Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel How Do Budget Deficits and the National Debt Affect Future Generations Application 2

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Budget Deficits and the National Debt

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Budget Deficits and the National Debt u A budget surplus is when receipts exceed revenues. n The national debt is the sum of the outstanding bonds of the U.S. Treasury. u It is increased by budget deficits and reduced by budget surpluses. n The national debt reflects the cumulative effect of prior budget deficits & surpluses. n A budget deficit is a fiscal year where expenditures (e.g. government spending) exceed revenues (e.g. taxes).

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Privately held Federal debt as a % of GDP National debt as a % of GDP Other federal debt a Deficit Surplus Budget Deficits and the National Debt n Throughout most of the 1950s and 1960s, federal budget deficits were small as a % of GDP, and occasionally the government ran a surplus. n During this period, the national debt declined as a % of GDP. n During , budget deficits were quite large, causing the national debt to increase as a % of GDP. n During the last few years, the national debt has fallen as a % of the economy.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Who Owns the National Debt?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. (a) National debt(b) Privately held federal debt Source: Federal Reserve Bulletin, January = $5.548 trillion Federal Reserve Banks 8.3% U.S. Government Agencies 31.7% Federal Investors 37.5% Domestic Investors 62.5% Private Investors 60% = $3.331 trillion Who Owns the National Debt n Of the $5.548 trillion national debt, 40% is held by government agencies (primarily the social security trust fund), and Federal Reserve banks. The other 60% is held privately (by both private domestic and foreign investors). n Of the $3.331 trillion privately held federal debt, 62.5 percent is held by domestic investors and 37.5 percent by foreigners. u Only the privately held debt imposes a net interest obligation on the Federal Government.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Concerns About the National Debt

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Concerns about the National Debt n How does debt financing influence future generations? u For domestically held debt (62.5% of total privately held debt), the future generations that pay the tax liability accompanying the debt will also receive the interest income. u The opportunity cost of resources used by the government is incurred during the current period regardless of how the government activity is financed.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Concerns about the National Debt n Budget deficits affect future generations through their impact on capital formation. There are two views about their effects: u The traditional view is that budget deficits reduce future capital stock by increasing current consumption, pushing up real interest rates, and retarding private investment. u The new classical theory argues that people will increase their savings in anticipation of the higher future taxes implied by additional debt, leaving interest rates, consumption, and investment unaffected.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Concerns about the National Debt n The empirical evidence on the impact of the deficit is mixed. u Empirical studies have found little, if any, relationship between year-to-year changes in the budget deficit and real interest rates — providing support of the new classical theory. u Consistent with the traditional view, however, when budget deficits rose sharply during the ‘80s, American’s current consumption expenditures rose while domestically financed capital formation fell, and net foreign investment rose while net exports fell. u At this point, the bulk of the evidence appears to be consistent with the traditional view.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Concerns about the National Debt n Dependence on foreign investors: u The inflow of foreign capital leads to lower interest rates and a higher level of investment than would take place in its absence, increasing the productivity & wages of U.S. workers. u Wisely invested funds will generate returns (future income) that will offset the future income claims of foreigners; but poorly invested funds will not. u If foreigners suddenly tried to sell their assets here, falling prices would create bargains for domestic investors; domestic investors would gain and foreign investors would lose.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Concerns about the National Debt n Dependence on foreign investors (cont.) : u The vulnerability accompanying foreign investment lies mainly with the foreign investor, because the investment is a hostage to the domestic policies of the recipient country. u A major reason why investment in the United States is attractive to foreigners is their confidence that the U.S. government will not confiscate investment properties.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Debt Financing in Other Countries

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Australia Japan United States United Kingdom France Germany Spain Canada Italy Belgium N et I nterest on G overnment D ebt, 1998 a N et P ublic D ebt as a % of GDP, 1998 Source: OECD Economic Outlook (December 1998), Annex Tables 30 and n A large national debt relative to the size of an economy leads to a large tax burden just to pay the interest on the debt. n Several countries have government debt to GDP ratios greater than the United States. Government Debt of Industrial Countries

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. How Does the Social Security System Influence the National Debt?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How Does the Social Security System Influence the National Debt? n Including social security in the unified budget of the federal government makes the deficit appear smaller or the surplus appear larger than would otherwise be the case. u Using these funds to finance current government expenditures undermines this strategy. u Many economists argue that the federal budget, exclusive of the social security system, should be balanced. u In the decade ahead, projections indicate that the social security system will run a large surplus while the operating budget will be (approximately) in balance. n Social security surpluses are intended to increase the national saving rate and stimulate additional investment helping to finance baby-boomer retirement benefits.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. Political Economy, Demographics, and Debt Financing

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Political Economy, Demographics, and Debt Financing n Sustained economic growth and favorable demographic factors moved the federal budget to surplus in n Sizable budget surpluses are likely to occur in the decade ahead. n However, as the baby-boom generation moves into the retirement phase of their life beginning in 2015, large budget deficits are likely to re-emerge.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. “The national debt is a mortgage against the future of our children and grandchildren. We are forcing them to pay for our current consumption of goods and services.” Evaluate this statement. Questions for Thought: 2. When government bonds are held by foreigners, the interest income from the bonds goes to foreigners rather than to Americans. Would Americans be better off if we prohibited the sale of bonds to foreigners? 3. How is the social security system currently influencing the size of the budget deficit? If it is not reformed, how will social security influence the budget deficit in the years following 2020? Is this a cause for concern? Why or why not?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Application 2