Long-run Implications of Fiscal Policy: Deficits and the Public Debt Module Long-run Implications of Fiscal Policy: Deficits and the Public Debt 30 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: Why governments calculate the cyclically adjusted budget balance Why a large public debt may be a cause for concern Why implicit liabilities of the government are also a cause for concern

The Budget Balance Deficits Surpluses Good? Bad?   We hear a lot about the federal, or your state, government’s attempts to balance a budget. If there is a surplus, this is usually considered to be a good outcome. If there is a deficit, this is cause for concern. Before we decide whether something normatively “good” or “bad”, let’s analyze the particulars.

The Budget Balance as a Measure of Fiscal Policy Sgov = T - G - Transfers Expansionary policies reduce budget balance Contractionary policies increase budget balance G has a greater impact than T or Transfers Changes in budget balance are often result, not cause, of economic fluctuations The budget balance is the difference between the government’s tax revenue and its spending, both on goods and services and on government transfers, in a given year.   That is, the budget balance—savings by government—is defined by: SGovernment = T - G - TR where T is the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers. A budget surplus is a positive budget balance and a budget deficit is a negative budget balance. How does this relate to fiscal policy discussed in previous modules? Case 1: Recessionary Gap Expansionary fiscal policy is in order. 3 options: Cut taxes. Increase transfers. Increase government spending. These three policies should increase AD and reverse the recession, but will cause the budget balance to decrease. This means either a smaller surplus or a bigger deficit. Case 2: Inflationary Gap. Contractionary fiscal policy is in order. 3 options: Increase taxes. Decrease transfers. Decrease government spending. These three policies should decrease AD and reverse the inflation, but will cause the budget balance to increase. This means either a bigger surplus or a smaller deficit. But changes in the budget balance don’t always perfectly reflect changes to fiscal policy. Two important reasons why it is more complicated. Two different changes in fiscal policy that have equal-size effects on the budget balance may have quite unequal effects on the economy. Example: If government spending increases by $1000, it will have a larger impact on real GDP than a tax decrease of $1000. The budget balance would change by $1000 in each case, but the impacts would be different. Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.

The Business Cycle and the Cyclically Adjusted Budget Balance Strong relationship between budget balance and business cycle The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls.   Why? Is it a deliberate result of expansionary fiscal policy? Not necessarily. Recall the automatic stabilizers discussed in earlier modules. These are programs built into our tax and transfer system that work to reduce the swings of the business cycle. Several things happen to the budget balance when the economy heads into a recession. Tax revenues decline because incomes and profits are declining. Transfer payments, like welfare assistance, begin to rise as more people find themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes and the budget balance declines. On the other hand, Several things happen to the budget balance when the economy is heading into an inflationary period. Tax revenues rise because incomes and profits are rising. Transfer payments, like welfare assistance, begin to fall as fewer people find themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes and the budget balance rises. What we need is a way to separate out two effects on the budget balance: The impact due to deliberate changes in fiscal policy. The impact due to the current state of the business cycle. To do this many governments produce an estimate of what the budget balance would be if there was neither a recessionary nor an inflationary gap. The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated. If we adjust for the effects of the business cycle, and the government is still running a deficit, then we might come to the conclusion that their fiscal policy decisions are not sustainable over the long run.

The Business Cycle and the Cyclically Adjusted Budget Balance (Continued) The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls.   Why? Is it a deliberate result of expansionary fiscal policy? Not necessarily. Recall the automatic stabilizers discussed in earlier modules. These are programs built into our tax and transfer system that work to reduce the swings of the business cycle. Several things happen to the budget balance when the economy heads into a recession. Tax revenues decline because incomes and profits are declining. Transfer payments, like welfare assistance, begin to rise as more people find themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes and the budget balance declines. On the other hand, Several things happen to the budget balance when the economy is heading into an inflationary period. Tax revenues rise because incomes and profits are rising. Transfer payments, like welfare assistance, begin to fall as fewer people find themselves unemployed and struggling. These changes happen without any deliberate fiscal policy changes and the budget balance rises. What we need is a way to separate out two effects on the budget balance: The impact due to deliberate changes in fiscal policy. The impact due to the current state of the business cycle. To do this many governments produce an estimate of what the budget balance would be if there was neither a recessionary nor an inflationary gap. The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated. If we adjust for the effects of the business cycle, and the government is still running a deficit, then we might come to the conclusion that their fiscal policy decisions are not sustainable over the long run.

Should the Budget Be Balanced? Political motivation for running deficits or balancing the budget Economists argue against balanced budget rule in favor of cyclically balanced budget Limits on deficits as a compromise Would it be a good idea to require a balanced budget annually? Most economists don’t think so.   What if: the economy is in a recessionary gap. Falling tax revenue and rising transfer payments push the budget toward deficit How would we balance this deficit? We would need to increase taxes or decrease government spending. How would that impact the recession? It would worsen it! What if: the economy is in an inflationary gap. Rising tax revenue and falling transfer payments pus ht eh budget toward surplus. How would we balance this surplus? WE would need to decrease taxes or increase government spending. How would this impact the inflationary period? It would worsen it. Most economists believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. Political pressures (who doesn’t like tax cuts?) make this difficult. So are there serious downsides to an unbalanced budget?

Deficits, Surpluses, and Debt When spending exceeds tax revenue, government borrows Fiscal years Public Debt When a government spends more than the tax revenue it receives—when it runs a budget deficit—it almost always borrows the extra funds. And governments that run persistent budget deficits end up with substantial debts.   The national debt is the accumulation of all past deficits, minus all past surpluses. Public debt: government debt held by individuals and institutions outside the government. US federal government’s public debt was “only” $5.8 trillion, or 40% of GDP at the end of the 2008 fiscal year. $5,800,000,000,000 That’s a lot of zeroes!

Problems Posed by Rising Government Debt Government competes with private sector for investment funds Financial pressure on future budgets Possibility of Default Monetizing the Debt Cyclical budget Two reasons to be concerned when a government runs persistent budget deficits. 1. When the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may “crowd out” private investment spending, increasing interest rates and reducing the economy’s long­-­run rate of growth. 2. Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. Interest must be paid in the future, and this can take dollars away from other future obligations like education, the military, space exploration, etc.   So out into the future, how can a government pay off the debt? Borrowing to pay off your debt isn’t really an option. That’s like getting a new credit card to pay off the old credit card. Eventually, that is the road to personal bankruptcy. Nations have essentially declared bankruptcy in the past. It’s not pretty. Increase taxes or cut spending. Probably the best solution, but isn’t very politically successful, especially when a nation as become accustomed to low taxes. Printing money. Basically this means the Fed creates new money to pay the debts of the Treasury. This proves to be a fast track to serious inflation.

Deficits and Debt in Practice Debt-GDP Ratio To assess the ability of governments to pay their debt, we often use the debt–GDP ratio, the government’s debt as a percentage of GDP.   We use this measure, rather than simply looking at the size of the debt, because GDP, which measures the size of the economy as a whole, is a good indicator of the potential taxes the government can collect. If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government’s potential tax revenue. Note: have the students find data from 1990-2000 and also from 2000-present to see if the debt-GDP ratio is rising, falling, or staying roughly the same.

Implicit Liabilities Implicit Liabilities Social Security Demographics Medicare Medicaid Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.   In the US, promises to honor Social Security, Medicare and Medicaid amount to 40% of federal spending. Big deal? Maybe, because the American population is aging and these commitments will only get larger. Note: the instructor can add more to this discussion with current event articles or charts from the text. However for the AP exam, it is enough for students to know that the US debt is likely to grow as American demographics change to an older population.