Government Budget and Deficit Notes
Government Budget and Deficit
Introduction
The development of public debt and budget deficits has become a concern in most industrialized countries. The sustainability of public finances is a permanent topic in policy debate.
Government debt: Accumulation of past borrowing; a stock variable.
Budget deficit: When government spending exceeds tax revenue (G > T).
To finance the extra expenditure, the government borrows money, usually through issuing government bonds.
Budget deficit/surplus is a flow variable.
Example (UK, fiscal year 2021/22):
Revenue: £915bn
Spending: £1,040bn
Deficit: £1,040bn - £915bn = £125bn
GDP: £2.2tn
Deficit as % of GDP: 5.4%
Government debt increased by £125bn
Government Responses During Recession
In recessions, government revenue typically decreases due to lower economic activity and consequently lower tax revenue.
Two options for the government:
Keep expenditures () constant: This leads to an increase in the deficit and subsequently the debt.
Decrease () (austerity): This involves cutting government spending.
To compare debt across countries, the debt-to-GDP ratio is used.
Debt-to-GDP Ratios (OECD 2021)
Japan: 256%
Greece: 224%
Italy: 173%
USA: 148%
UK: 120%
Germany: 77%
Russia: 29%
Estonia: 24%
How Does Debt Work?
Debt has a maturity date after which it needs to be paid back (e.g., a 1-year government bond).
When debt matures, the government has two options:
Default:
Refuse to pay back the debt.
Comes at a high reputational cost.
Makes it difficult to borrow in the future at reasonable interest rates.
Pay back:
Run a government surplus.
Roll over (issue new debt).
Risk and Interest Rate Spreads
Some governments borrow at significantly higher interest rates than others. This difference reflects different perceptions of the government bonds' riskiness.
Example:
Argentina defaulted 3 times on its debt since 2000.
Countries like the US, UK, and Germany have consistently met their obligations.
Investors want to be compensated for the higher risk when investing in countries like Argentina.
The graph shows bond spreads on 10-year government debt relative to German debt:
Green: at most 1.5% higher interest rate.
Yellow: at most 3.0% higher interest rate.
Red: more than 3.0% higher interest rate than Germany.
Government Budget Constraint
(See projector)
Evolution of Debt-to-GDP Ratio
(See projector)
Ricardian Equivalence
Idea originated from economist David Ricardo.
Contrasts with the traditional (Keynesian) view of government deficits.
Keynesian view: Government can run deficits/surpluses to smooth business cycles, particularly to mitigate the adverse impact of recessions. Government policy affects aggregate demand in the short run.
Ricardian view: It does not matter if the government finances expenditures by increasing debt or by increasing taxes; they are equivalent. Government cannot affect aggregate demand.
If the government lowers taxes today and increases debt, individuals realize that the debt increase needs to be eventually paid for.
They do not increase demand but rather save the tax cuts for anticipated later tax increases.
Ricardian Equivalence - 2 period model
(See projector)
Ricardian Equivalence Assumptions
Consumers are forward-looking and have rational expectations.
Consumers live forever or are perfectly altruistic towards future generations.
No liquidity constraints.
Taxes are lump-sum, i.e., non-distortionary.
In Reality:
Some individuals are myopic (not rational).
May not be so altruistic towards future generations.
Borrowing constraints.
Most taxes are distortionary.
Ricardian Equivalence - Practical Implications
While Ricardian equivalence is unlikely to hold precisely, it offers a useful benchmark.
Keynesian view: Consumers are completely myopic.
Holders of debt do not believe they will have to pay future taxes to service the debt.
Their savings behavior is unaffected by debt issuance.
Consumption will increase because they feel wealthier (“Fiscal illusion”).
Ricardian view: Individuals believe that they (or their heirs) will eventually have to pay taxes to service the increased debt.
Perceive an increase in the net present value of their taxes that exactly offsets deficit-financed tax cuts.
The stock of government debt are not part of their wealth.
While some of the assumptions behind Ricardian equivalence may be violated, it is also unlikely that individuals are completely ignorant regarding potential future changes in taxes.
Introduction
Discussion of public debt and budget deficits as a concern in industrialized countries.
Definitions of government debt and budget deficit.
Government Responses During Recession
Decrease in revenue during recessions and government options (keeping expenditures constant or cutting spending).
Use of debt-to-GDP ratio for comparison across countries.
Debt-to-GDP Ratios (OECD 2021)
Comparative analysis of debt-to-GDP ratios for various countries.
How Does Debt Work?
Explanation of debt maturity and options when debt matures (default or repayment).
Risk and Interest Rate Spreads
Discussion of different interest rates on government bonds reflecting perceived risk.
Example of Argentina vs. stable countries like the US and Germany.
Government Budget Constraint
Description of the government's budget constraint.
Evolution of Debt-to-GDP Ratio
Historical context for changes in debt-to-GDP ratios.
Ricardian Equivalence
Overview of the Ricardian equivalence theory and its contrast to Keynesian views.
Implications for government financing and consumer behavior.
Ricardian Equivalence - 2 Period Model
An explanation of the Ricardian equivalence model across two periods.
Ricardian Equivalence Assumptions
Overview of underlying assumptions of Ricardian equivalence.
In Reality
Discussion of deviations from Ricardian assumptions.
Ricardian Equivalence - Practical Implications
Examination of consumer behavior under Keynesian and Ricardian perspectives regarding government debt and taxes.