1. Fiscal Macroeconomics in 2011

2. Debts and Deficits Last time: -Conceptual issues of debts and deficits -Deficits and slower growth of potential Y in the closed economy -Deficits and foreign borrowing and lower Y in the open economy Today: -Economics of an internal debt -The death spiral of debt and default -Keynes and the classical economist on deficit financing 2

3. 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 $0.30. -Net value of government program is minus $0.30. 3

4. 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

5. Economics of External Debts

6. Debt and financial crises “Political incentives for additional borrowing could change quickly if financial markets began to penalize the United States for failing to put its fiscal house in order. If investors become less certain of full repayment or believe that the country is pursuing an inflationary course that would allow it to repay the debt with devalued dollars, they could begin to charge a “risk premium” on U.S. Treasury securities. That could happen suddenly in a confidence crisis and ensuing financial shock. There is precedent for a financial disruption first contributing to large, chronic deficits and then in some cases contributing to the loss of investor confidence and even to a default on a nation’s debt. [However,] the unique position of the United States—because of its economic dominance and the dominant role of the dollar internationally—make it difficult to extrapolate from the experience of other nations in estimating the risk or timing of a financial crisis arising from failure to address the projected U.S. fiscal imbalance. [National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009] 6

7. A less nuanced view by the Deficit Commissioner “When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.” [Erskine Bowles, Chair, President’s Commission] * BTW: This is completely wrong analytically. 7

8. Country crises as bank runs Problem arises because have an unstable equilibrium where country’s liquid liabilities >> its liquid assets. A higher debt → higher probability of default ( π) → higher r → requires more budget cuts and less likely to pay → higher π → eventually the country decides to default or restructure. Examples: Greece β=1.4. If markets put π =5%, primary surplus ratio must be 7% of GDP. If Greeks start revolting, π =10%, then required surplus goes to 14% of GDP. So have a good and bad equilibrium like bank runs. 8

9. Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts Country fiscal position Rising risk premium and interest burden

10. Romer’s analysis π = probability of default. R = (1+r) = interest factor T = taxes A = stable equilibrium B = unstable equilibrium Zero profit line for investors Default as function of interest rate

11. ΔR= Δ(1+r) Stable dynamics; good equilibrium Unstable dynamics

12. EZ interest rates

13. European interest rates UK and Spain have virtually identical fiscal positions. Why is Spain in trouble and UK not?

14. Two Views of the Great Unraveling (I): Soft Landing The two faces of saving and the deficit dilemma

15. 15 What is the effect of deficit reduction on the economy? 1. In short run: Higher savings is contractionary Mechanism: higher S, lower AD, lower Y (straight Keynesian effect) 2. In long-run, neoclassical growth model Higher savings leads to higher potential output Mechanism: higher I, K, Y, w, etc. (through neoclassical growth model) Dilemma of the deficit: Should we raise G today or lower G?

16. Real output (Y) Inflation AD AS’ Impact of fiscal stimulus AS AD’ ?

17. The dilemma of the deficit Compare (1) a deficit spending program to reach full employment with (2) a balanced budget program This numerical example combines our AS-AD and Solow models: - Potential output from AF[K,(1-u*) LF], closed economy - Actual output from calibrated Mankiw AS-AD - Assumes closed economy (but not essential) These are “plausible” simulations but not projections or forecasts. 17

18. Stimulus v. balanced budget -Balance FE budget in 4 years -Stimulate enough to get to FE in 3 years 18

19. Actual deficits -Actual deficit is still large because of recession. 19

20. The long-term debt Have higher debt-GDP ratio for long time 20

21. But the economy pays the price -With fiscal austerity, have long period of stagnation. 21

22. The dilemma of the deficit Slower growth in potential with stimulus, but it doesn’t make up the difference. 22

23. 23 Conclusions on Debt and Deficits Central long-run impact of fiscal policy is on potential economic growth through impact on national savings rate. But in recessions, need to remember that country needs less saving, not more saving, in the short run.