Chapter 12: Deficits and Debt
Chapter 12: Deficits and Debt
Learning Objectives
After reading this chapter, you should know:
The origins of cyclical and structural deficits.
How the national debt has accumulated.
How and when "crowding out" occurs.
What the real burden of the national debt is.
Chapter Goals
How do deficits arise?
What harm, if any, do deficits cause?
Who will pay off the accumulated national debt?
This chapter aims to understand how fiscal stimulus is financed.
Budget Effects of Fiscal Policy
Fiscal Policy: Involves using the budget to stabilize the economy which signifies that federal expenditures and receipts won't always be equal.
Deficit Spending: This occurs when government expenditures exceed tax revenues, utilizing borrowed funds to finance the excess.
Budget Deficit: Defined as the amount by which government spending exceeds government revenue in a specified time period.
Budget Surplus: Exists when government revenues exceed government expenditures in a specified time period.
Table 12.1: Budget Deficits and Surpluses
Budget deficits arise when government outlays (spending) exceed revenues (receipts).
Conversely, when revenues surpass outlays, a budget surplus is present.
Figure 12.1: A String of Deficits
Context: A budget surplus has been achieved only in four years (1998–2001) since 1970.
Causal Factors: Deficits are influenced by cyclical slowdowns and discretionary policies.
Front Page Economics: Americans Worried About Uncle Sam’s Debt
The Congressional Budget Office reports that the American Rescue Plan will add approximately $3 trillion to the national debt.
Public Sentiment: 75% of voters express concern regarding this debt; 66% believe it unfairly burdens future generations.
Keynesian View
Macro Policy Goal: The objective is not to balance the budget, but to achieve economic balance (full employment).
When necessary, budget deficits or surpluses should be accepted to adjust aggregate demand.
A balanced budget is apt only if other economic injections and leakages are in balance and the economy is at full-employment equilibrium.
Discretionary vs. Automatic Spending
Discretionary Fiscal Spending: Elements of the budget not predetermined by prior commitments, accounting for 20% of the federal budget.
Automatic Spending: Comprises the remaining 80% and is a consequence of past decisions.
Current revenues and expenditures primarily stem from previous actions, limiting potentials to change budget outlays markedly in any given year.
Automatic Stabilizers
Income Transfers: Payments made to individuals without an exchange of goods or services, e.g., Social Security, welfare, unemployment benefits.
Automatic Stabilizers: Federal expenditures or revenue items that respond countercyclically to national income changes, including unemployment benefits and income taxes.
Cyclical Deficits
Definition: Portion of the budget deficit attributable to economic conditions such as unemployment or inflation.
Characteristics: A cyclical deficit widens when GDP growth slows or inflation rises, and it shrinks when GDP growth accelerates or inflation decreases.
Impact of GDP Growth Rate on Cyclical Deficits
When GDP Growth Rate Decreases by 1 Percentage Point:
Increases in government spending (G):
Unemployment insurance benefits
Food stamps
Welfare benefits
Social Security benefits
Medicaid
Decreases in government tax revenues (T):
Individual income taxes
Corporate income taxes
Social Security payroll taxes
Deficit Increase: $71 billion
Impact of Inflation Rates on Cyclical Deficits
When Inflation Rate Increases by 1 Percentage Point:
Increases in government spending (G):
Indexed retirement benefits
Higher interest payments
Increases in government tax revenues (T):
Corporate income taxes
Social Security payroll taxes
Deficit Increase: $92 billion
Structural Deficits
Definition: The component of the budget deficit that is not related to cyclical economic changes but arises from discretionary fiscal policy decisions.
Calculation: Involves federal revenues at full employment minus expenditures at full employment under existing fiscal policy.
Changes in structural deficits result from policy changes, unlike cyclical deficit changes which arise from economic shifts.
Table 12.3: Cyclical vs. Structural Budget Balances (in billions of dollars)
The budget balances include both cyclical and structural components, reflecting differing impacts from policy changes and economic conditions.
Economic Effects of Deficits: Crowding Out
Definition: Occurs when the government borrows funds, resulting in reduced availability of funds for private sector borrowing and spending.
Consequence: Crowding out leads to lower private sector output.
Figure 12.2: Crowding Out
Process: A deficit-financed increase in government expenditure shifts the economy from point a to point b, causing private sector output to be crowded out (from h1 to h2).
Notably, if the economy begins at point c with unemployed resources, crowding out does not have to happen.
Economic Effects of Deficits: Opportunity Cost
Definition: The most desired goods or services foregone to obtain something else; associated with government spending.
Focus: We need to evaluate whether the reduced private sector output is of higher or lower desirability than the increased public sector output.
Economic Effects of Deficits: Interest Rate Movements
Consequences of increased Government Borrowing:
Potentially causes interest rates to rise, affecting how households and businesses engage with borrowing.
Effects:
Households may hesitate to borrow for purchases (cars, houses).
Businesses may show reluctance in borrowing and investment.
Rising interest rates act both as symptoms and causes of crowding out.
Economic Effects of Surpluses: Crowding In
Potential Uses for a Budget Surplus:
Spending on goods and services
Reducing taxes
Increasing income transfers
Paying off old debt
Results: Private sector output may expand, interest rates can decrease, and overall growth in the economy can stabilize.
The Accumulation of Debt
Definition: The national debt is the total accumulated debt of the federal government, representing the sum of accumulated deficits minus any repayments made during surplus years.
Functions of U.S. Treasury:
Acts as the fiscal agent, collecting tax revenues, signing checks for federal spending, and borrowing funds to address budget deficits.
Debt Creation/Bonds
The Treasury issues Treasury bonds as a method of borrowing funds.
Definition of Treasury Bonds: Promissory notes (IOUs) issued by the U.S. Treasury.
National debt consists of a stock of these IOUs created through annual deficit flows.
A budget deficit increases national debt whereas a surplus allows debt reduction.
Early History (1790–1900)
During 1790-1812, the U.S. incurred debt but quickly repaid it.
War of 1812 caused national debt to surge, reaching over $129 million (13% of national income) by 1816.
After this period, the government effectively utilized budget surpluses to reduce its debt.
Notably, in 1835 and 1836, there were instances of no national debt with the government achieving budget balance.
Early History During the Civil War (1861–1865)
Both Union and Confederacy resorted to debt financing.
By war's end, the North was over $2.6 billion in debt (50% of national income); the South relied heavily on currency printing without successful bond financing due to defeat.
Twentieth Century
WWI escalated the national debt from 3% of national income in 1917 to 41% in 1918; the debt decreased during the 1920s but surged again during the Great Depression.
WWII further pushed national debt from 45% in 1940 to over 125% by 1946.
In the 1980s, national debt surged by nearly $2 trillion, influenced by two recessions, significant tax cuts, and increased defense spending.
From 1993 to 1997, budget deficits caused the national debt to exceed $5 trillion.
Recent Years
By 2002, accumulated debt surpassed $5.6 trillion, heavily influenced by Bush tax cuts and defense increases.
By January 2009, the national debt exceeded $10 trillion as the Great Recession prompted further stimulus spending, raising it to nearly $20 trillion by 2016.
In 2020, responses to the COVID-19 pandemic added significantly to the deficit, pushing the national debt to $27 trillion.
Under the Biden administration, over $4 trillion in new spending was approved, bringing the debt to over $33 trillion by 2023.
Table 12.4: The National Debt
It took nearly a century for the national debt to reach $1 trillion but it tripled within the decade of 1980-1990 and quintupled by 2000.
The current accumulated debt exceeds $27 trillion.
Who Owns the Debt?
Asset vs. Liability: National debt constitutes both a liability (obligation for future payments) and an asset (value for bondholders).
When borrowing money, the U.S. Treasury issues bonds which represent liabilities for the government but assets for holders.
Ownership Breakdown:
U.S. government owns nearly 50% of outstanding Treasury bonds (including Social Security and Federal Reserve).
State and local governments hold 5%, private sector holds 21%, and foreigners own 24%.
Internal vs. External Debt
Internal Debt: U.S. government debt held by U.S. households and institutions; 75% of national debt is categorized as internal.
External Debt: U.S. bonds held by foreign entities, indicating our reliance on foreign investors for funding our national debt.
Figure 12.4: Debt Ownership
A visualization depicting that approximately 50% of the national debt is held by the U.S. government with 21% held by the private sector and 24% by foreigners.
Burden of the Debt
Refinancing: The government can manage multiple debts through refinancing (taking out new loans to pay old ones).
Debate Agendas: While it may appear that government borrowing incurs no costs, this overlooks two critical issues:
Interest expenses associated with debt.
Real economic costs associated with government activities.
Debt Service
Definition: Refers to annual interest payments on outstanding debt, which limit governmental capacity to fund other activities or balance the budget.
The process significantly redistributes income from taxpayers to bondholders, albeit with minimal opportunity costs for the economy.
Opportunity Cost
Understanding: True opportunity costs involve use of real resources (factors of production) which are minimally affected by debt servicing activities.
The principal burden of the debt stems from the opportunity costs linked to government activity funding initiated through borrowing.
The Real Trade-offs
Deficits prompt shifts in output towards public goods, with the true debt burden being the opportunity cost associated with deficit-driven government actions.
Expansion of public sector services may come at the expense of private sector investment.
Future Generations and Debt
Future taxpayers will likely be tasked with paying interest on debt incurred by previous generations, inheriting not just the debt but also ownership bonds as well.
The economic redistribution from future interest payments will affect both future taxpayers and bondholders, indicating a long-term financial impact.
External Debt
Benefits of External Borrowing: Affords greater consumption, investment, and government financing flexibility.
Trade-off: External debts will eventually necessitate real good and service exports to service.
Figure 12.5: External Financing
Illustrates that temporary external borrowing can allow for increased public services without immediate reductions in private sector production.
Deficits and Debt Limits
Control Measures: Addressing national debt growth necessitates eliminating budget deficits.
Deficit Ceiling: A legislative limit on the size of the budget deficit.
Debt Ceiling: A legislative limit on total outstanding national debt.
Both ceilings are seen as political mechanisms for budget compromise and deficit reduction efforts.
Policy Decisions: Can We Keep Social Security Afloat?
Revenue Mechanism: The payroll (FICA) tax, funding the Social Security Trust Fund, allowing monthly benefits to retired individuals.
Historical Note: For over 40 years, annual revenues exceeded outflows, thus financing deficits.
Future Challenges in Social Security
Demographic Changes: With Baby Boomers retiring and living longer, the balance of tax revenues and expenditure shifts toward annual deficits.
Future Sustainability of Social Security depends on:
The U.S. Treasury paying interest on Bonds held by the Trust Fund.
Treasury redeeming the bonds when due.
Strategies for meeting obligations include raising taxes, cutting other programs, or incurring additional deficits.
Table 12.5: Changing Worker/Retiree Ratios
Historical Context: 70 years ago, over 16 workers funded each retiree; current ratios display only 2.5 workers per retiree, demonstrating a challenging future for Social Security funding.