Views of American leaders on the national debt “A national debt, if it is not excessive, will be to us a national blessing.” [Alexander Hamilton, 1781] “It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F. D. Roosevelt] “There are myths also about our public debt. Borrowing can lead to over- extension and collapse – but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [John F. Kennedy, Yale Commencement Address, 1962] “It is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now.” [B. Obama, 2010] 1

Five Genuine Concerns about Government Debt 1. Impact on growth of potential output -Higher deficit and debt leads to lower saving and capital stock -Leads to lower potential output (we will review the savings experiment) 2. Efficiency impacts of higher debt: -Higher debt means higher interest payments -These require higher taxes, and this has a “dead-weight loss” 3. In open economy, some of debt will be held abroad -To extent that have net foreign borrowing (trade deficit), this requires net exports to pay. -If debt is in foreign currency, can lead to financial crisis, higher interest rates, higher deficits, and a death spiral of confidence, and eventual default 4. Higher debt forces higher taxes or crowds out other critical spending 2

The overall federal budget 3 Deficit

Current projections of debt/GDP “Extended Alternative” = continuation of certain policies (war, Bush era tax cuts, Medicare, etc.). “Extended Baseline” = cliff

Long-term projection of debt/GDP 5 CBO, The Long-Term Budget Outlook, June 2010

What are the sources of the spending growth? CBO, The Long-Term Budget Outlook, June 2010/ 6

Debt bathtub Debt (beginning of year) Spending Revenues Debt (end of year) = Debt (beginning) + deficit 7

Debt algebra Basic identity: Debt (end of t) = Debt (beginning of t) + Deficit (t) Stable system when debt-GDP ratio is constant. Define debt-GDP ratio = β Primary surplus = PS = taxes – noninterest spending. Given U.S. parameters, stable β when PS = 0.

Primary surplus ratio Clinton-era surpluses Recession and stimulus package CBO Forecast

Case 1. Closed classical economy Fundamental difference between spending on I and spending on C: -Borrowing for spending on productive I does not lower long-run C -Growth lowered from borrowing for government or private C Two problems from domestic debt (or closed economy debt) -Internal debt requires taxation to service and leads to inefficiency -Debt crowds out capital and reduces the growth/level of potential output 10

The marginal dead weight loss of debt/taxes P(1+τ 1 ) P P(1+τ 2 ) X0X0 X1X1 X2X2 = incremental DWL of higher taxes ~ increase revenues DWL Empirical estimates: 20 – 40 cents of DWL per $ of taxes from higher tax rates

Taxes and debt for a purely internal debt Assume that we “owe the debt to ourselves” -Many identical people -All get benefits and pay taxes to service debt -Suppose that we have program which provides $1 in PV of C; and finances it by $1 of debt. Classical case: -Suppose no change in path of output. -Higher interest payments with present value of $1. -Taxes cause efficiency losses with a dead-weight loss (DWL). -If marginal DWL on taxes is 30%, then have cost of $ Net value of government program is minus $

Debt in neoclassical growth model National investment = national saving = private saving + government saving NS = PS + GS If PS unchanged, then higher deficit leads to lower saving and investment. Then follow through standard Solow neoclassical growth model, with lower s. 13

14 k y = f(k) (n+δ)k y** (I/Y)* k** Impact of Deficits on Economy k* y* i = s 1 f(k) i = s 2 f(k)

time ln K, ln GD ln K ln GD ln GD’ ln K’ 15

time ln Y, ln C ln Y ln (C+G)’ ln Y’ Note that govt spending first raises (C+G), but then lowers (C+G)’ 16 ln (C+G)

17 Case 2. Impact of government debt in an open economy (assuming borrowing in own currency) In open economy: K + NFA = Wealth = Private wealth – Government Debt W/L = v = (K + NFA)/L = k +nfa, where nfa=NFA/L For small open economy, the marginal investment is abroad! –With r = r w, no change in domestic capital stock! –Therefore, no effect on GDP, but has effect on income from abroad –Will show up in national income (NNP) not in GDP! (Most macro models get this wrong.) Large open economy like US: –Somewhere in between small open and closed. –I.e., some decrease in domestic I and some in decrease net foreign assets But results on changes in W and C are same in open as closed economy.

18 k, v y = f(k*)+f’(k*)(w-k) = f(k*)+r w (w-k) (n+δ)k v* Solow model for open economy with net foreign borrowing k* i = sy nfa* y=NNP/L; v = per capita wealth v= k + nfa; Show how: ↓s → ↓v → ↓nfa but no change k → ↓y

The fiscal cliff Everything goes poof on December 31, Tax cuts expire, doctors don’t get paid, unemployed lose insurance, military and government programs slashed, rich get big tax increase. The actual details… 19

20

21 = contentious.

Game of chicken and the cliff R’s concedeR’s hang tough D’s concede No recession. Everyone one looks good. Politically neutral. No recession. Obama loses face early in second term. Repubs get overconfident. D’s hang tough No recession. Repubs lose face. Dems get overconfident. Deep recession. Everyone looks equally bad politically. *** *** Nash equilibrium if prisoners’ dilemma zero-sum structure.