Deficits, Surpluses, and Debt

1. Deficits, Surpluses, and Debt Chapter 12

2. Budget Effects of Fiscal Policy Keynesian theory highlights the potential of fiscal policy to solve macro problems. Fiscal Policy is the use of government taxes and spending to alter macroeconomic outcomes.

3. Budget Surpluses and Deficits Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.

4. Budget Surpluses and Deficits Budget deficit is the amount by which government spending exceeds government revenue in a given time period.

5. Budget Surpluses and Deficits If the government spends less than its tax revenues, a budget surplus is created.

6. Budget Deficits and Surpluses

7. A String of Deficits

8. Keynesian View Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy. The goal of macro policy is not to balance the budget but to balance the economy at full-employment.

9. Discretionary vs. Automatic Spending At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.

10. Discretionary vs. Automatic Spending To a large extent, current revenues and expenditures are the result of decisions made in prior years.

11. Discretionary vs. Automatic Spending Since most of the budget is uncontrollable, fiscal restraint or fiscal stimulus are less effective.

12. Automatic Transfers Most of the uncontrollable line items in the federal budget change with economic conditions. Outlays for unemployment compensation and welfare benefits increase when the economy goes into a recession.

13. Automatic Transfers Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits.

14. Automatic Transfers Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.

15. Automatic Transfers Automatic stabilizers also exist on the revenue side of the budget.

16. Cyclical Deficits The size of the federal deficit or surplus is sensitive to expansion and contraction of the macro economy. Actual budget deficits and surpluses may arise from economic conditions as well as policy.

17. Cyclical Deficits The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation.

18. Structural Deficits To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.

19. Structural Deficits The structural deficit is federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.

20. Structural Deficits Part of the deficit arises from cyclical changes in the economy.

21. Structural Deficits Fiscal policy is categorized as follows:

22. Economic Effects of Deficits There are a number of consequences of budget deficits. Crowding out. Opportunity cost. Interest-rate movements.

23. Crowding Out Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing. Crowding out implies less private-sector output.

24. Crowding Out

25. Opportunity Cost Crowding out reminds us that there is an opportunity cost to government spending. Opportunity cost is the most desired goods or services that are forgone in order to obtain something else.

26. Interest-Rate Movements Rising interest rates are both a symptom and a cause of crowding out.

27. Economic Effects of Surpluses The economic effects of budget surpluses are the mirror image of those for deficits.

28. Crowding In There are four potential uses for a budget surplus: Cut taxes. Increase income transfers. Spend it on goods and services. Pay off old debt (�save it�).

29. Crowding In Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing.

30. Cyclical Sensitivity Crowding in depends on the state of the economy. In a recession, a decline in interest rates is not likely to stimulate much spending if consumer and investor confidence is low.

31. The Accumulation of Debt The United States has accumulated a large national debt. The national debt is the accumulated debt of the federal government.

32. Debt Creation When the Treasury borrows funds it issues treasury bonds. Treasury bonds are promissory notes (IOUs) issued by the U.S. Treasury. The national debt is a stock of IOUs created by annual deficit flows.

33. Early History, 1776-1900 By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War.

34. Early History 1776-1900 During the period 1790-1812 the U.S. often incurred debt but typically repaid it quickly.

35. Early History 1776-1900 1835-36: Debt Free! � The U.S. was completely out of debt by 1835.

36. Early History 1776-1900 By the end of the Civil War (1861-65), the North owed over $2.6 billion, nearly half of its national income.

37. The Twentieth Century The Spanish-American War (1898) also increased the national debt. World War I raised the debt from 3% to 41% of the national income.

38. The Twentieth Century National debt declined during the 1920�s but rose again during the Great Depression.

39. World War II The greatest increase in national debt occurred during World War II. Rather than raise taxes, the government rationed consumer goods. U.S. War Bond purchases raised the debt from 45% of GDP to over 125% in 1946.

40. The 1980s During the 1980s, the national debt rose by nearly $2 trillion. The increase was not war-related but as a result of recessions, a military buildup, and massive tax cuts.

41. The 1990s The early 1990s continued the same trend. Discretionary federal spending increased sharply in the first two years of the Bush administration.

42. The 1990s The 1988-92 period saw the national debt increased by another trillion dollars.

43. 2000 - By 2002, the accumulated debt was $5.6 trillion, which works out to nearly $20,000 of debt for every American citizen. By 2005, the debt surpassed $8 trillion.

44. Historical View of the Debt/GDP Ratio

45. Who Owns the Debt? Who can ever expect to pay off a debt measured in the trillions of dollars?

46. Liabilities = Assets National debt represents a liability as well as an asset in the form of bonds. Liability � An obligation to make future payment; debt. Asset � Anything having exchange value in the marketplace; wealth.

47. Liabilities = Assets The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).

48. Ownership of Debt Federal agencies hold roughly 50 percent of the outstanding Treasury bonds. State and local governments hold 7 percent of the national debt. U.S. households hold nearly 20% of the national debt, either directly or indirectly.

49. Ownership of Debt Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions.

50. Ownership of Debt

51. Burden of the Debt The burden of the debt is not so evident: Refinancing. Debt service. Opportunity cost

52. Refinancing The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due. Refinancing is the issuance of new debt in payment of debt issued earlier.

53. Debt Service Debt service is the interest required to be paid each year on outstanding debt. Interest payments restrict the government�s ability to balance the budget or fund other public sector activities.

54. Opportunity Costs Opportunity costs are incurred only when real resources (factors of production) are used. The true burden of the debt is the opportunity costs of the activities financed by the debt.

55. Government Purchases The opportunity cost of government purchases is the true burden of government activity, however financed.

56. Transfer Payments The only direct cost of transfer payments are the resources involved in the administrative process of making the transfer.

57. The Real Trade-Offs Deficit financing tends to change the mix of output in the direction of more public-sector goods. The burden of the debt is the opportunity costs (crowding out) of deficit-financed government activity.

58. The Real Trade-Offs The primary burden of the debt is incurred when the debt-financed activity takes place.

59. Economic Growth Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment. The whole debate about the burden of debt is really an argument over the optimal mix of output.

60. Repayment Future interest payments entail a redistribution of income among taxpayers and bondholders living in the future.

61. External Debt External debt presents some special opportunities and problems.

62. No Crowding Out External financing allows us to get more public-sector goods without cutting back on private-sector production. As long as foreigners are willing to hold U.S. bonds, external financing imposes no real cost.

63. External Financing

64. Repayment Foreigners may not be willing to hold bonds forever. External debt must be paid with exports of real goods and services.

65. Deficit and Debt Limits The key policy question is whether and how to limit or reduce the national debt.

66. Deficit Ceilings The only way to stop the growth of the national debt is to eliminate the budget deficit that created it. Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.

67. Deficit Ceilings The Balanced Budget and Emergency Deficit Control Act of 1985 (Gramm-Rudman-Hollings Act) was the first explicit attempt to force the federal budget into balance.

68. Gramm-Rudman-Hollings Act It set a lower ceiling on each year�s deficit until budget balance was achieved. It called for automatic cutbacks in spending if Congress failed to keep the budget below the ceiling.

69. Debt Ceilings A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt. Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.

70. Dipping into Social Security The Social Security Trust Fund has been a major source of funding for the federal government for over 20 years.

71. Aging Baby Boomers Persistent surpluses in the Trust Fund largely result from Baby Boomers paying lots more payroll taxes than are paid out in benefits to the retired.

72. Social Security Deficits The Trust Fund balance shifts from surplus to deficit soon after 2014. To pay back Social Security loans, Congress will have to significantly raise future taxes or substantially cut other programs.

73. Changing Worker-Retiree Ratios

74. Deficits, Surpluses, and Debt End of Chapter 12