1. © 2003 McGraw-Hill Ryerson Limited. Politics, Surpluses, Deficits, and Debt Chapter 12

2. 12 - 2 © 2003 McGraw-Hill Ryerson Limited. Introduction u After having run budget deficits for many decades, in 1997 the federal government began to run budget surpluses.

3. 12 - 3 © 2003 McGraw-Hill Ryerson Limited. Introduction u In the long-run framework, surpluses are good because they provide additional saving for an economy. u Deficits are bad because they reduce saving, growth, and income.

4. 12 - 4 © 2003 McGraw-Hill Ryerson Limited. Introduction u In a short-run framework, the view of surpluses and deficits depends on the state of the economy relative to its potential income.

5. 12 - 5 © 2003 McGraw-Hill Ryerson Limited. Introduction u If the economy is running below its potential output, deficits are good and surpluses are bad. u Deficits increase expenditures, increasing output by a multiple of that amount.

6. 12 - 6 © 2003 McGraw-Hill Ryerson Limited. Introduction u Combining the long-and short-run frameworks gives the following policy: l Whenever possible, run surpluses, or at least a balanced budget, to help stimulate long-term growth. l This is especially true when the economy is booming – when it is above its level of potential income.

7. 12 - 7 © 2003 McGraw-Hill Ryerson Limited. Introduction u The argument for surpluses is weakened, and likely reversed, when the economy falls into a recession.

8. 12 - 8 © 2003 McGraw-Hill Ryerson Limited. Introduction u At the beginning of 2000 there was a large surplus. l The economy was booming. l Unemployment was low. l There was general agreement that the economy was closing in on its potential output.

9. 12 - 9 © 2003 McGraw-Hill Ryerson Limited. Introduction u Both short- and long-term economic frameworks would recommend cutting the national debt. u Instead of doing so, government looked at ways to spend the surplus, either by cutting taxes or by increasing spending.

10. 12 - 10 © 2003 McGraw-Hill Ryerson Limited. Defining Surpluses and Deficits u A surplus is an excess of revenues over payments. u A deficit is a shortfall of revenues under payments. u Both are flow concepts.

11. 12 - 11 © 2003 McGraw-Hill Ryerson Limited. Financing the Deficit u The deficit must be financed. u The government finances its deficits by selling bonds – promises to pay back the money in the future – to private individuals and to the central bank.

12. 12 - 12 © 2003 McGraw-Hill Ryerson Limited. Financing the Deficit u Since the central bank's IOUs are money, the loans can also be made by printing money. u Potentially, the central bank has an unlimited source of funds.

13. 12 - 13 © 2003 McGraw-Hill Ryerson Limited. Financing the Deficit u However, printing too much money would trigger inflation which can have a negative effect on the economy.

14. 12 - 14 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Surpluses and Deficits u Defining surpluses and deficits can be arbitrary.

15. 12 - 15 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Surpluses and Deficits u Whether or not a nation has a deficit depends on what is included as a revenue and what is included as an expenditure. u This accounting issue is central to the debate about whether we should be concerned about a deficit.

16. 12 - 16 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Surpluses and Deficits u The Retirement Income system is based on promises to pay. l Retirement Income System - social insurance programs that provide financial benefits to the elderly and disabled and to their eligible dependents and/or survivors.

17. 12 - 17 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Surpluses and Deficits u The way these programs is accounted for plays an important role in whether there is a budget deficit or surplus.

18. 12 - 18 © 2003 McGraw-Hill Ryerson Limited. Surpluses and Deficits As Summary Measures u As a summary, a surplus or deficit figure reduces a complicated set of accounting relationships down to a single figure.

19. 12 - 19 © 2003 McGraw-Hill Ryerson Limited. Surpluses and Deficits As Summary Measures u Deficit need not matter - what is important is the health of the economy.

20. 12 - 20 © 2003 McGraw-Hill Ryerson Limited. Nominal and Real Surpluses and Deficits u A nominal deficit is the deficit determined by looking at the difference between expenditures and receipts. u A real deficit is the nominal deficit adjusted for inflation.

21. 12 - 21 © 2003 McGraw-Hill Ryerson Limited. Nominal and Real Surpluses and Deficits u Inflation wipes out debt (accumulated deficits less accumulated surpluses). u The larger the debt and the larger the inflation, the more debt will be eliminated by inflation.

22. 12 - 22 © 2003 McGraw-Hill Ryerson Limited. Nominal and Real Surpluses and Deficits u If inflation is wiping out debt, and the deficit is equal to the increases in debt from one year to the next, inflation also affects the deficit.

23. 12 - 23 © 2003 McGraw-Hill Ryerson Limited. Nominal and Real Surpluses and Deficits u The real deficit is calculated by adjusting the nominal deficit for inflation. real deficit = nominal deficit - (inflation x total debt)

24. 12 - 24 © 2003 McGraw-Hill Ryerson Limited. Nominal and Real Surpluses and Deficits u The lowering of the real deficit by inflation is not costless to the government. u Persistent inflation becomes built into expectations and causes higher interest rates.

25. 12 - 25 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u It is important to make a distinction between structural and passive deficits. u Not all government expenditures are independent of the level of income in the economy.

26. 12 - 26 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u There is a difference between a budget deficit being used as a policy instrument to affect the economy and a budget deficit that is the result of income deviating from its potential.

27. 12 - 27 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u A structural deficit or surplus is the part of the budget deficit or surplus that would exist even if the economy were at its potential level of income.

28. 12 - 28 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u A passive deficit or surplus is the part of the deficit or surplus that exists because the economy is operating below or above its potential level of output. u The passive deficit is also known as the cyclical deficit.

29. 12 - 29 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u When an economy is operating above its potential, it has a passive surplus. u If the economy is operating below its potential, the actual deficit would be larger than the structural deficit.

30. 12 - 30 © 2003 McGraw-Hill Ryerson Limited. Structural and Passive Surpluses and Deficits u There is a significant debate about what is an economy’s potential income level. u There is disagreement about what percentage of a deficit is structural and what part is passive.

31. 12 - 31 © 2003 McGraw-Hill Ryerson Limited. The Definition of Debt and Assets u Debt is accumulated deficits minus accumulated surpluses. u Deficits and surpluses are flow concepts. u Debt is a stock concept.

32. 12 - 32 © 2003 McGraw-Hill Ryerson Limited. Debt Management u The debt must be managed. u The Canadian government must refinance the bonds that are coming due by selling new bonds, as well as sell new bonds when running a deficit.

33. 12 - 33 © 2003 McGraw-Hill Ryerson Limited. Debt Management u In the late 1990s, the federal government ran a budget surplus. u The government retired some of its previously issued bonds by buying them back and did not replace them as they come due.

34. 12 - 34 © 2003 McGraw-Hill Ryerson Limited. The Need to Judge Debt Relative to Assets u Debt needs to be judged relative to assets. u Debt is a summary measure of a nation’s financial situation. u As a summary measure, debt has even more problems than deficit.

35. 12 - 35 © 2003 McGraw-Hill Ryerson Limited. The Need to Judge Debt Relative to Assets u Debt by itself is only half the picture. u The other half of the picture is assets.

36. 12 - 36 © 2003 McGraw-Hill Ryerson Limited. The Need to Judge Debt Relative to Assets u For a government, assets include: l Its skilled work force. l Natural resources. l Its factories. l Its housing stock. l Holdings of foreign assets.

37. 12 - 37 © 2003 McGraw-Hill Ryerson Limited. l The buildings and land it owns. l A portion of the assets of the people in the country, since government gets a portion of all earnings of those assets in tax revenue. The Need to Judge Debt Relative to Assets u For a government, assets include:

38. 12 - 38 © 2003 McGraw-Hill Ryerson Limited. u If the assets are valued at more than their costs, then the deficit is making the society better off. The Need to Judge Debt Relative to Assets u When the government runs a deficit, it might be spending on projects that increase its assets.

39. 12 - 39 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Debt and Assets u Defining debt and assets can be arbitrary. u As was the case with income, revenues, and deficits, there is no perfect answer as to how assets and debt should be valued.

40. 12 - 40 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Debt and Assets u Even after assets are taken into account, you still have to be careful when deciding whether or not to be concerned about debt.

41. 12 - 41 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Debt and Assets u The total stock of gross debt can be broken down into market debt and non- market debt. u Market debt includes marketable bonds, treasury bills and other securities. u Non-market debt includes federal public sector pension liabilities and other federal liabilities.

42. 12 - 42 © 2003 McGraw-Hill Ryerson Limited. Arbitrariness in Defining Debt and Assets u To calculate debt, we add market debt and non-market debt, and subtract the value of financial assets held by the government, such as cash, reserves, and loans.

43. 12 - 43 © 2003 McGraw-Hill Ryerson Limited. Difference Between Individual and Government Debt u Individual and government debt are different.

44. 12 - 44 © 2003 McGraw-Hill Ryerson Limited. l Government debt is ongoing. l Government can print money to pay off its debt – individuals can’t. l Three quarters of government debt is internal debt – debt owed to other government agencies or to its citizens. Difference Between Individual and Government Debt u Government debt is different from an individual’s debt for three reasons:

45. 12 - 45 © 2003 McGraw-Hill Ryerson Limited. Difference Between Individual and Government Debt u Paying interest on the internal debt involves a redistribution among citizens of the country, but it does involve a net reduction in income of the average citizen.

46. 12 - 46 © 2003 McGraw-Hill Ryerson Limited. l External debt – government debt owed to individuals in foreign countries. Difference Between Individual and Government Debt u External debt is more like an individual’s debt.

47. 12 - 47 © 2003 McGraw-Hill Ryerson Limited. Government Deficits and Debt: The Historical Record u Most economists do not look at absolute figures of deficits and debt. u They are much more concerned with deficits and debt relative to GDP.

48. 12 - 48 © 2003 McGraw-Hill Ryerson Limited. Government Deficits and Debt: The Historical Record u Deficits and debt relative to GDP rose significantly in the 1970s and 1980s. u In the late 1990s debt started to fall, reaching 50% of GDP in 2001.

49. 12 - 49 © 2003 McGraw-Hill Ryerson Limited. Canadian Budget Deficit Relative to GDP, Fig. 12-1a, p 293

50. 12 - 50 © 2003 McGraw-Hill Ryerson Limited. Canadian Debt Relative to GDP, Fig. 12-1b, p 293

51. 12 - 51 © 2003 McGraw-Hill Ryerson Limited. Government Deficits and Debt: The Historical Record u Economists prefer the “relative to GDP measurement” because it better measures the government’s ability to handle the deficit and pay off the debt. u The ability to pay off a debt depends on a nation’s productive capacity, the asset side of the equation.

52. 12 - 52 © 2003 McGraw-Hill Ryerson Limited. The Debt Burden u Decrease of debt/GDP ratio was mainly due to growth in GDP. u There are two ways in which GDP can grow: l Through inflation – a rise in nominal, but not real GDP. l Through real growth.

53. 12 - 53 © 2003 McGraw-Hill Ryerson Limited. The Debt Burden u When GDP grows, the debt the government can reasonable handle also grows. u The economy becomes richer, and, being richer, it can handle more debt.

54. 12 - 54 © 2003 McGraw-Hill Ryerson Limited. The Debt Burden u Real growth in Canada has averaged about 2.5 to 3.5 percent a year. u This means that Canadian debt can grow at the same rate without increasing the debt/GDP ratio.

55. 12 - 55 © 2003 McGraw-Hill Ryerson Limited. Debt Relative to Other Countries u Canada has a relatively large debt burden compared to other advanced economies. u The increasing trend of debt to GDP has been reversed in the 1990s, when government revamped its programs and policies.

56. 12 - 56 © 2003 McGraw-Hill Ryerson Limited. Debt Relative to Other Countries u There was a structural deficit in Canada – even at full employment, spending exceeded revenue. u While Canada’s debt is still high, it is much lower than it was in the 1990s.

57. 12 - 57 © 2003 McGraw-Hill Ryerson Limited. Debt Relative to Other Countries, Fig. 12-2, p 294

58. 12 - 58 © 2003 McGraw-Hill Ryerson Limited. Interest Rates and Debt Burden u Besides the debt relative to GDP figures, economists are concerned about the interest rate paid on the debt because interest rates affect debt burden.

59. 12 - 59 © 2003 McGraw-Hill Ryerson Limited. Interest Rates and Debt Burden u How much of a burden a given amount of debt imposes depends on the interest rate that must be paid on that debt.

60. 12 - 60 © 2003 McGraw-Hill Ryerson Limited. Interest Rates and Debt Burden u The interest rate determines annual debt service. u Annual debt service – the interest rate on debt times the total debt.

61. 12 - 61 © 2003 McGraw-Hill Ryerson Limited. Interest Rates and Debt Burden u Ultimately, the interest payments are the burden of the debt. u That is what people mean when they say a deficit is burdening future generations.

62. 12 - 62 © 2003 McGraw-Hill Ryerson Limited. Interest Rates and Debt Burden u Canada can actually afford more debt since Canadian government securities are considered to be very safe.

63. 12 - 63 © 2003 McGraw-Hill Ryerson Limited. Federal Interest Payments Relative to GDP, Fig. 12-3, p 295

64. 12 - 64 © 2003 McGraw-Hill Ryerson Limited. The Modern Debate About the Surplus u The modern debate about the government budget concerns what to do with the surplus.

65. 12 - 65 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u Keynesian economics made clear that deficits could serve a positive function when the economy was below its potential. u This view was never fully accepted by politicians, nor by the public.

66. 12 - 66 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u The 1980s saw a change in the political landscape. u Politicians were pushing the economy toward deficits by cutting taxes, and expanding the deficits.

67. 12 - 67 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u In the 1990s, the federal government realized it increased its spending to the point it was running a structural deficit. u Even if the economy were operating at the potential output, the budget would be in deficit.

68. 12 - 68 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u The authorities raised taxes, cut many social programs and redesigned existing programs.

69. 12 - 69 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u The surpluses of the late 1990s were brought about by the unexpected growth of the economy and a low and stable rate of inflation. u Interest rates stayed low, holding down government interest payments.

70. 12 - 70 © 2003 McGraw-Hill Ryerson Limited. Why Did the Surpluses Come About? u Expected tax revenue also increased, and deficit predictions moved in the opposite direction, to surplus predictions.

71. 12 - 71 © 2003 McGraw-Hill Ryerson Limited. Federal Deficit and Debt Are Only Part of the Picture u Provinces and municipalities also run deficits by borrowing to spend in excess of their revenues, and thereby raise the total amount of government debt in the economy.

72. 12 - 72 © 2003 McGraw-Hill Ryerson Limited. Net Debt: Federal, Provincial and Local, Fig. 12-4a, p 298

73. 12 - 73 © 2003 McGraw-Hill Ryerson Limited. Net Debt: Federal, Provincial and Local, Fig. 12-4b, p 298

74. 12 - 74 © 2003 McGraw-Hill Ryerson Limited. Federal Deficit and Debt Are Only Part of the Picture u Net provincial and territorial debt rose significantly during the 1990s. u The increase in spending by the provinces was partly a response to the federal budget cuts. u “Fiscal responsibility” is the agenda of many newly elected politicians.

75. 12 - 75 © 2003 McGraw-Hill Ryerson Limited. A Different Type of Crowding Out u High government deficits require more and more borrowing, reducing the capital available to government and private enterprise. u Interests rates increase as a result, and this means that borrowing is more expensive for firms who wish to fund expansion by issuing debt (such as bonds).

76. 12 - 76 © 2003 McGraw-Hill Ryerson Limited. A Different Type of Crowding Out u Private sector investment is crowded out – higher levels of government spending raise interest rates, which in turn reduce the level of private investment.

77. 12 - 77 © 2003 McGraw-Hill Ryerson Limited. A Different Type of Crowding Out u Increase in government spending increases interest rates, and appreciates domestic currency. u When domestic currency gains value, exports decrease, and imports rise.

78. 12 - 78 © 2003 McGraw-Hill Ryerson Limited. Is the Deficit a Good Measure of the Stance of Fiscal Policy? u Can we use deficit to find out if fiscal policies are becoming more or less expansionary – the stance of fiscal policy? u The answer is NO. Deficit can change as a result of a shift in an autonomous component of demand.

79. 12 - 79 © 2003 McGraw-Hill Ryerson Limited. Is the Deficit a Good Measure of the Stance of Fiscal Policy? u If autonomous spending (investment, for example) decreased, deficit would rise because income would fall and reduce tax revenues. u This deficit increase was not a result of expansionary fiscal policy.

80. 12 - 80 © 2003 McGraw-Hill Ryerson Limited. Is the Deficit a Good Measure of the Stance of Fiscal Policy? u Budget surplus: BS = T – G G = G 0 T = T 0 + tY BS = [T 0 - G 0 ] + tY

81. 12 - 81 © 2003 McGraw-Hill Ryerson Limited. The Budget Surplus Function, Fig. 12-5a, p 299 BS 0 Y0Y0 Y1Y1 0 BS BS 1 BS Income

82. 12 - 82 © 2003 McGraw-Hill Ryerson Limited. Is the Deficit a Good Measure of the Stance of Fiscal Policy? u A change in equilibrium income would affect the budget surplus equation, independent of policy variables (T 0,G 0 or t). u A better measure of the stance of fiscal policy is the structural deficit.

83. 12 - 83 © 2003 McGraw-Hill Ryerson Limited. Is the Deficit a Good Measure of the Stance of Fiscal Policy? u Holding income at its potential level, we can see how changes in fiscal policy affect the budget surplus.

84. 12 - 84 © 2003 McGraw-Hill Ryerson Limited. The Budget Surplus Function, Fig. 12-5b, p 299 BS 0 BS 1 Increase in tax shifts BS Income BS 0 BS 1 BS 0 YpYp

85. © 2003 McGraw-Hill Ryerson Limited. Politics, Surpluses, Deficits, and Debt End of Chapter 12