DEFICITS, SURPLUSES AND DEBT Eva Hromádková, Macroeconomics ECO 110/1, AAU Lecture 8

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. 2

Budget Deficits and Surpluses Definitions  Budget deficit is the amount by which government spending exceeds government revenue in a given time period.  Budget surplus is an excess of government revenues over government expenditures in a given time period. 3 Budget deficit / surplus = gvt spending – tax revenues > /< 0

Budget Deficits and Surpluses Real world example - USA 4

US budget deficits

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 6

Discretionary vs. Automatic Spending  At the beginning of each fiscal year, the government and parliament (Czech Republic) or President and Congress (US) put together a budget blueprint (proposal) for next fiscal year.  Fiscal year (FY) is the twelve-month period used for accounting purposes In the Czech Rep, the same as calendar year In US, begins on October 1 for the federal government.  After approval it is published as a bill (law) 7

Discretionary vs. Automatic Spending  To a large extent, current revenues and expenditures are the result of decisions made in prior years past legislative or executive commitments.  Q: Examples?  Roughly 80 percent of the budget is given by previous commitments, so that only about 20 percent represents discretionary fiscal spending.  Left to or regulated by gvt's own discretion or judgment.  Available for use as needed or desired LO1 8

Discretionary vs. Automatic Spending  Since most of the budget is uncontrollable, fiscal restraint or fiscal stimulus is less effective. Remember?  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 9

Automatic Stabilizers Automatic budget fluctuations w.r.t. business cycle  Some items on the budget actually change with economic conditions, irrespectively of government plans.  Expenditure side:  Unemployment insurance benefits  Welfare benefits  Revenue side:  Income taxes (progressive even more)  Corporate taxes Stabilizing effect = countercyclical response to changes in national income (inject/withdraw spending power) LO1 10

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 11

Automatic Transfers  Automatic stabilizers are federal expenditure or revenue items that automatically respond counter- cyclically to changes in national income. 12

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. 13

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 14

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 15

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 16

Structural Deficits  The structural deficit is federal revenues at full- employment minus expenditures at full employment under prevailing fiscal policy. LO1 17

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 18

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 19

Economic Effects of Deficits  There are a number of consequences of budget deficits.  Crowding out.  Opportunity cost.  Interest-rate movements. 20

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 21

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 22

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. 23

Interest-Rate Movements  Rising interest rates are both a symptom and a cause of crowding out. 24

Economic Effects of Surpluses  The economic effects of budget surpluses are the mirror image of those for deficits. 25

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 26

Crowding In  Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing. LO2 27

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 28

The Accumulation of Debt  The United States has accumulated a large national debt.  The national debt is the accumulated debt of the federal government. 29

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. 30

Early History,  By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War. 31

Early History,  During the period 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. 32

Early History,  : Debt Free! – The U.S. was completely out of debt by The Mexican-American War ( ) caused a four-fold increase in the debt. 33

Early History,  By the end of the Civil War ( ), the North owed over $2.6 billion, nearly half of its national income. After the South lost, Confederate currency and bonds had no value. 34

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. 35

The Twentieth Century  National debt declined during the 1920’s but rose again during the Great Depression. 36

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

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. 38

The 1990s  The early 1990s continued the same trend.  Discretionary federal spending increased sharply in the first two years of the Bush administration. 39

The 1990s  The period saw the national debt increased by another trillion dollars. There was some success in reducing the structural deficit in Budget deficits for have pushed the national debt to over $5 trillion. 40

 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. 41

Historical View of the Debt/GDP Ratio Great Depression Civil War World War I World War II recession recession Bush tax cuts 42

Who Owns the Debt?  Who can ever expect to pay off a debt measured in the trillions of dollars? 43

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. 44

Liabilities = Assets  The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury). 45

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. 46

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. 47

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%

Burden of the Debt  The burden of the debt is not so evident:  Refinancing.  Debt service.  Opportunity cost. LO3 49

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 50

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 51

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 52

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 53

Government Purchases  The true burden of the debt is the opportunity cost of the activities financed by the debt. LO3 54

Transfer Payments  The only direct cost of transfer payments are the resources involved in the administrative process of making the transfer. LO3 55

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 56

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 57

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 58

Repayment  Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future. LO3 59

External Debt  External debt presents some special opportunities and problems. LO3 60

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 61

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 62

Repayment  Foreigners may not be willing to hold bonds forever.  External debt must be paid with exports of real goods and services. LO3 63

Deficit and Debt Limits  The key policy question is whether and how to limit or reduce the national debt. LO3 64

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. 65

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. 66

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. 67

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. 68

Dipping into Social Security  The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years. 69

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. 70

Social Security Deficits  The Trust Fund balance shifts from surplus to deficit soon after  To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs. 71

Changing Worker-Retiree Ratios 72

DEFICITS, SURPLUSES, AND DEBT End of Chapter 12