Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved CHAPTER 14 The Budget Balance, the National Debt, and Investment

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Questions From the standpoint of analyzing stabilization policy, what is the best measure of the government’s budget balance? From the standpoint of analyzing the effect of changes in the national debt on long-run growth, what is the best measure of the government’s budget balance?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Questions What is the typical pattern America’s debt follows over time? How has recent experience in the past generation deviated from this traditional pattern of debt behavior? What are the reasons that we should worry about a rising national debt? What are the reasons that we shouldn’t worry too much about a rising national debt?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Debt & Deficits The national debt (D) is the amount of money that the government owes those from whom it has borrowed –when government spending < tax revenues, the difference is the government surplus (-d) the national debt falls by d –when government spending > tax collections, the difference is the government deficit (d) the national debt rises by d

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Debt & Deficits Economists are interested in the debt and the deficit for two reasons –the deficit is an index of how government spending and tax plans affect the IS curve –the debt and deficit are closely connected with national savings and investment a rising debt tends to depress capital formation a high national debt means that future taxes will have to be higher to pay interest charges

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Deficit & the IS Curve An increase in government purchases or a decrease in taxes increases aggregate demand –the IS curve shifts out The appropriate measure of fiscal policy is the full-employment deficit (or surplus) –it measures what the government’s budget balance would be if the economy was at full employment

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure An Increase in the Full- Employment Deficit Shifts the IS Curve Outward

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Measuring the Budget Balance The government budget balance reported in the news is generally the unified cash balance –the difference between the money the government actually spends in a year and the money it takes in –unifies all of the government’s accounts and trust funds –doesn’t take account of changes in the value of government-owned assets or future liabilities

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Measuring the Budget Balance The full-employment budget balance is a better index than the unified cash balance –the cash budget balance can change even when there is no change in government policy to shift the IS curve tighter monetary policy raises interest rates and lowers real GDP and tax collections –we must adjust the cash balance deficit (surplus) for the automatic fiscal stabilizers

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure A Fall in Real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Full-Employment and the Cash Budget Deficit

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inflation 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 –we should correct the officially-reported cash budget balance for inflation –the real deficit (d r ) is related to the cash deficit (d c ) by

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Cash Balance and the Inflation-Adjusted Budget Balance

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Public Investment Private spending on long-lived assets is called investment –standard accounting treatment of long- lived assets is to spread out their costs over their useful lives (amortization) The government spends money on long-lived assets –shouldn’t the government amortize these assets? which government expenditures are capital expenditures?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Liabilities & Generational Accounting The correct way to count the government’s debt is to look at all of its promises to pay money out in the future –this system is called generational accounting it would examine the lifetime impact of taxes and spending programs on individuals born in specific years and would come up with a balance that could be used for long-term planning

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Steady-State Debt-to- GDP Ratio Fiscal policy is sustainable if the debt- to-GDP ratio (D/Y) is heading for a steady state –D and Y must be growing at the same proportional rate Y grows at a proportional rate equal to the sum of the annual rate of growth of the labor force (n) and the annual rate of growth of labor efficiency (g)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Steady-State Debt-to- GDP Ratio The debt next year will be equal to Since tax revenues and spending grow with real GDP, it makes sense to focus on the deficit as a share of GDP (=d/Y)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Steady-State Debt-to- GDP Ratio The proportional growth rate of the debt is

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Steady-State Debt-to- GDP Ratio The debt-to-GDP ratio will be stable when this proportional growth rates of the debt and GDP are equal

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Steady-State Debt-to- GDP Ratio Example –growth rate of labor force (n) = 2% –growth rate of output/worker (g) = 1% –inflation rate () = 5% –if the current debt-to-GDP ratio<1/2, the debt-to-GDP ratio will rise –if the current debt-to-GDP ratio>1/2, the debt-to-GDP ratio will fall

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Sustainability The higher the debt-to-GDP ratio, the more risky an investment do financiers judge the debt of a country –if the government changes hands, the new government must decide whether to honor the debt issued by previous governments –the government can lower the real value of its debt by increasing the rate of inflation

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Sustainability 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 If a government’s has too much debt to be considered safe, the interest rates it must pay will rise dramatically –the government will then be faced with a larger deficit (because of interest costs)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Debt-to-GDP Ratio in the U.S. The typical pattern the U.S. has followed is one of sharp spikes in the debt-to-GDP ratio during wartime, followed by the paying-off of the debt during peacetime –the greatest peaks in the debt-to-GDP ratio occurred after the Civil War, World War I, and World War II –the debt-to-GDP ratio also rose during the Great Depression and the Reagan and Bush presidencies

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure U.S. Debt-to-GDP Ratio Since the Revolutionary War

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Federal Revenues and Expenditures as Shares of National Product since the Civil War

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Effects of Deficits A deficit can have three significant effects on the economy –it may affect the political equilibrium that determines the government’s tax and spending levels –it may affect the level of real GDP in the short run (if the central bank allows it) –it will affect the level of real GDP in the long run

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Political Consequences The possibility of financing government spending through borrowing makes the government less effective at advancing public welfare –the benefits from higher government spending today are clear and visible to voters –the costs of higher taxes in the future are distant and excessively discounted

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Political Consequences Since the 1980s, some have argued for deficits created by tax cuts –in this view, the political system delivers steadily-rising government spending unless it is placed under pressure to reduce the deficit –thus, the only way to avoid an ever- growing inefficient government share of GDP is to run a constant deficit that politicians feel the need to try to reduce

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Short-Run Consequences A deficit produced by either a cut in taxes or an increase in government spending raises aggregate demand and shifts the IS curve to the right –if monetary policy is unchanged, output and employment will rise –if the Federal Reserve does not want inflation to rise, it will respond by raising interest rates, neutralizing the expansionary effect of the deficit

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Open-Economy Effects An increase in the government’s budget deficit also leads to an increase in the trade deficit –the outward shift of the IS curve pushes interest rates up –higher interest rates mean an appreciated dollar –imports rise and exports fall

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Long-Run Effects Higher full-employment deficits lead to low investment –a deficit shifts the IS curve out, leading to lower national savings, higher real interest rates, and lower investment Low investment reduces capital accumulation and productivity growth –puts the economy on a lower steady- state growth path

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Higher Full-Employment Deficits Reduce Investment

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Long-Run Effects If the deficits continue for long, they will affect the economy’s capital intensity A lower steady-state capital-output ratio implies a lower level of output per worker for any given level of the efficiency of labor

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Long-Run Effects of Persistent Deficits on Economic Growth

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Long-Run Effects A higher deficit also implies a higher debt, which means that the government owes more in the way of interest payments to bondholders –over time, the increase in interest payments will require tax increases –these tax increases will discourage entrepreneurship and economic activity

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The U.S. is usually a moderate-debt country –the level of national debt with which politicians and voters are comfortable is not large relative to the debts of other countries –only immediately after total wars does the U.S. national debt reach a high value relative to real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The 1980s and 1990s, however, saw steep rises in the national debt-- unprecedented rises in peacetime –the era of deficits is now at an end –The United States’ national debt is significantly below the level at which economists begin serious worrying about the consequences of the debt for the health of the economy

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary From the standpoint of analyzing stabilization policy, the best measure of the government’s stance is the full- employment deficit –the full-employment deficit is not a bad measure of the net effect of government policy on the location of the IS curve

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary From the standpoint of analyzing the effect of changes in the national debt on long-run growth, the debt and deficit need to be adjusted for inflation and government investment –a third adjustment--for outstanding government liabilities--has been proposed and has some very attractive features, but is not usually used

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Persistent deficits--a rising national debt--threaten to diminish national savings, reduce the level of output per worker along the economy’s steady- state growth path, and retard economic growth

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Past deficits--a high current debt-to- GDP ratio-- threaten to reduce national prosperity because the higher taxes required to service the national debt act as a drag on economic activity