1. Surpluses, Deficits, and Debt
Chapter 12

2. Introduction The focus in this chapter is on the following questions:
How do deficits and surpluses arise?
What harm (good) do deficits (surpluses) cause?
Who will pay off the accumulated national debt?

3. 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.

4. Budget Effects of Fiscal Policy
The federal budget is a key policy lever for controlling the economy.
Use fiscal stimulus to eliminate unemployment.
Use fiscal restraint to control inflation.

5. Budget Surpluses and Deficits
Reducing tax revenues and increasing federal government spending throws the budget out of balance.
Creates a budget deficit through deficit spending.

6. Budget Surpluses and Deficits
Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.

7. Budget Surpluses and Deficits
Budget deficit is the amount by which government spending exceeds government revenue in a given time period.
Budget deficit = government spending – tax revenues > 0

8. Budget Surpluses and Deficits
If the government spends less than its tax revenues, a budget surplus is created.
Budget Surplus is an excess of government revenues over government expenditures in a given time period.

9. Budget Deficits and Surpluses

10. A String of Deficits
Prior to 1998, the most recent budget surplus occurred in 1969.
Between 1982 and 1996, the deficit got as high as $290 billion (1992) and never got below $100 billion.

11. A String of Deficits
1970
1994
1996
1998
2000
2002
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
Budget Surpluses
Budget Deficits

12. Keynesian View
From a Keynesian perspective, 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.

13. Discretionary vs. Automatic Spending
Budget analysts say Congress could not balance the budge even if it wanted to.
Neither deficits nor surpluses are necessarily the result of fiscal policy decisions.

14. Discretionary vs. Automatic Spending
At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.
Fiscal Year (FY) is the twelve-month period used for accounting purposes – begins on October 1 for the federal government.

15. Discretionary vs. Automatic Spending
To a large extent, most current revenues and expenditures are a result of decisions made in prior years.
In this sense, much of each year’s budget is “uncontrollable”.

16. Discretionary vs. Automatic Spending
Discretionary fiscal spending account for only 20% of the federal budget.
Discretionary fiscal spending are those elements of the federal budget not determined by past legislative or executive commitments.

17. Discretionary vs. Automatic Spending
If most of the budget is uncontrollable, fiscal restraint or fiscal stimulus are less effective.
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.

18. Automatic Transfers
Most of the uncontrollable line items in the federal budget change with economic conditions.
Examples include unemployment compensation and other income transfers.

19. Automatic Transfers
Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits.

20. Automatic Transfers
Acting as automatic stabilizers, transfer payments increase during recessions.
Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.

21. 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.

22. Cyclical Deficits
The size of the federal deficit is sensitive to expansion and contraction of the macro economy.

23. Cyclical Deficits
Actual budget deficits and surpluses may arise from economic conditions as well as policy.

24. Cyclical Deficits
The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation.

25. Cyclical Deficits
The cyclical deficit widens when GDP growth slows or inflation decreases.
The cyclical deficit shrinks when GDP growth accelerates or inflation increases.

26. Total budget deficit = Cyclical deficit + Structural deficit
Structural Deficits
To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.
Total budget deficit = Cyclical deficit + Structural deficit

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

28. 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.

29. 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).

30. Economic Effects of Deficits
There are a number of consequences of budget deficits.

31. Crowding Out
If government borrows funds to finance deficits, the availability of funds for private sector spending may be reduced.
This is known as crowding-out.

32. Crowding Out
Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing.

33. Crowding Out Crowding out implies less private-sector output.
The risk of crowding out is greater the closer the economy is to full employment.

34. Crowding Out g2 b Increase in government spending . . . g1 a c
Public-sector output (quantity per year)
Private-sector output (quantity per year) g2 b
Increase in
government spending . . . g1 a c
Crowds out private spending h2 h1

35. 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.

36. Opportunity Cost
Deficits are only desirable if the resulting change in the mix of output is desired.

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

38. Crowding In There are four potential uses for a budget surplus:
Cut taxes.
Increase income transfers.
Spend it on goods and services.
Pay off old debt (“save it”).

39. Crowding In
The first two options effectively wipe out the surplus but give consumers more disposable income and change the public-private mix of output.

40. Crowding In
The third option, spending the surplus, wipes out the surplus and enlarges the relative size of government.

41. Crowding In
The third option entails paying back accumulated debt potentially causing a crowding-in effect.

42. Crowding In
A reduction in debt takes pressure off market interest rates.
Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing.

43. Crowding In
As interest rates drop, consumers are willing and able to purchase more big-ticket items like cars, appliances, and houses.

44. 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.

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

46. 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.

47. Debt Creation
Whenever there is a budget deficit, the national debt increases.
In years when a budget surplus exists, the national debt can be pared down.

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

49. Early History
During the period the U.S. often incurred debt but typically repaid it quickly.

50. Early History
The War of 1812 caused a massive increase in national debt and, by 1816, the national debt was over $129 million.

51. Early History
: Debt Free! – The U.S. was completely out of debt by 1835.
The Mexican-American War ( ) caused a four-fold increase in the debt.

52. 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.

53. 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.

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

55. 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 1946.

56. 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.

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

58. The 1990s
The period saw the national debt increased by another trillion dollars.
There was some success in reducing the structural deficit in 1993.

59. 1990s
Budget deficits for have pushed the national debt to over $5 trillion.
By 2002, the accumulated debt was $5.6 trillion, which works out to nearly $20,000 of debt for every American citizen.

60. Historical View of the Debt/GDP Ratio
140
130
120
110
100 90 80 70 60 50 40 30 20 10
1800
1850
1900
1950
2000
World War II
Reagan tax cuts
recession
Great Depression
World War I
Civil War

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

62. Liabilities = Assets
National debt represents a liability as well as an asset in the form of bonds.
Liability – An obligation to make future payment; debt.
Asset – Anything having exchange value in the marketplace; wealth.

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

64. Ownership of Debt
Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.
The Federal Reserve acquires Treasury bonds in its conduct of monetary policy.
The Social Security Trust Fund is the largest owner of U.S. debt.

65. Ownership of Debt
State and local governments hold 7 percent of the national debt.
The general public directly owns about 6% of the national debt.
The general public indirectly owns over 22% through banks, insurance companies, corporations, etc.

66. Ownership of Debt
Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions.
Internal debt equals approximately 80% of the total.

67. Ownership of Debt
The remaining 20% of the national debt is held by foreign households and institutions.
The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.

68. Ownership of Debt Public Sector Foreigners Private Sector
Federal agencies 17%
Social Security 13%
Federal Reserve 9%
State and local
governments 8%
Public Sector
Foreigners
Foreigners 20%
Private Sector
Individuals 6%
Banks, corporations,
insurance companies,
etc, 8%

69. Burden of the Debt
The burden of the debt is not so evident.

70. 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.

71. 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.

72. Debt Service
Most debt servicing is simply a redistribution of income from taxpayers to bondholders.
Interest payments themselves have virtually no direct opportunity cost.

73. Opportunity Costs
Opportunity costs are incurred only when real resources (factors of production) are used.
The process of debt servicing uses few resources, and has negligible opportunity costs.

74. Opportunity Costs
The true burden of the debt is the opportunity costs of the activities financed by the debt.

75. Government Purchases
The opportunity cost of government purchases is the true burden of government activity, however financed.

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

77. Transfer Payments
Income transfers change work, saving or investing patterns, causing changes in output or prices.
These indirect behavior responses should be distinguished from the direct costs of the transfer.

78. Transfer Payments
The debt that originated in deficit-financed income transfers is not a meaningful measure of economic burden.

79. 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.

80. 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.

81. Economic Growth
Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment.
The debate about the burden of the debt is an argument over the optimal mix of output.

82. Economic Growth
The optimal mix of output is the most desirable combination of output attainable with existing resources, technology, and social values.

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

84. External Debt
External debt presents some special opportunities and problems.

85. 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.

86. External Financing Extra output (imports) financed with external debt
Public-sector Output (units per year)
Private-sector Output (units per year)

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

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

89. Deficit Ceilings
The only way to stop the growth of the national debt is to eliminate the budget deficit that created it.

90. Deficit Ceilings
Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.

91. 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.

92. 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.

93. Gramm-Rudman-Hollings Act
Congress refused to cut spending and raise taxes enough to meet the deficit reduction targets.
The Supreme Court declared unconstitutional the “automatic” mechanisms for spending cuts.

94. Debt Ceilings
A debt ceiling is another mechanism for curbing the national debt.
A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt.

95. Debt Ceilings
Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.

96. “Saving Social Security”
The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years.

97. 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.

98. Social Security Deficits
The Trust Fund balance shifts from surplus to deficit soon after 2014.
To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs.

99. Alternative Surplus Projections
Total,
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Budget Surplus (in $billions)
Optimistic Scenario
8,856
Baseline Scenario
5,610
Pessimistic Scenario
1,627

100. Deficits and Debt
End of Chapter 12