Chapter 12 Part 2 National Debt: Myths and Realities 1

Chapter 12 Part 2National Debt: Myths and

Realities

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Long Run: Deficits and the National Debt

• Budget deficit (G>T)– when government purchases exceed net

tax revenue • Consequences of budget deficit

– raising interest rates (Loanable funds)– crowding out consumption and investment

spending– an increase in the government’s debt

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Long-run: Deficits and the National Debt• National debt is the total amount the federal

government still owes to the general public from past borrowing

• Budget-related figures such as government outlays, tax revenues, or government debt– should be considered relative to a nation’s

total income - as percentages of GDP

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Long-run: Deficits and the National Debt

• What are Government outlays?– total disbursements by the government

for: • Government purchases • Transfer payments• Interest on the national debt

Budget surplus = Tax revenue > Outlays

Budget deficit = Tax revenue < Outlays

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Federal Outlays and Revenue, 1965–2025

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Budget Surplus or Deficit, 1959–2014

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Deficits increase during recessions and decrease during expansions

Deficits and the National Debt• In a recession

– budget deficit automatically increases – transfers rise and tax revenue falls

(or the budget surplus decreases)• In an expansion

– budget deficit automatically decreases – transfers decrease and tax revenue rises

(or the budget surplus increases)• Because of the automatic-stabilizers we

discussed in chapter 117

Deficits and the National Debt• Budget deficits need to be financed

– increase the public’s bond holdings– increase the national debt

• Budget surpluses– decrease the public’s bond holdings– decrease the national debt

• Debt ratio – publicly held national debt as a

percentage of GDP

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The U.S. Debt Ratio (1940 - 2014)

ReaganClinton

Obama

Debt as a percentage of GDP soared during World War II, then fell steadily for several decades. It rose during the 1980s, fell in the 1990s, and then surged from 2009–2011 due to recession and fiscal stimulus policies.

National Debt• The total national debt

– In 2014, it was approaching $18 trillion– Amount the government owed to the

public (~$13 trillion)• This has a macroeconomic impact

– Amount that one government agency owed to another ($5 trillion)• No macroeconomic impact at all• http://

www.treasurydirect.gov/govt/reports/pd/mspd/2014/opds122014.pdf 10

A mythical concern about the national debt

• “One day we’ll have to pay it all back”

• Don’t have to as long as the nation’s total income (GDP) is rising– The government can safely take on more

debt as long as national income grows and tax receipts can cover additional interest payments

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The Burden of the Debt? • The interest payments the government

owes and the taxes it must collect to pay that interest.– its measured as the annual interest on the

national debt as a percentage of annual GDP

– can also be defined as the tax rate (taxes as a percentage of GDP) needed to pay interest on the debt

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Source: Congressional Budget Office.

Why is this a Burden ?

• Higher tax rates needed to pay interest on the national debt are a burden:

– they lead to slower economic growth

– they transfer purchasing power to other

countries

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Major Foreign Holders of U.S. Federal Debt, July 2011

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http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

National Debt: Myths and Realities• Can a country’s debt keep rising without

imposing any added burden?– yes, as long as the country follows the

basic debt guideline• Basic debt guideline

– total nominal debt should grow no faster than nominal GDP

– for example, if NGDP rises by 10% per year, debt should rise by no more than 10% per year.

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A Growing National Debt with a Constant Debt Burden: GDP and Debt grow at 10%

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In this example, the government must collect taxes equal to 4% of GDP to pay the interest on the debt

National Debt: Myths and Realities• The debt ratio will remain constant as

long as the debt grows by the same percentage as nominal GDP

• The burden of the debt will remain constant if the interest rate doesn’t change

• NOTE: in this example, the debt grows each year which means the government is continually running a budget deficit

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Genuine Concern #1: A rising debt burden

• Allowing debt to grow faster than GDP• violates of the basic guideline

• requires higher and higher tax rates

• cannot go on forever, because: –100% upper limit, and–Will reduce potential GDP (would you

work more or invest in human capital if 90% of your income was taxed?)

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A Growing National Debt with a Rising Debt Burden: Debt Grows Faster Than GDP: 20% vs. 10%

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Genuine Concern #1: A rising debt burden

• Even if the rise in the burden of the debt is temporary,

• It can create a permanently higher burden, meaning permanently higher taxes

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A Growing National Debt with a Rising Debt Burden: Debt Grows Faster Than GDP for 3 years.

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Year 5 $14641 billion $9504 billion 65.0% $760.3 billion 5.2%

How to bring debt burden down after a temporary violation of the guideline

1. Raise the growth rate of nominal GDP above the growth rate of the debt for some time• Need to be aware of inflation. Remember

in the LR, ability to affect RGDP is limited.

• With inflation comes inflationary expectation which increases the nominal interest rate. Interest cost on the debt will increase.

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How to bring debt burden down after a temporary violation of the guideline

2. Lower the growth rate of the debt below the growth rate of nominal GDP for some time

• which means reduce the deficit which in turn means cut G or increase T

• Austerity!

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National Debt: Myths and Realities• Genuine Concern #2: A debt disaster

– if debt were to rise too rapidly relative to GDP, for too long there is a danger of reaching the nation’s credit limit

• This is a debt ratio that would make lenders worry about the government’s ability to continue paying interest

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National Debt: Myths and Realities• A small increase in the debt ratio would lead

to a cutoff of further lending or very high interest rates

• The budget would have to be balanced immediately.

• Fiscal austerity- Significant and sudden drop in government outlays and/or a significant rise in tax rates and cuts in transfer payments

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National Debt: Myths and Realities• When a nation hits its credit limit

– it is forced to choose among extremely unpleasant options

• Each option is likely to impose more economic pain than the country would have faced if it had reduced its debt ratio earlier and more gradually, and not reached its credit limit in the first place

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National Debt: Myths and Realities• Default as an option

• Simply refuse to repay debt• This would reduce the government’s

debt and debt ratio• But creates a great deal of economic

pain– Devastating the wealth of households and

businesses that held government bonds• Could collapse a country’s own financial

system, as well as the systems of other countries that hold its bonds

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National Debt: Myths and Realities• How high can a country’s debt ratio go

before it hits its credit limit? – There is no hard and fast rule

• A country’s credit limit is determined by– Its current debt ratio– Its reputation for honoring its obligations

in the past– The likely change in its debt ratio in the

near and distant future29

Case Study: Greece• By the early 2000s

– after years of spending more than it collected in taxes, Greek government debt was about equal to its annual GDP• debt ratio of 100%

• Up to 2008 Greece was not yet at its credit limit – lenders still lending

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Greece’s Debt Disaster

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Greece’s Debt Disaster • In 2008, Europe fell into recession

– Greece was particularly hard hit– GDP fell and budget deficits rose– Rapidly rising debt ratio from its

already high level• Bumping up against its credit limit

lenders charged higher interest rates

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Greece’s Debt Disaster

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Greece’s Debt Disaster • The vicious cycle began

– higher interest rates demanded by lenders added to Greece’s deficit

– causing its debt to rise even more rapidly

– escalating fears of default– interest rate rose even higher

• Greece was in the midst of a debt disaster

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Case Study: Greece• Was there a solution?

– One option was to print money: – Oops, not an option

• Gave up control of the money supply when joined the European Monetary Union

– A second option was to leave the Eurozone• Give up important long-run benefits

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Case Study: Greece• Was there a solution?

– A third option was to default• If too small, it wouldn’t help much• If too large, Greece might be cut off from

all further borrowing• Threatened financial systems: Europe• Lenders would worry that other

European countries might default next–Fear that Spain, Italy, Portugal, and Ireland

might default next (PIIGS)

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Case Study: Greece• In 2010 and 2011European governments

and international organizations were scrambling to prevent a Greek default

• Agreed to lend Greece billions of euros at lower interest rates

• Demanded fiscal austerity from Greece– Higher taxes and government

spending cuts

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The U.S. Long-Term Debt Problem• In 2011, the U.S. debt ratio: 72%

– The problem: debt ratio projected to rise over the next couple of decades

• Why? U.S. government’s promises: – Social security benefits when people retire

to fund health care for the elderly and the poor

• Medicare, Medicaid, and related programs

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The U.S. Long-Term Debt Problem• Rising social security and health care

payments – aging population, using more health care– new and evermore expensive technologies

and procedures– increased from 4% to 10% of GDP from

1971 to 2011– projected: increase to 17% of GDP by 2037

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The U.S. Debt Ratio: Past and Projected

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The U.S. Long-Term Debt Problem• Rapid debt growth is a looming danger

that must be solved by shrinking projected future budget deficits - G↓ or T ↑

• Shrinking deficits too soon, before the economy has sufficiently recovered from its long slump

• Deepen and prolong the economic slump• Or propel the economy into another recession

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