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Understanding the Structural vs. Actual Federal Budget Deficit: Implications and Theories

This analysis delves into the vital differences between structural and actual budget deficits within the federal budget framework. The actual budget reflects current spending and revenues, while the structural budget forecasts spending and taxes based on an economy operating at potential output. By examining the cyclical aspects of deficits, impacts on national savings, and complexities of debt dynamics, we explore perspectives on fiscal policies and theories, including the Ricardian equivalence. This discussion highlights the significance of these distinctions in economic planning and government policy-making.

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Understanding the Structural vs. Actual Federal Budget Deficit: Implications and Theories

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  1. Fiscal Policy 1

  2. The overall federal budget Deficit

  3. Structural v Actual Budget • Actual budget is actual spending and receipts • Structural budget records spending, taxes, and deficit that would occur if economy at potential output • Important because taxes, spending programs respond to state of economy

  4. Structural and Actual Budget A substantial part of the deficit is cyclical.

  5. Debt bathtub Spending Debt (end of year) = Debt (beginning) + deficit Debt (beginning of year) Revenues

  6. Debt algebra Basic identity: Change in Debt (end of t) = Deficit (t) + ε Government budget constraint: Debt = PV(future taxes) – PV(future expenditures) Unstable dynamics: Debt is explosive if when debt-GDP ratio (β) grows steadily, which occurs when the ratio grows rapidly:

  7. CBO, September 2009

  8. How Quickly the Budget Picture Can Change From CBO reports, 1997 2009.

  9. National saving is falling sharply … Data from BEA.

  10. Current projection of debt/GDP

  11. Long-term projection of debt/GDP

  12. What is responsible for the fiscal problem?

  13. What is responsible for the fiscal problem?

  14. Presidential (or near-so) views “It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F.D.Roosevelt] “There are myths also about our public debt. Borrowing can lead to over-extension and collapse--but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [J.F.Kennedy, Yale Commencement Address, 1962] "But most of all because I think this [deficit spending] can only be described as generational theft.“ [John McCain]

  15. Preliminary Considerations • Deficits (and therefore higher debt) may be necessary to stabilize the business cycle (particularly in liquidity trap situations). • However, burden and impact of debt should be considered in long-run. Impacts on AD can be offset by fiscal and monetary policy. • One cost of debt is the efficiency losses (deadweight losses) from higher taxation (micro/public finance) • Ricardian debt theory holds that people offset it in saving (next slide) • Don’t blame it on the Chinese! (next week) • The main macro cost is the “crowding out” of capital (today) • Higher debt displaces capital from portfolios • This lowers growth of K and potential Q

  16. 1. Do Deficits Matter? The Ricardian Theory of the Debt • Robert Barro (Chicago/Harvard) introduced a theory in which deficits do not affect national saving or output. • Chicago view of households: They are "clans" or "dynasties" in which parents have children’s welfare in utility function: Ui = ui (ci, Ui+1) where Ui is utility of generation i and ci is consumption of generation i 3. This implies by substitution: Ui = ui (ci, ui+1(ci+1, Ui+2)) = vi(ci, ci+1, ci+2, ...) which is just like an infinitely lived person! 4. Important result: Barro consumers are like a life-cycle model with infinitely lived agents with perfect foresight: there will be no impact of anticipated taxes (or deficits) on consumption or on aggregate demand. 5. Controversial, but empirically questionable. Reasons are myopia, singles, liquidity constraints, non-altruistic parents.

  17. Mechanism of Crowding Out • Assume closed economy with full employment • Government borrows for consumption G • wars, food stamps, ice cream, … • Wealth accounting: W = K + GD • Wealth is owned in form of private assets (houses, bonds, stocks) and government debt; non-Ricardian consumers • Demand for K by firms for production. • Demand for K is downward-sloping function of real interest rate, r • Supply of capital and wealth: • Households accumulate wealth in K and GD for life cycle and other purposes • For simplicity, assume supply is interest-inelastic • Increased government debt then “crowds out” equities/capital from portfolio • Higher GD with constant W reduced K • Higher GD → lower K → lower potential output

  18. Before increase in GD Firm Balance Sheet Assets Liabilities Capital Stock 5000 Equities (stock) 5000 Net worth 0 Government Balance Sheet Assets Liabilities Assets 0 Debt (bonds) 1000 Net worth -1000 Household Balance Sheet Liabilities Assets Equities 5000 Net worth 6000 Govt bonds 1000

  19. After increase in GD Firm Balance Sheet Assets Liabilities -100 -100 Capital Stock 5000 Equities (stock) 5000 Net worth 0 Government Balance Sheet Assets Liabilities Assets 0 Debt (bonds) 1000 +100 Net worth -1000 -100 Household Balance Sheet Liabilities Assets -100 Equities 5000 Net worth 6000 Govt bonds 1000 +100 Net effect: +100 in GD → -100 of capital stock

  20. r K = W r0 r = f′(K) Capital stock K0

  21. r K = W - GD K = W r1 r0 r = f′(K) Capital stock K0 K1

  22. r K = W - GD K = W r1 Loss of NNP = r ΔK r0 r = f′(K) Capital stock K0 K1

  23. ln K, ln GD ln K ln K’ ln GD’ ln GD time

  24. ln Q, ln C ln Q ln Q’ ln (C+G) ln (C+G)’ Note that govt spending first raises (C+G), but then lowers (C+G)’ time

  25. A word on the open economy • In open economy: W = K + GD + NFA (NFA = net foreign assets) • Higher GD reduces (K+NFA) • Therefore, govt. debt displaces domestic K and/or foreign capital

  26. The deficit dilemma Suppose that we increase G by $1. Short run: • Increases Y by mult x 1 = 1.5 • Taxes rise by t x 1.5 = 0.5 • So deficit and debt rises by 0.5 Long-run: • National saving down by (say) 0.5, decreasing K by 0.5, for annual loss of r x 0.5 = 0.05 x 0.5 = $0.025 per year • Taxes rise to service debt by (r – g) 0.5 = 0.03 x 0.5 = 0.015 per year • Dead weight loss on taxes of (say) 50 % = $0.0075 per year Total: Short run gain of 1.5 Long run loss of (0.025 + 0.0075). At discount rate of 5%, = -$0.65 Net gain = + $0.85

  27. Conclusions on Fiscal Policy and Economic Growth • Fiscal policy affects economic growth through impact of government surplus through national savings rate • Deficits and higher govt debt lowers national saving • Decreases potential output through: • Lower capital stock for domestic investment • Lower income on foreign assets for foreign investment in open economy • Consumption (C + G) increases at first and then declines with the lower growth rate • Deficit dilemma of stimulus package 27

  28. Readings David Wessel, In Fed We Trust William Cohen, House of Cards Alessandri and Haldane Banking on the State (web page)

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