1. Chapter 13: Government Borrowing 13 - 1 Chapter 13 Government Borrowing Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Chapter 13: Government Borrowing 13 - 2 Introduction Deficit versus debt The burden of debt U.S. deficits, debt, and interest during the past half century Inflation, debt, and deficits The long-term budget outlook for the U.S.

3. Chapter 13: Government Borrowing 13 - 3 Spending minus taxes in a given year Deficit A flow that occurs during a period of time – one year The cumulative result of the deficits in prior years Deficit versus Debt Debt A stock that is measured at a point in time

4. Chapter 13: Government Borrowing 13 - 4 This does not mean that all borrowing should be avoided Individuals, firms, and government are justified to borrow for long-lived productive assets If the government defaults on loans, then… Common Sense Concern about Excessive Borrowing Creditors may become wary … excessive borrowing today means heavy payments to creditors tomorrow. There may be increased taxes or a cut in spending Inflation may occur if the government prints money

5. Chapter 13: Government Borrowing 13 - 5 Children are not legally responsible for their parents’ borrowing The burden of family borrowing In some cases, parents’ borrowing imposes a burden on children The Burden of the Debt The burden of government borrowing Government borrowing shifts the burden of today’s government spending from today’s taxpayers to tomorrow’s taxpayers

6. Chapter 13: Government Borrowing 13 - 6 Borrowing is inappropriate when government spending doesn’t benefit tomorrow’s taxpayers. It depends. Current expenditures Capital Expenditures Is it fair to shift the burden of today’s government spending? Borrowing is appropriate when government spending does benefit tomorrow’s taxpayers. Capital expenditures

7. Chapter 13: Government Borrowing 13 - 7 r increases Government Borrowing, Interest Rates, and the Crowding Out of Investment The government increases borrowing to finance spending Government borrowing crowds out private investment Interest Rate (r) D S Loanable Funds (F) Figure 13.1 r0r0 D’ r1r1 F0F0 F1F1

8. Chapter 13: Government Borrowing 13 - 8 Disciplining Politicians with a Balanced Budget Rule Spending must be entirely financed by tax revenue. The prohibition on borrowing and printing money The problem is that this rule may make a recession worse FEBAR compared to NUBAR An always balanced budget rule Politicians and citizens naturally demand excessive spending A balanced budget leads to optimal spending

9. Chapter 13: Government Borrowing 13 - 9 A planned balanced budget for next year is based on an estimate if next year’s unemployment rate is normal. Would provide discipline A Normal-Unemployment Balanced Budget Rule NUBAR Questions How would it be implemented? Would avoid worsening a recession How would it be enforced? What about a recession or a war?

10. Chapter 13: Government Borrowing 13 - 10 Suppose $110,000 is promised next year and $100,000 of taxes is raised this year. It depends on the interest rate. Fiscal Imbalance Examples of long-term fiscal imbalance Medicare Is the $100,000 enough? Social Security Federal debt The present value of future promised benefits ( ) The present value of future assigned taxes ( ) =

11. Chapter 13: Government Borrowing 13 - 11 Generational Accounting …focuses on how each generation fares with respect to government taxing and spending Some generations get a better or worse deal from government taxing and spending Examples First public schools Social Security The present value of benefits it receives ( ) The present value of taxes it pays ( ) =

12. Chapter 13: Government Borrowing 13 - 12 Table 13.1 U.S. Treasury debt held by the public (U.S. net debt)$5 trillion U.S. Treasury debt held by the public – domestic$2.8 trillion U.S. Treasury debt held by the public – foreign$2.2 trillion U.S. Treasury debt held by the public – China, Japan, U.K.$1.2 trillion U.S. Treasury debt held by the public – All other countries$1 trillion U.S. Treasury debt held by U.S. government (including SS)$4 trillion Total U.S. Treasure debt (U.S. gross debt)$9 trillion U.S. GDP$14 trillion U.S. Treasury debt held by the public as a % of GDP37% Total U.S. Treasury debt as a % of GDP63% U.S. Treasury Debt Held by the Public and by U.S. Government Agencies

13. Chapter 13: Government Borrowing 13 - 13 Table 13.2 1980199320012007 U.S. net debt as a % of GDP26%49%33%37% Interest rate on U.S. Treasury bonds7.3%6.1%6%4.6% Net interest as a % of GDP1.9%3%2%1.7% Revenue as a % of GDP19%17.5%19.8%18.8% Net interest as a % of revenue10%17%10%9% % of revenue available to finance programs 90%83%90%91% The Interest Burden of the U.S. Treasury Net debt as a percent of GDP Bond interest rate Consequences for the interest burden Source: CBO, The Budget and Economic Outlook: Fiscal Years 2008 to 2018 (Jan. 2008), Table F-2 and F-6

14. Chapter 13: Government Borrowing 13 - 14 Table 13.3 g = 5%f = 5%r = 5% YearDebtGDPbDeficitInteresti 0$5,000$10,00050%$500$2502.5% 1$5,500$10,50052.4%$525$2752.62% 2$6,025$11,02554.6%$551.25$301.252.73% Long Run100%5% The Deficit, Debt, and Interest as a Percent of GDP b* = f/g i* = rb* = r(f/g)

15. Chapter 13: Government Borrowing 13 - 15 Inflation, Debt, and Deficits Real surplus Real deficit = (Taxes) – (Spending) + (the reduction in the real value of the debt due to inflation) = (Nominal surplus) + (the reduction in the real value of the debt due to inflation) = (Spending) – (Taxes) – (the reduction in the real value of the debt due to inflation) = (Nominal Deficit) – (the reduction in the real value of the debt due to inflation)

16. Chapter 13: Government Borrowing 13 - 16 Generating Inflation Combined fiscal-monetary stimulates the economy Congress and the president have the power to borrow money from the public The Federal Reserve has the power to inject money into the economy Separation of powers Which raises aggregate demand for goods and services above supply Which causes prices to rise – inflation

17. Chapter 13: Government Borrowing 13 - 17 Generating Inflation Excess demand raises inflation Deficits and inflation Deficits can cause inflation Deficits do not have to generate inflation Do deficits directly cause inflation? Deficient demand reduces inflation

18. Chapter 13: Government Borrowing 13 - 18 The Long-Term Budget Outlook for the U.S. Figure 1.11 % of GDP 24% 23% 22% 20% 19% 18% 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year Federal Spending 21% 17% 16% Federal Taxes Average federal spending ~ 20% of GDP Average federal revenue ~ 18% of GDP

19. Chapter 13: Government Borrowing 13 - 19 The Long-Term Budget Outlook for the U.S. Figure 1.12 % of GDP 50% 45% 40% 35% 30% 25% 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year Federal Debt Average federal deficit ~ 2% of GDP

20. Chapter 13: Government Borrowing 13 - 20 Summary Deficit versus debt The burden of debt U.S. deficits, debt, and interest during the past half century Inflation, debt, and deficits The long-term budget outlook for the U.S.