DEFICITS, SURPLUSES AND DEBT

Eva Hromádková, 12.4 2010

Macroeconomics ECO 110/1, AAULecture 8

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.

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Budget Deficits and SurplusesDefinitions

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

Budget surplus is an excess of government revenues over government expenditures in a given time period.

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Budget deficit / surplus = gvt spending – tax revenues > /< 0

Budget Deficits and SurplusesReal world example - USA

US Budget Totals (billions of dollars)

2000 2001 2002 2003

Revenues 2,025 1,991 1,853 1,782

Outlays -1,789 -1,864 -2,011 -2,157

Surplus (deficit) 236 127 -158 -375

2004 2005 2006

Revenues 1,880 2,154 2,407

Outlays -2,293 -2,472 -2,654

Surplus (deficit) -413 -318 -247

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US budget deficits 1970-2008

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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.

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Discretionary vs. Automatic Spending At the beginning of each fiscal year, the

government and parliament (Czech Republic) or President and Congress (US) put together a budget blueprint (proposal) for next fiscal year. Fiscal year (FY) is the twelve-month period

used for accounting purposes In the Czech Rep, the same as calendar year In US, begins on October 1 for the federal

government. After approval it is published as a bill (law)

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Discretionary vs. Automatic Spending To a large extent, current revenues and

expenditures are the result of decisions made in prior years past legislative or executive commitments.

Q: Examples? Roughly 80 percent of the budget is given by

previous commitments, so that only about 20 percent represents discretionary fiscal spending. Left to or regulated by gvt's own discretion or judgment. Available for use as needed or desired

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Discretionary vs. Automatic Spending Since most of the budget is uncontrollable,

fiscal restraint or fiscal stimulus is less effective.

Remember? Fiscal restraint – tax hikes or spending

cuts intended to reduce (shift) aggregate demand.

Fiscal stimulus – tax cuts or spending hikes intended to increase (shift) aggregate demand.

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Automatic StabilizersAutomatic budget fluctuations w.r.t. business cycle

Some items on the budget actually change with economic conditions, irrespectively of government plans.

Expenditure side: Unemployment insurance benefits Welfare benefits

Revenue side: Income taxes (progressive even more) Corporate taxesStabilizing effect = countercyclical response to changes

in national income (inject/withdraw spending power)

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Automatic Transfers These income transfers act as automatic

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

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Automatic Transfers Automatic stabilizers are federal

expenditure or revenue items that automatically respond counter-cyclically to changes in national income.

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Automatic Transfers Automatic stabilizers also exist on the

revenue side of the budget.Income taxes move up and down with the value of spending and output.Being progressive, personal taxes siphon off increasing proportions of purchasing power as incomes rise.

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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.

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Cyclical Deficits The cyclical deficit is that portion of

the budget deficit attributable to unemployment or inflation.

The cyclical deficit widens when GDP growth slows or inflation decreases.The cyclical deficit shrinks when GDP growth accelerates or inflation increases.

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Structural Deficits To isolate effects of fiscal policy, the

deficit is broken down into cyclical and structural components.

Structural deficit

Cyclical deficit

Total budget deficit

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Structural Deficits The structural deficit is federal

revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.

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Structural Deficits Part of the deficit arises from cyclical

changes in the economy.The rest is the result of discretionary fiscal policy.Only changes in the structural deficit measure the thrust of fiscal policy.

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Structural Deficits Fiscal policy is categorized as follows:

Fiscal stimulus is measured by the increase in the structural deficit (or shrinkage in the structural surplus).Fiscal restraint is gauged by the decrease in the structural deficit (or increase in the structural surplus).

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Economic Effects of Deficits There are a number of consequences of

budget deficits. Crowding out. Opportunity cost. Interest-rate movements.

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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.

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Private-sector output (quantity per year)

Crowding Out

Increase in government spending . . .

Crowds out private spending

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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.

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Interest-Rate Movements Rising interest rates are both a symptom

and a cause of crowding out.

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Economic Effects of Surpluses The economic effects of budget

surpluses are the mirror image of those for deficits.

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Crowding In There are four potential uses for a

budget surplus: Spend it on goods and services. Cut taxes. Increase income transfers. Pay off old debt (“save it”).

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Crowding In Crowding in is the increase in private

sector borrowing (and spending) caused by decreased government borrowing.

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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.

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The Accumulation of Debt The United States has accumulated a

large national debt. The national debt is the accumulated

debt of the federal government.

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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.

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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.

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Early History, 1776-1900 During the period 1790-1812 the U.S.

often incurred debt but typically repaid it quickly.

The War of 1812 caused a massive increase in national debt and, by 1816, the national debt was over $129 million.

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Early History, 1776-1900 1835-36: Debt Free! – The U.S. was

completely out of debt by 1835.The Mexican-American War (1846-48) caused a four-fold increase in the debt.

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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.

After the South lost, Confederate currency and bonds had no value.

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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.

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The Twentieth Century National debt declined during the 1920’s

but rose again during the Great Depression.

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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.

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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.

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The 1990s The early 1990s continued the same

trend. Discretionary federal spending increased

sharply in the first two years of the Bush administration.

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The 1990s The 1988-92 period saw the national

debt increased by another trillion dollars.

There was some success in reducing the structural deficit in 1993.Budget deficits for 1993-96 have pushed the national debt to over $5 trillion.

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2000 - By 2002, the accumulated debt was $5.6

trillion. By 2007, the debt approximated $9

trillion, which works out to nearly $30,000 of debt for every U.S. citizen.

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Historical View of the Debt/GDP Ratio

Great Depression

Civil War World War I

World War II

1990-91 recession

1990-91recession

Bush tax cuts

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Who Owns the Debt? Who can ever expect to pay off a debt

measured in the trillions of dollars?

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Liabilities = Assets National debt represents an asset as well

as a liability in the form of bonds. Liability – An obligation to make future

payment; debt. Asset – Anything having exchange value in

the marketplace; wealth.

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Liabilities = Assets The national debt creates as much

wealth (for bondholders) as liabilities (for the U.S. Treasury).

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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.

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Ownership of Debt Internal debt is the U.S. government

debt (Treasury bonds) held by U.S. households and institutions.The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.

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Ownership of Debt

Foreigners

Foreigners 25%

State and localgovernments 7%

Public SectorSocial Security21%

Federal agencies

24%Federal Reserve 9%

Private Sector

Internal debt14%

Burden of the Debt The burden of the debt is not so evident:

Refinancing. Debt service. Opportunity cost.

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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.

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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.

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Debt Service Most debt servicing is simply a

redistribution of income from taxpayers to bondholders.

Interest payments themselves have virtually no direct opportunity cost.

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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.

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Government Purchases The true burden of the debt is the

opportunity cost of the activities financed by the debt.

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Transfer Payments The only direct cost of transfer payments

are the resources involved in the administrative process of making the transfer.

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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.

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The Real Trade-Offs The primary burden of the debt is

incurred when the debt-financed activity takes place.

The real burden of the debt cannot be passed on to future generations.

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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.

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Repayment Future interest payments entail a

redistribution of income among taxpayers and bondholders living in the future.

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External Debt External debt presents some special

opportunities and problems.

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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.

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External Financing

Extra output (imports)

financed with external debt

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Repayment Foreigners may not be willing to hold

bonds forever. External debt must be paid with exports

of real goods and services.

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Deficit and Debt Limits The key policy question is whether and

how to limit or reduce the national debt.

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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.

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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.

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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.

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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.

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Dipping into Social Security The Social Security Trust Fund has been

a major source of funding for the federal government for over 20 years.

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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.

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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.

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Changing Worker-Retiree Ratios

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DEFICITS, SURPLUSES, AND DEBT End of Chapter 12