© The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill Deficits And Debt Chapter 19.

© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill

Deficits And DebtDeficits And Debt

Chapter 19


Laugher CurveLaugher Curve

How many neoclassical economists does it take to change a lightbulb?


Laugher CurveLaugher Curve

How many neoclassical economists does it take to change a lightbulb?

It depends on the wage rate.


Chapter ObjectivesChapter Objectives

Define the terms deficit and debt.



Define the terms deficit and debt. State why economists focus on financial

health rather than on deficits.



Explain why, in an expanding economy, a government can run a limited, but continual, deficit without serious concern about the consequences.



Differentiate between a real deficit and a nominal deficit.



Explain why, even though the real budget deficit of the United States is much lower than the nominal deficit, there is still reason for concern about the deficit.



Explain why there are alternative reasonable views about the deficit.


U.S. Government U.S. Government Deficits and DebtDeficits and Debt Introductory Definitions



A deficit is a shortfall of incoming revenues under outgoing payments—it is a flow concept.



If revenues exceed payment, you are running a surplus.



If revenues exceed payment, you are running a surplus.

If the opposite happens, you are running a deficit.



Debt is accumulated deficits minus accumulated surpluses—it is a stock concept.



As debt accumulates, governments must borrow to pay the interest.


U.S. Government U.S. Government Deficits and DebtDeficits and Debt Why has the U.S. consistently run

deficits since World War II?



deficits since World War II? The reason is a change in

macroeconomic policy regimes—the general set of rules that governs the monetary and fiscal policies that a nation follows.



deficits since World War II? Keynesians, in arguing in favor of

deficit spending, removed its stigma.



deficits since World War II? As deficits grew, they were blamed

for its growth.



deficits since World War II? The modern Classical supply-side

regime of the 1980s, resulted in even greater deficits than those run up by the Keynesians.


U.S. Government U.S. Government Deficits and DebtDeficits and Debt The public dislikes both deficits and

debt.



debt. The Gramm-Rudman-Hollings Act of

1985 established mandatory deficit targets for the U.S. in an effort to meet public demands for their elimination.



debt. Since the law proved ineffective, the

Budget Enforcement Act of 1990 was enacted.



debt. The Budget Enforcement Act of 1990

put caps on certain aspects of federal spending, and established a pay-as-you-go test for new spending or tax cuts.



debt. Up until 1996, any new legislation,

except for emergencies, must be accompanied by offsetting tax increases or spending cuts.



debt. As these laws, and others proved

weak, some politicians demanded a balanced budget amendment to the Constitution.



debt. It was felt that without the

amendment, American politics lacks the political will to prevent deficit spending.


U. S. Budget DeficitsU. S. Budget DeficitsD

olla

rs (

in b

illio

ns

)

Do

llars

(in

bill

ion

s)

200

100

0

$300

100 –

200–

300–

400–

Surplus

Years

1950 1960 1970 1980 1990 2000 2010

Deficit


U. S. Government DebtU. S. Government Debt

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0

Years

1950 1960 1970 1980 1990 2000 2010

$5,500


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Arbitrariness in Defining Deficits



How one defines a revenue and an expenditure is crucial.



Should capital equipment be charged off completely the year it was bought or be depreciated over its useful life?



Should the gain in the market value of an issued U.S. government obligation be counted as additional revenue or ignored?



Putting aside the issue of “cooking the books,” reasonable people can disagree on how to handle government revenue and expenditures.


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Deficits As a Summary Measure



The deficit is a summary measure of the financial health of the economy—a single figure.



Therefore, to understand the summary, you must understand the logic used to calculate it.


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt The Need to Judge Deficits Relative to

Assets



Assets Debt, being a summary measure of a

nation’s accumulated deficits, has even more problems than deficits.



Assets Debt is only half the picture—the

other half being assets.



Assets Debt must be judged in its relation to

assets.


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Arbitrariness in Defining Debt



Assets and debt are subject to varying definitions.



There is no perfectly objective and universal way of defining how debt and assets should be valued.


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Difference Between Individual and

Government Debt



Government Debt Government debt is different than an

individual’s debt.



Government Debt Since government is ongoing, it never

has to settle its accounts as when an individual dies.



Government Debt Governments can pay off debt by

creating money.



Government Debt Much of government debt is internal

government debt, debt owed to its own citizens.



Government Debt This means that the government

must collect taxes to pay the debt which is giving to the debt holders as income.



Government Debt Not counting the distribution effects

(the same people may not be involved) the nation is neither richer nor poorer.



Government Debt External government debt on the

other hand is debt owed individuals in foreign nations.



Government Debt Paying interest on it means a net

reduction in domestic income.


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Deficits, Debt, and Debt Service

Relative to GDP



Relative to GDP Government deficits and debt relative

to GDP is less alarming compared to government deficits and debt in absolute terms.



Relative to GDP Measuring deficits and debt relative

to GDP highlights a nation’s productive capacity relative to debt management.



Relative to GDP Although the absolute size of the

deficits and debt have grown since World War II, their importance relative to GDP have not.


Budget Deficits as a Budget Deficits as a Percentage of GDPPercentage of GDP

Years

Def

icit

s as

per

cen

tag

e o

f G

DP

10

0

–10

–20

–3019001910 1920 1930 1940 1950 1960 1970 1980 1990


Debt as a Percentage of Debt as a Percentage of GDPGDP

De

bt

as

pe

rce

nta

ge

of

GD

P

1980

100

75

50

25

0

Years

1800 1820 1840 1860 1880 1900 1920 1940 1960 2000


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt


Economists’ Way of Economists’ Way of Looking at Deficits and Looking at Deficits and DebtDebt Economists are also concerned about

the interest rate paid on debt.



the interest rate paid on debt. Debt service is the interest rate on

debt times the total debt.



the interest rate paid on debt. Debt service as payment for past

expenditures puts a burden on future generations.



the interest rate paid on debt. Debt service payments relative to

GDP suggests that it is a greater problem than the debt/GDP measure, but less of a problem than absolute debt.



the interest rate paid on debt. The U.S. can actually afford more

debt since U.S. government securities are considered the safest in the world.


Federal Interest Federal Interest Payments Relative to GDPPayments Relative to GDP

Inte

res

t p

ay

me

nts

as

p

erc

en

tag

e o

f G

DP

3.5%

3.0

2.5

2.0

1.5

1.0

0.5

0

1945 1955 1965 1975 1985 1995 2005

Years


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits Structural Deficits, Cycles and Growth



As aggregate income increases, tax revenues increase and the deficit declines.



As aggregate income increases, tax revenues increase and the deficit declines.

The opposite occurs as aggregate income falls.



The structural deficit is the deficit that would remain when these cyclical elements have been netted out.



The structural deficit is the deficit that would remain when these cyclical elements have been netted out.

This would result in an economy at its potential income.


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits Real Growth and the Deficit





Some argue that as long as the economy is growing in real terms, and the debt/GDP ratio is maintained, the debt can grow without deleterious effects.



Others argue that the debt-GDP ratio is already too high and should be brought down.


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits Inflation, Debt, and the Real Deficit



Inflation wipes out debt.



The larger the debt and the larger the inflation, the more debt will be eliminated with inflation.



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.



A nominal deficit is the deficit determined by looking at the difference between expenditures and receipts.



A real deficit is the nominal deficit adjusted for inflation’s effect on the debt.



A real deficit is the nominal deficit adjusted for inflation’s effect on the debt.

real deficit = nominal deficit - (inflation x total debt)


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits Inflation, Debt, and Nominal Deficits



Inflation wipes out debt, and that fact must be considered when evaluating the effect of a deficit.



Inflation is not a costless answer to eliminating debt.



The government’s gain from an inflation is the private bond holder’s loss from inflation.


GDP Growth Reduces GDP Growth Reduces Problems Posed by Problems Posed by DeficitsDeficits Nominal and Real Interest Rates and

Deficits



Deficits Expectations of inflation push up the

nominal interest rate and cause bond holders to demand an inflation premium on their bonds.



Deficits Future expectations of inflation

causes the real interest rate to be different form the nominal interest rate.



Deficits If bond holders don’t lose when they

make a full adjustment for expected inflation, government cannot win.



Deficits With full adjustments in expectations,

creditors don’t lose. See numerical example on page 473 of the textbook.


Summary to This PointSummary to This Point

Deficits are summary measures of the state of the economy.



Deficits are summary measures of the state of the economy.

They are dependent on the accounting procedures used.



It is the financial health of the economy, not the deficit, with which we should be concerned.



Deficits and debt should be viewed relative to GDP to determine their importance.



The real deficit is the nominal deficit adjusted for the inflation reduction in the real debt.


Reasons for Concern Reasons for Concern About Budget DeficitsAbout Budget Deficits The U.S. does not include many

government obligations.



government obligations. The U.S. uses a cash flow accounting

system—an accounting system entering expenses and revenues only when cash is received or paid out.



government obligations. The cash flow accounting system

leads to a number of distortions in the budget and deficit.



government obligations. A number of government obligations

do not show up as part of the deficit.


Reasons for Concern Reasons for Concern About Budget DeficitsAbout Budget Deficits The government uses accounting tricks

to make the deficit look smaller.



to make the deficit look smaller. In the S&L bailout, the government

increased insurance fees on member institutions and counted them as revenue.



to make the deficit look smaller. Since they were not nearly enough to

cover the costs, the government sold special bonds which were not counted as expenditures.



to make the deficit look smaller. These are called off-budget

expenditures, expenditures of money that are not counted as expenditures in the budget.


The Social Security The Social Security Retirement SystemRetirement System Funded and Unfunded Retirement

Systems



Systems A funded pension system is one in

which money is collected and invested in a special fund from which pension payments are made.



Systems An unfunded pension system is one in

which pensions are paid from current revenues.



Systems The social security system is largely

an unfunded pension system.



Systems The problem with this is that there is

no trust fund of assets earning interest to cover future payments.


The Social Security The Social Security Retirement SystemRetirement System A Potential Problem With Unfunded

Systems



Systems The potential problem is that the

amount paid out exceeds the amount paid in.



Systems As long as each succeeding

generation remains about the same size, the process works.



Systems If there is a baby boom generation, followed

by normal-sized generations, when the baby boomers begin to retire, there is not enough money being paid into the system to sustain them.

There are a number of ways to deal with this. Partially fund the system. Raise the retirement age.


The Social Security The Social Security Retirement SystemRetirement System Social Security and the Budget Deficit

The government responded to the unfunded social security system by raising the retirement age slightly and legislating a large increase in the rate of social security contributions.



Systems The tax increase was to fund a large

trust fund.



Systems Unfortunately, deficit spending grew

apace so the government was forced to finance the trust fund by issuing bonds as a promise to pay for funding the trust fund.


The Social Security The Social Security Retirement SystemRetirement System An Alternative



Raise the eligibility age so that by 2010, it will stand at 70 years.



Lower the current social security tax rates by 10 percent.



The effect would be an increase in the current budget deficit accompanied by an increase in U.S. financial strength.


The Deficit Debate: The Deficit Debate: Wolves, Pussycats, or Wolves, Pussycats, or TermitesTermites Three Alternative Views of the Deficit



The wolf-at-the-door group believes that the deficit will bring about imminent doom.



The wolf-at-the-door group believes that the deficit will bring about imminent doom.

Few economists belong to this group.



The domesticated-pussycat group believes that the deficit does not matter.



The domesticated-pussycat group believes that the deficit does not matter.

A small but vocal group belong to this group.



The termites-in-the-basement group believes that continuing deficits will cause serious problems in the long run.



The termites-in-the-basement group believes that continuing deficits will cause serious problems in the long run.

The largest number of economists belong to this group.


The Deficit Debate: The Deficit Debate: Wolves, Pussycats, or Wolves, Pussycats, or TermitesTermites Who’s Right?





The Proxmire letter mirrors the views of most lay people’s views of the deficit.



Eisner’s response represents the views of liberal Keynesian economists, of which he is one.



Some Classical economists believe deficits don’t matter because people are rational and fully discount future tax payments deficits would entail.



The Modigliani/Solow response to Eisner argues that the deficits are gnawing away at the structure of the economy.



The economy is fundamentally sick and using slick accounting Band-Aids will not cure the illness.


Comparisons of Comparisons of Government Debt to Government Debt to GDPGDP

120%

100%

92%

67%

60%

50%

15%

15%

Approximate ratios of government debt to GDP

Italy

Canada

Japan

United States

Germany

United Kingdom

Switzerland

Australia

Source: World Economic Outlook, 1996 (International Monetary Fund).

© The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill Deficits And Debt Chapter 19.

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