1. Deficit Spending and The Public Debt
Chapter 14
Deficit Spending and The Public Debt

2. A government budget is in deficit when spending exceeds receipts.
Introduction
A government budget is in deficit when spending exceeds receipts.
When the U.S. federal government runs a budget deficit, other countries tend to experience deficits as well. Why does this correlation exist?

3. Learning Objectives
Explain how federal government budget deficits occur
Define the public debt and understand alternative measures of the public debt
Evaluate circumstances under which the public debt could be a burden to future generations

4. Learning Objectives
Discuss why the federal budget deficit might be measured incorrectly
Analyze the macroeconomic effects of government budget deficits
Describe possible ways to reduce the government budget deficit

5. Chapter Outline Public Deficits and Debts Government Finance
Evaluating the Rising Public Debt
Federal Budget Deficits in An Open Economy
Growing U.S. Government Deficits

6. Did You Know That...
Throughout the rest of this decade, the U.S. federal government expects to run annual budget deficits?
The relationship between budget deficits and macroeconomic performance is somewhat elusive?

7. Public Deficits and Debts
A government budget deficit
Exists if the government spends more than it receives in taxes during a given period of time
Is financed by the selling of government securities (bonds)

8. Public Deficits and Debts
The federal deficit is a flow variable, one defined for a specific period of time, usually one year

9. Public Deficits and Debts
If spending equals receipts, the budget is balanced.
If receipts exceed spending, the government is running a budget surplus.

10. Public Deficits and Debts
The public debt
A stock variable
The total value of all outstanding government securities

11. Government Finance
Since 1940, the U.S. federal government has operated with a budget surplus in 13 years.
In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.

12. Government Finance
Figure 14-1

13. Evaluating the Rising Public Debt
Some government bonds are held by government agencies
In this case, the funds are owed from one branch of the federal government to another
To arrive at the net public debt, we subtract interagency borrowings from the gross public debt

14. Evaluating the Rising Public Debt
Tax revenues tend to be stagnant during times of slow economic growth.
Tax revenues grow more quickly when overall growth enhances incomes.
As long as spending exceeds revenues, the budget deficit will persist.

15. Evaluating the Rising Public Debt
Table 14-1

16. Evaluating the Rising Public Debt
The government must pay interest on the public debt outstanding.
The level of these payments depends on the market interest rate.
Interest payments as a percentage of GDP are likely to rise in the future.

17. Evaluating the Rising Public Debt
As more of the public debt is held by foreigners, then the amount of interest to be paid outside the U.S. increases.
The presence of the debt may place a burden on future generations.

18. Evaluating the Rising Public Debt
If the economy is already at full employment, then further provision of government goods will crowd out some private goods.
Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.

19. Evaluating the Rising Public Debt
Burdens on Future Generations:
Crowding out then may place a burden on future generations by dampening the rate of economic growth
Taxes may be increased in the long term to retire the debt

20. Policy Example: Jefferson and Hamilton on the Public Debt
Jefferson argued that it was unfair to place the burden of public debt on future generations.
He favored an annually balanced government budget.

21. Policy Example: Jefferson and Hamilton on the Public Debt
Alexander Hamilton, the first U.S. Treasury Secretary, argued that a nation which handled a debt responsibly could build a reputation for creditworthiness.
He concluded that there could be a blessing in a national debt that was not excessive and was repaid on time.

22. Evaluating the Rising Public Debt
Is there anything positive about the public debt?
While the debt in and of itself may not offer a benefit to our economy, the government expenditures incurred in creating it provide goods and services that are needed.

23. Federal Budget Deficits in An Open Economy
Is there a connection between the U.S. trade deficit and the federal government budget deficit?
A trade deficit exists when the value of imports exceeds the value of exports.
There is a statistical correlation between the two.

24. Federal Budget Deficits in An Open Economy
Figure 14-4

25. Federal Budget Deficits in An Open Economy
As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners.
The interest rate paid on bonds will need to be high enough to attract foreign investors.

26. Federal Budget Deficits in An Open Economy
If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports.
This shows that a U.S. budget deficit can contribute to a trade deficit.

27. Growing U.S. Government Deficits
There is some debate among economists and policymakers as to what should be considered the best measure of the deficit.

28. Growing U.S. Government Deficits
Most businesses use two budgets:
An operating budget
A capital budget

29. Growing U.S. Government Deficits
An operating budget includes current outlays for on-going expenses, such as salaries, supplies, utilities, etc.

30. Growing U.S. Government Deficits
A capital budget includes expenditures on investment items, such as a new building or implementation of new technology.
These are generally items that are expected to have a life of many years.

31. Growing U.S. Government Deficits
For the federal government, items in an operating budget would include Social Security benefits, interest on the public debt, upkeep of national parks, salaries of federal employees, and the costs of operating the IRS.

32. Growing U.S. Government Deficits
Items in the capital budget would include a new aircraft carrier or weapons system, a new federally- funded highway, construction of a dam, and the design of new software to handle the federal payroll.

33. Growing U.S. Government Deficits
Some economists argue that Congress should establish a separate capital budget which would include investment expenditures.
This might give a more accurate reflection of the deficit.

34. Growing U.S. Government Deficits
Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure.

35. Growing U.S. Government Deficits
Deficit estimates are produced both by the Office of Management and Budget and by the Congressional Budget Office.
Each estimate is based on a different set of assumptions, and they have names such as the baseline deficit, policy deficit, or on-budget deficit.

36. Growing U.S. Government Deficits
There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers.
Keep in mind that any one specific deficit measure you hear is based on a definition and a set of assumptions with which others may disagree.

37. Growing U.S. Government Deficits
Question
How do higher deficits affect the economy in the short run?
If the economy is below full employment, the deficit can close the recessionary gap.
If the economy is already at full employment, the deficit an create an inflationary gap.

38. Growing U.S. Government Deficits
What is the long-run effect?
In the long run, a higher deficit does not affect the equilibrium level of real GDP.
The lasting effect of a persistent deficit is to redistribute resources from the private sector to the public sector.

39. Growing U.S. Government Deficits
How could the deficit be reduced?
Either by increasing taxes or by reducing government spending
Both of these solutions involve political realities

40. E-Commerce Example: Internet Taxes
Some state governments have considered imposing taxes on internet transactions as a means of supplementing their budget revenues.
Estimates show that, at best, this would cover about 25 percent of deficits experienced at the state level.

41. Growing U.S. Government Deficits
In considering how expenditures might be reduced, it is important to look at entitlements.
These are federal government payments that are legislated obligations, and cannot be reduced or eliminated.
Entitlements include Social Security, Medicare, and Medicaid.

42. International Policy Example: Unrealized Public Debts
Peter Heller of the International Monetary Fund has devised a measure intended to include the implicit future indebtedness of a country based on its current entitlements.
The fact that a country’s debt appears larger when using this measure shows that there are significant economic burdens ahead in following through on political promises.

43. Growing U.S. Government Deficits
Entitlements are the largest component of the U.S. federal budget.
To make a significant cut in expenditures, entitlement programs would have to be revised.
What are the political costs of reducing Social Security and Medicare benefits?

44. Issues and Applications: International Cycles in Deficits
Among the nations of Canada, France, Germany, the U.K. and the U.S., changes in the size of federal budget deficits seem to be correlated.
In part, this is because the business cycles of all these economies are closely aligned.

45. Issues and Applications: International Cycles in Deficits
Also, this correlation occurs because the need for military spending by each nation is determined by outside factors that affect all countries at the same time.
And further, stock market trends that are internationally correlated affect the amount of capital gains tax that can be collected by each federal treasury.

46. Summary Discussion of Learning Objectives
Federal government budget deficits:
The U.S. federal government operated with a surplus from 1998 through 2001, but it returned to a deficit condition in 2002.
The public debt:
Total value of all government bonds outstanding
Net public debt as a share of GDP is 35 percent

47. Summary Discussion of Learning Objectives
How the public debt might prove a burden to future generations:
Higher taxes will reduce private consumption
Crowding out could reduce economic growth
Why the federal budget deficit might be incorrectly measured
No distinction between capital expenses and operating expenses
Each estimate is based on a set of assumptions

48. Summary Discussion of Learning Objectives
The macroeconomic effects of government budget deficits:
In the short run, a deficit can close a recessionary gap or cause an inflationary gap.
The long run effect is to shift resources from the private sector to the public sector.

49. Summary Discussion of Learning Objectives
Possible ways to reduce the government budget deficit:
Increase taxes
Reduce expenditures by revising the terms of entitlement programs

50. Deficit Spending and The Public Debt
End of Chapter 14
Deficit Spending and The Public Debt