens. Deficits, surpluses, and debt should be viewed relative to GDP because this ratio better measures the government’s ability to handle the deficit and pay off the debt.

Summary The Economic Growth and Tax Relief Reconciliation Act of 2001, an economic slowdown, and the war on terrorism contributed to a return to budget deficits in 2002. Beginning in 2017, the Social Security system will run deficits. The real problem is not the solvency of the Social Security system but the future mismatch between real production and real expenditures.

Review Question 15-1 Distinguish between a structural deficit and a passive deficit. A structural deficit is the part of the budget deficit that would exist even if the economy were at its potential level of income. A passive deficit is the part of the deficit that exists because the economy is below potential. Review Question 15-2 What are some of the possible solutions to the problem of Social Security solvency? Increase taxes on those working in 2020. Cut benefits to baby boomers when they retire. Make Social Security means tested. Increase the retirement age to 72. Privatization will not solve the solvency problem because Social Security is a partially unfunded pension system. Funds diverted to private accounts would not be available to pay as benefits to current retirees.