© 2003 McGraw-Hill Ryerson Limited. Politics, Surpluses, Deficits, and Debt Chapter 12

© 2003 McGraw-Hill Ryerson Limited.

Politics, Surpluses, Politics, Surpluses, Deficits, and DebtDeficits, and Debt

Chapter 12Chapter 12

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IntroductionIntroduction

After having run budget deficits for many decades, in 1997 the federal government began to run budget surpluses.

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In the long-run framework, surpluses are good because they provide additional saving for an economy.

Deficits are bad because they reduce saving, growth, and income.

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In a short-run framework, the view of surpluses and deficits depends on the state of the economy relative to its potential income.

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If the economy is running below its potential output, deficits are good and surpluses are bad.

Deficits increase expenditures, increasing output by a multiple of that amount.

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Combining the long-and short-run frameworks gives the following policy: Whenever possible, run surpluses, or

at least a balanced budget, to help stimulate long-term growth.

This is especially true when the economy is booming – when it is above its level of potential income.

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The argument for surpluses is weakened, and likely reversed, when the economy falls into a recession.

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At the beginning of 2000 there was a large surplus. The economy was booming. Unemployment was low. There was general agreement that the

economy was closing in on its potential output.

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Both short- and long-term economic frameworks would recommend cutting the national debt.

Instead of doing so, government looked at ways to spend the surplus, either by cutting taxes or by increasing spending.

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Defining Surpluses and Defining Surpluses and DeficitsDeficits A surplus is an excess of revenues

over payments. A deficit is a shortfall of revenues under

payments. Both are flow concepts.

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Financing the DeficitFinancing the Deficit

The deficit must be financed. The government finances its deficits by

selling bonds – promises to pay back the money in the future – to private individuals and to the central bank.

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Since the central bank's IOUs are money, the loans can also be made by printing money.

Potentially, the central bank has an unlimited source of funds.

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However, printing too much money would trigger inflation which can have a negative effect on the economy.

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Arbitrariness in Arbitrariness in Defining Surpluses and Defining Surpluses and DeficitsDeficits Defining surpluses and deficits can be

arbitrary.

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Arbitrariness in Arbitrariness in Defining Surpluses and Defining Surpluses and DeficitsDeficits Whether or not a nation has a deficit

depends on what is included as a revenue and what is included as an expenditure.

This accounting issue is central to the debate about whether we should be concerned about a deficit.

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Arbitrariness in Arbitrariness in Defining Surpluses and Defining Surpluses and DeficitsDeficits The Retirement Income system is

based on promises to pay. Retirement Income System - social

insurance programs that provide financial benefits to the elderly and disabled and to their eligible dependents and/or survivors.

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Arbitrariness in Arbitrariness in Defining Surpluses and Defining Surpluses and DeficitsDeficits The way these programs is accounted

for plays an important role in whether there is a budget deficit or surplus.

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Surpluses and Deficits Surpluses and Deficits As Summary MeasuresAs Summary Measures As a summary, a surplus or deficit figure

reduces a complicated set of accounting relationships down to a single figure.

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Surpluses and Deficits Surpluses and Deficits As Summary MeasuresAs Summary Measures Deficit need not matter - what is

important is the health of the economy.

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Nominal and Real Nominal and Real Surpluses and DeficitsSurpluses and Deficits 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.

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Nominal and Real Nominal and Real Surpluses and DeficitsSurpluses and Deficits Inflation wipes out debt (accumulated

deficits less accumulated surpluses). The larger the debt and the larger the

inflation, the more debt will be eliminated by inflation.

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Nominal and Real Nominal and Real Surpluses and DeficitsSurpluses and Deficits 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.

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Nominal and Real Nominal and Real Surpluses and DeficitsSurpluses and Deficits The real deficit is calculated by

adjusting the nominal deficit for inflation.

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

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Nominal and Real Nominal and Real Surpluses and DeficitsSurpluses and Deficits The lowering of the real deficit by

inflation is not costless to the government.

Persistent inflation becomes built into expectations and causes higher interest rates.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits It is important to make a distinction

between structural and passive deficits. Not all government expenditures are

independent of the level of income in the economy.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits There is a difference between a budget

deficit being used as a policy instrument to affect the economy and a budget deficit that is the result of income deviating from its potential.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits A structural deficit or surplus is the

part of the budget deficit or surplus that would exist even if the economy were at its potential level of income.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits A passive deficit or surplus is the part

of the deficit or surplus that exists because the economy is operating below or above its potential level of output.

The passive deficit is also known as the cyclical deficit.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits When an economy is operating above

its potential, it has a passive surplus. If the economy is operating below its

potential, the actual deficit would be larger than the structural deficit.

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Structural and Passive Structural and Passive Surpluses and DeficitsSurpluses and Deficits There is a significant debate about what

is an economy’s potential income level. There is disagreement about what

percentage of a deficit is structural and what part is passive.

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The Definition of Debt The Definition of Debt and Assetsand Assets Debt is accumulated deficits minus

accumulated surpluses. Deficits and surpluses are flow

concepts. Debt is a stock concept.

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Debt ManagementDebt Management

The debt must be managed. The Canadian government must refinance

the bonds that are coming due by selling new bonds, as well as sell new bonds when running a deficit.

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Debt ManagementDebt Management

In the late 1990s, the federal government ran a budget surplus.

The government retired some of its previously issued bonds by buying them back and did not replace them as they come due.

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The Need to Judge Debt The Need to Judge Debt Relative to AssetsRelative to Assets Debt needs to be judged relative to

assets. Debt is a summary measure of a

nation’s financial situation. As a summary measure, debt has even

more problems than deficit.

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The Need to Judge Debt The Need to Judge Debt Relative to AssetsRelative to Assets Debt by itself is only half the picture. The other half of the picture is assets.

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The Need to Judge Debt The Need to Judge Debt Relative to AssetsRelative to Assets For a government, assets include:

Its skilled work force. Natural resources. Its factories. Its housing stock. Holdings of foreign assets.

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The buildings and land it owns. A portion of the assets of the people in the

country, since government gets a portion of all earnings of those assets in tax revenue.

The Need to Judge Debt The Need to Judge Debt Relative to AssetsRelative to Assets For a government, assets include:

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If the assets are valued at more than their costs, then the deficit is making the society better off.

The Need to Judge Debt The Need to Judge Debt Relative to AssetsRelative to Assets When the government runs a deficit, it

might be spending on projects that increase its assets.

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Arbitrariness in Arbitrariness in Defining Debt and Defining Debt and AssetsAssets Defining debt and assets can be

arbitrary. As was the case with income, revenues,

and deficits, there is no perfect answer as to how assets and debt should be valued.

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Arbitrariness in Arbitrariness in Defining Debt and Defining Debt and AssetsAssets Even after assets are taken into

account, you still have to be careful when deciding whether or not to be concerned about debt.

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Arbitrariness in Arbitrariness in Defining Debt and Defining Debt and AssetsAssets The total stock of gross debt can be

broken down into market debt and non-market debt.

Market debt includes marketable bonds, treasury bills and other securities.

Non-market debt includes federal public sector pension liabilities and other federal liabilities.

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Arbitrariness in Arbitrariness in Defining Debt and Defining Debt and AssetsAssets To calculate debt, we add market debt

and non-market debt, and subtract the value of financial assets held by the government, such as cash, reserves, and loans.

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Difference Between Difference Between Individual and Individual and Government DebtGovernment Debt Individual and government debt are

different.

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Government debt is ongoing. Government can print money to pay off its

debt – individuals can’t. Three quarters of government debt is

internal debt – debt owed to other government agencies or to its citizens.

Difference Between Difference Between Individual and Individual and Government DebtGovernment Debt Government debt is different from an

individual’s debt for three reasons:

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Difference Between Difference Between Individual and Individual and Government DebtGovernment Debt Paying interest on the internal debt

involves a redistribution among citizens of the country, but it does involve a net reduction in income of the average citizen.

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External debt – government debt owed to individuals in foreign countries.

Difference Between Difference Between Individual and Individual and Government DebtGovernment Debt

External debt is more like an individual’s debt.

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Government Deficits Government Deficits and Debt: The and Debt: The Historical RecordHistorical Record Most economists do not look at absolute

figures of deficits and debt. They are much more concerned with

deficits and debt relative to GDP.

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Government Deficits Government Deficits and Debt: The and Debt: The Historical RecordHistorical Record Deficits and debt relative to GDP rose

significantly in the 1970s and 1980s.

In the late 1990s debt started to fall, reaching 50% of GDP in 2001.

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Canadian Budget Canadian Budget Deficit Relative to GDP, Deficit Relative to GDP, Fig. 12-1a, p 293Fig. 12-1a, p 293

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

1961 1971 1981 1991 2001

Years

% f

luctu

ati

on

in

defi

cit

/GD

P

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Canadian Debt Relative Canadian Debt Relative to GDP, to GDP, Fig. 12-1b, p 293Fig. 12-1b, p 293

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

1961 1971 1981 1991 2001

Years

% f

luc

tua

tio

ns

in

de

bt/

GD

P

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Government Deficits Government Deficits and Debt: The and Debt: The Historical RecordHistorical Record Economists prefer the “relative to GDP

measurement” because it better measures the government’s ability to handle the deficit and pay off the debt.

The ability to pay off a debt depends on a nation’s productive capacity, the asset side of the equation.

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The Debt BurdenThe Debt Burden

Decrease of debt/GDP ratio was mainly due to growth in GDP.

There are two ways in which GDP can grow: Through inflation – a rise in nominal,

but not real GDP. Through real growth.

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When GDP grows, the debt the government can reasonable handle also grows.

The economy becomes richer, and, being richer, it can handle more debt.

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Real growth in Canada has averaged about 2.5 to 3.5 percent a year.

This means that Canadian debt can grow at the same rate without increasing the debt/GDP ratio.

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Debt Relative to Other Debt Relative to Other CountriesCountries Canada has a relatively large debt

burden compared to other advanced economies.

The increasing trend of debt to GDP has been reversed in the 1990s, when government revamped its programs and policies.

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Debt Relative to Other Debt Relative to Other CountriesCountries There was a structural deficit in Canada

– even at full employment, spending exceeded revenue.

While Canada’s debt is still high, it is much lower than it was in the 1990s.

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Debt Relative to Other Debt Relative to Other Countries, Countries, Fig. 12-2, p 294Fig. 12-2, p 294

0

20

40

60

80

100

120

Italy Canada Germany France U.S. Japan U.K.

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Interest Rates and Debt Interest Rates and Debt BurdenBurden Besides the debt relative to GDP

figures, economists are concerned about the interest rate paid on the debt because interest rates affect debt burden.

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Interest Rates and Debt Interest Rates and Debt BurdenBurden How much of a burden a given amount

of debt imposes depends on the interest rate that must be paid on that debt.

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Interest Rates and Debt Interest Rates and Debt BurdenBurden The interest rate determines annual

debt service. Annual debt service – the interest rate

on debt times the total debt.

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Interest Rates and Debt Interest Rates and Debt BurdenBurden Ultimately, the interest payments are

the burden of the debt. That is what people mean when they

say a deficit is burdening future generations.

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Interest Rates and Debt Interest Rates and Debt BurdenBurden Canada can actually afford more debt

since Canadian government securities are considered to be very safe.

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Federal Interest Federal Interest Payments Relative to Payments Relative to GDP, GDP, Fig. 12-3, p 295Fig. 12-3, p 295

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

1961 1971 1981 1991 2001

Years

% f

luctu

ati

on

s o

ut

of

GD

P

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The Modern Debate The Modern Debate About the SurplusAbout the Surplus The modern debate about the

government budget concerns what to do with the surplus.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? Keynesian economics made clear that

deficits could serve a positive function when the economy was below its potential.

This view was never fully accepted by politicians, nor by the public.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? The 1980s saw a change in the political

landscape. Politicians were pushing the economy

toward deficits by cutting taxes, and expanding the deficits.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? In the 1990s, the federal government

realized it increased its spending to the point it was running a structural deficit.

Even if the economy were operating at the potential output, the budget would be in deficit.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? The authorities raised taxes, cut many

social programs and redesigned existing programs.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? The surpluses of the late 1990s were

brought about by the unexpected growth of the economy and a low and stable rate of inflation.

Interest rates stayed low, holding down government interest payments.

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Why Did the Surpluses Why Did the Surpluses Come About?Come About? Expected tax revenue also increased,

and deficit predictions moved in the opposite direction, to surplus predictions.

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Federal Deficit and Federal Deficit and Debt Are Only Part of Debt Are Only Part of the Picturethe Picture Provinces and municipalities also run

deficits by borrowing to spend in excess of their revenues, and thereby raise the total amount of government debt in the economy.

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Net Debt: Federal, Net Debt: Federal, Provincial and Local, Provincial and Local, Fig. Fig.

12-4a, p 29812-4a, p 298

0

100000

200000

300000

400000

500000

600000

700000

1977 1980 1983 1986 1989 1992 1995 1998 2001

Federal Net Debt

Provincial Net Debt

Local Net Debt

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Net Debt: Federal, Net Debt: Federal, Provincial and Local, Provincial and Local, Fig. Fig.

12-4b, p 29812-4b, p 298

-50000

-40000

-30000

-20000

-10000

0

10000

20000

1 2 3 4 5 6 7 8 9 10 11 12 13

Federal Deficit

Provincial and LocalDeficit

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Federal Deficit and Federal Deficit and Debt Are Only Part of Debt Are Only Part of the Picturethe Picture Net provincial and territorial debt rose

significantly during the 1990s.

The increase in spending by the provinces was partly a response to the federal budget cuts.

“Fiscal responsibility” is the agenda of many newly elected politicians.

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A Different Type of A Different Type of Crowding OutCrowding Out High government deficits require more

and more borrowing, reducing the capital available to government and private enterprise.

Interests rates increase as a result, and this means that borrowing is more expensive for firms who wish to fund expansion by issuing debt (such as bonds).

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A Different Type of A Different Type of Crowding OutCrowding Out Private sector investment is crowded

out – higher levels of government spending raise interest rates, which in turn reduce the level of private investment.

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A Different Type of A Different Type of Crowding OutCrowding Out Increase in government spending

increases interest rates, and appreciates domestic currency.

When domestic currency gains value, exports decrease, and imports rise.

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Is the Deficit a Good Is the Deficit a Good Measure of the Stance of Measure of the Stance of Fiscal Policy?Fiscal Policy? Can we use deficit to find out if fiscal

policies are becoming more or less expansionary – the stance of fiscal policy?

The answer is NO. Deficit can change as a result of a shift in an autonomous component of demand.

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Is the Deficit a Good Is the Deficit a Good Measure of the Stance of Measure of the Stance of Fiscal Policy?Fiscal Policy? If autonomous spending (investment, for

example) decreased, deficit would rise because income would fall and reduce tax revenues.

This deficit increase was not a result of expansionary fiscal policy.

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Is the Deficit a Good Is the Deficit a Good Measure of the Stance of Measure of the Stance of Fiscal Policy?Fiscal Policy? Budget surplus:

BS = T – GG = G0

T = T0 + tY

BS = [T0 - G0] + tY

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The Budget Surplus The Budget Surplus Function, Function, Fig. 12-5a, p 299Fig. 12-5a, p 299

BS0

Y0

Y10

BS

BS1

BS

Income

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Is the Deficit a Good Is the Deficit a Good Measure of the Stance of Measure of the Stance of Fiscal Policy?Fiscal Policy? A change in equilibrium income would

affect the budget surplus equation, independent of policy variables (T0,G0 or t).

A better measure of the stance of fiscal policy is the structural deficit.

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Is the Deficit a Good Is the Deficit a Good Measure of the Stance of Measure of the Stance of Fiscal Policy?Fiscal Policy? Holding income at its potential level, we

can see how changes in fiscal policy affect the budget surplus.

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The Budget Surplus The Budget Surplus Function, Function, Fig. 12-5b, p 299Fig. 12-5b, p 299

BS0

BS1

Increasein tax shifts BS

Income

BS

0

BS1

BS0

Yp


Politics, Surpluses, Politics, Surpluses, Deficits, and DebtDeficits, and Debt

End of Chapter 12End of Chapter 12

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© 2003 McGraw-Hill Ryerson Limited. Politics, Surpluses, Deficits, and Debt Chapter 12