CHAPTER 12-SURPLUSES, DEFICITS AND DEBT

I. Introduction
A. This chapter looks at the deficits (surpluses) and debt that occur when the government uses its tax and spending powers to shift AD. Schiller takes a closer look at how government spending is financed. The focus in this chapter is on the following questions:

1. How do deficits and surpluses arise?

2. What harm (good) do deficits (surpluses) cause?

3. Who will pay off the accumulated national debt?

II. Budget Effects of Fiscal Policy
A. Keynesian theory highlights the potential of fiscal policy to solve macro problems.

1. Fiscal Policy – The use of government taxes and spending to alter macroeconomic outcomes.

2. The guidelines are simple.

• Use fiscal stimulus to eliminate unemployment

• Use fiscal restraint to control inflation.

3. The federal budget is a key policy lever for controlling the economy.

B. Budget Surpluses and Deficits. (Table 12.1, Page 238)

1. Use of the budget to stabilize the economy implies that federal expenditures and receipts will not always be equal.

2. By reducing tax revenues and increasing spending the federal government throws its budget out of balance creating a budget deficit through deficit spending.

3. Deficit Spending – The use of borrowed funds to finance government expenditures that exceed tax revenues.

4. Budget Deficit – Amount by which government spending exceeds government revenue in a given time period.

5. Formula:

   Budget Deficit = Government Spending - Tax Revenues

   
   

6. If the government spends less than its tax revenues, a budget surplus is created.

7. Budget Surplus – An excess of government revenues over government expenditures in a given time period.

8. The U.S. federal government ran a $70 billion surplus in 1998.

9. A String of Deficits. (Figure 12.1, Page 239)

• Prior to 1998, the most recent budget surplus occurred in 1969.

• Between 1982 and 1996, the deficit got as high as $290 billion (1992) and never got below $100 billion.

• World View: “Budget Imbalances Common”
  Comparison of the US budget surplus in 2000 with deficits and surpluses in other countries.

10. Keynesian View (Figure 12.1, Page 239)

• From a Keynesian perspective, budget deficits and surpluses are a routine feature of fiscal policy.

• In Keynes’ view, a balanced budget would be appropriate only if all other injections and leakages were in balance and the economy was in full-employment equilibrium.

• The practice of fiscal policy has produced few budget surpluses.

C. Discretionary vs. automatic spending

1. Budget analysts say Congress could not balance the budget even if it wanted to. If true, the policymakers may not be responsible for the long string of deficits, nor do they deserve credit for any budget surpluses.

2. At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.

3. Fiscal Year (FY) – The twelve-month period used for accounting purposes; begins October 1 for the federal government.

4. To a large extent, most current revenues and expenditures are a result of decisions made in prior years. In this sense, much of each year’s budget is “uncontrollable”.

• Uncontrollables account for approximately 80% of the federal budget.

• This leaves 20% for discretionary fiscal spending.

5. Discretionary Fiscal Spending – Those elements of the federal budget not determined by past legislative or executive commitments.

6. The force behind Keynesian fiscal policy is the ability to change tax and spending levels, i.e. to provide fiscal restraint or fiscal stimulus.

7. Fiscal Restraint – Tax hikes or spending cuts intended to reduce (shift) aggregate demand.

8. Fiscal Stimulus – Tax cuts or spending hikes intended to increase (shift) aggregate demand.

9. Automatic Transfers.

• Most uncontrollable line items’ value also changes with economic conditions.

• Income transfers, such as outlays for unemployment compensation and welfare, increase during recessions, acting as automatic stabilizers.

• Income Transfers – Payments to individuals for which no current goods or services are exchanged, such as Social Security, welfare, unemployment benefits.

• Automatic Stabilizers – Federal expenditure or revenue item that automatically responds countercyclically to changes in national income, like unemployment benefits, income taxes.

• Automatic stabilizers also exist on the revenue side of the budget, e.g., income taxes move up and down with the value of spending and output. In addition, the tax code is progressive.

D. Cyclical Deficits. (Table 12.2, Page 242)

1. The size of the federal deficit is sensitive to expansion and contraction of the macro economy.

2. Inflation also affects the budget deficit.

• Social Security is automatically adjusted to inflation and federal outlays increase.

• This outlay is, however, offset by inflation-swollen tax receipts.

• Both Social Security payroll taxes and corporate profit taxes rise automatically with inflation.

• These offsetting expenditures and revenues almost cancel each other out.

3. Actual budget deficits and surpluses may arise from economic conditions as well as policy.

• President Reagan, in his 1980 campaign, promised to balance the budget. The 1981-82 recession, however, caused the deficit to soar.

• President Bush explained the huge deficits during his presidency on an increase in the nation’s unemployment rate due to the 1990-91 recession.

• President Clinton found the budget deficit declining during his presidency, but most of the deficit reduction was due to automatic stabilizers kicking in as the unemployment rate fell.

• The reduction in unemployment from 7.4 percent in 1993 to 4.3 percent in 1998 resulted in an increase in tax revenues, reduced income transfers and a budget surplus.

4. Cyclical deficit widens when unemployment or inflation increases and shrinks when unemployment or inflation decreases.

5. Cyclical Deficit – That portion of the budget deficit attributable to unemployment or inflation.

E. Structural Deficits (Table 12.3, Page 243)

1. To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.

2. Formula:

   Total Budget Deficit = Cyclical Deficit + Structural Deficit

    

3. Part of the deficit arises from cyclical changes in the economy; the rest is the result of discretionary fiscal policy.

4. Structural Deficit – Federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.

5. Only changes in the structural deficit measure the thrust of fiscal policy.

6. 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).

7. In The News: “Fiscal Policy in the Great Depression”
   Between 1931 and 1933, the structural deficit actually decreased. This fiscal restraint reduced aggregate demand and deepened the Great Depression.

III. Economic Effects of Deficits
A. Crowding Out. (Figure 12.2, Page 245)

1. If government borrows funds to finance deficits, the availability of funds for private sector spending may be reduced. This is known as crowding-out.

2. Crowding-Out – A reduction in private-sector borrowing (and spending) caused by increased government borrowing.

3. Crowding out implies less private-sector output.

4. The risk of crowding out is greater the closer the economy is to full employment.

B. Opportunity cost.

1. Crowding out reminds us that there is an opportunity cost to government spending.

2. Opportunity Cost – The most desired goods or services that are forgone in order to obtain something else.

3. Deficits are only desirable if the resulting change in the mix of output is desired.

IV. Economic Effects of Surpluses
A. The economic effects of budget surpluses are the mirror image of those for deficits.

B. Crowding In

1. Surpluses are a leakage in the circular flow.

2. There are four potential uses for budget surplus:

• Cut taxes

• Increase income transfers

• Save it

• Spend it

3. The first two options effectively wipe out the surplus but give consumers more disposable income and change the public-private mix of output.

4. The third option entails paying back accumulated debt potentially causing a crowding-in effect.

• Crowding In – An increase in private sector borrowing (and spending) caused by decreased government borrowing.

• If the government pays off some accumulated debt, households that were holding that debt end up with more money.

• If they use that money to buy goods and services, the private-sector output will expand.

• In addition, a reduction in debt takes pressure off market interest rates. As interest rates drop, consumers are willing and able to purchase more big-ticket items like cars, appliances, and houses.

5. The fourth option, spending the surplus, wipes out the surplus and enlarges the relative size of government.

C. Cyclical Sensitivity

1. Crowding in depends on the state of the economy.

2. In a recession, a surplus-induced decline in interest rates is not likely to stimulate much spending

3. If consumer and investor confidence is low, even a surplus-financed tax cut might not lift private-sector spending much.

4. In the News: “Tax cut shrinks projected surplus”
   Tax cuts enacted in 2001 may consume three-quarters of projected surpluses through 2004.

V. The Accumulation of Debt
A. Debt Creation

1. When the Treasury borrows funds it issues treasury bonds.

2. Treasury Bonds – Promissory notes (IOUs) issued by the U.S. Treasury.

3. The total stock of all outstanding bonds represents the national debt.

4. National Debt – Accumulated debt of the federal government.

5. Whenever there is a budget deficit, the national debt increases. In years when a budget surplus exists, the national debt can be pared down.

B. Early History 1776-1900.

1. By 1783, the United States had borrowed over $8 million from France and $250,000 from Spain to finance the Revolutionary War.

2. During the period 1790-1812 the U.S. often incurred debt but typically repaid it quickly.

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

4. 1835-36: Debt Free! - The U.S. was completely out of debt by 1835.

5. The Mexican-American War (1846-48) caused a four-fold increase in the debt.

6. By the end of the Civil War (1861-65), the North owed over $2.6 billion, nearly half of its national income and, after the South lost, Confederate currency and bonds had no value.

C. The Twentieth Century. (Figure 12.3, Page 248)

1. Spanish-American War (1898) also increased the national debt.

2. All prior debt was dwarfed by World War I which raised the debt from 3% to 41% of the national income.

3. National debt declined during the 1920’s but rose again during the Great Depression.

4. 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.

5. The Korean War (1950-53) added little to the national debt.

6. Vietnam War (1965-72) increased the debt by over $100 billion largely due to the refusal of the President or Congress to raise taxes.

7. The 1980s. (Tables 12.3 and 12.4)

• During the 1980s, the national debt rose by nearly $2 trillion.

• Increase was not war-related but as a result of recessions (1980-82 and 1990-91), a military buildup, and massive tax cuts (1981-84).

• The national debt nearly tripled in this decade.

8. The 1990s

• The early 1990s continued the same trend.

• Discretionary federal spending increased sharply in the first two years of the Bush administration.

• The federal government was forced to bail out hundreds of failed savings and loan associations.

• The 1990-91 recession killed any chance of achieving smaller deficits.

• The 1988-92 period saw the national debt increased by another trillion dollars.

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

• This works out to nearly $20,000 of debt for every American citizen.

VI. Who Owns the Debt?
A. Liabilities = Assets

1. National debt represents a liability as well as an asset in the form of bonds.

2. Liability – An obligation to make future payment; debt.

3. Asset – Anything having exchange value in the marketplace; wealth.

4. National debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).

B. Ownership of Debt (Figure 12.4, Page 249)

1. Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.

2. The Federal Reserve acquires Treasury bonds in its conduct of monetary policy.

3. Social Security Trust Fund is the largest owner of U.S. debt.

4. State and local governments hold 8 percent of the national debt.

5. The general public directly owns about 6% in the form of U.S. Savings Bonds or other treasury bonds and indirectly owns over 22% in banks, insurance companies, corporations, etc., totaling almost half of the national debt.

6. All debt held by U.S. households, institutions and governments is called internal debt and equals approximately 80% of the total.

7. Internal Debt – U.S. government debt (Treasury bonds) held by American households and institutions.

8. The other 20% is external debt and is held by foreign households and institutions.

9. External Debt – U.S. government debt (Treasury bonds) held by foreign households and institutions.

VII. Burden of the Debt
A. Refinancing

1. Prior to 1998, there has been almost no reduction of the national debt since 1957.

2. The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due.

3. Refinancing – The issuance of new debt in payment of debt issued earlier.

4. The ability of the U.S. Treasury to refinance its debt raises an intriguing question. What if the debt can be eternally refinanced?

B. Debt service

1. Debt Service – The interest required to be paid each year on outstanding debt.

2. Interest payments restrict the government’s ability to balance the budget or fund other public sector activities.

3. Most debt servicing is a redistribution of income from taxpayers to bondholders.

4. Interest payments themselves have virtually no direct opportunity cost.

C. Opportunity costs

1. Opportunity costs are incurred only when real resources (factors of production) are used.

2. The process of debt servicing uses few resources, and has negligible opportunity costs.

3. The true burden of the debt is the opportunity costs of the activities financed by the debt.

4. Government purchases.

• The opportunity cost of government purchases is the true burden of government activity, however financed.

5. Transfer payments.

• Only direct cost is the land, labor and capital involved in the administrative process of making the transfer.

• Changes in output or prices occurring because of income transfers result from indirect behavior responses (such as changes in work, saving or investing patterns) and should be distinguished from the direct costs of the transfer.

• The debt that originated in deficit-financed income transfers is not a meaningful measure of economic burden.

D. The Real Tradeoffs.

1. The national debt poses no special burden to the economy, but the transactions it finances have a substantial impact on the question of WHAT, HOW, and FOR WHOM to produce.

2. Deficit financing tends to change the mix of output in the direction of more public-sector goods.

3. The burden of the debt is really the opportunity costs (crowding out) of deficit-financed government activity.

4. This burden must be compared to whatever benefits society gets from government activity.

E. Debt Ceilings

1. In 2001 there were proposals before Congress to force the use of some of the current surplus to pay off old debt.

2. Although the debate about the burden of the debt is really an argument over the optimal mix of output, future interest payments entail a redistribution of income.

F. In the News: “How the Surplus Could Vanish”
A combination of the recession, tax cuts and new spending was expected to reduce the planned surplus in 2002.

VIII. External Debt
A. No Crowding Out. (Figure 12.5, Page 255)

1. External financing allows us to get more public-sector goods without cutting back on private-sector production.

2. As long as foreigners are willing to hold U.S. bonds, external financing has no real cost.

B. Repayment

1. Foreigners may not be willing to hold bonds forever.

2. External debt must be paid with exports of real goods and services.

IX. Deficit and Debt Limits
A. Deficit Ceilings

1. The only way to stop the growth of the national debt is to eliminate the budget deficit that created it.

2. Deficit ceilings - An explicit, legislated limitation on the size of the budget deficit.

3. 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.

• It set a lower ceiling on each year’s deficit until budget balance was achieved.

• Called for automatic cutbacks in spending if Congress failed to keep the budget below the ceiling.

• Required Congress to pare the deficit from over $200 billion in FY1985 to zero (balanced) by 1991.

• Congress refused to cut spending and raise taxes enough to meet the targets, and the Supreme Court declared the “automatic” mechanisms unconstitutional.

X. The Economy Tomorrow: “Saving Social Security”
A. “Saving Social Security”

1. Since 1985, the Trust Fund has collected more than it paid out.

2. Between 2002 and 2014 the Fund will acquire another $2 trillion.

B. Aging Baby Boomers

1. Baby boomers, now in their peak earning years are approaching retirement age.

2. By 2030 there will be only 2 workers for every retiree.

C. Social Security Deficits

1. To finance baby boomer retirement, Congress will have to raise future taxes or make cuts in other programs.

2. If GDP growth slows, it will tougher to fund Social Security benefits.

COMMON STUDENT ERRORS

Students often believe the following statement is true. The correct answer is explained after the incorrect statement is presented.

Our grandchildren will feel the burden of the deficit. Deficit and debt are concepts that are often confused. While deficits occur because of the excess of expenditures over taxes during a given year, the debt can be calculated at any given point in time and represents the cumulative effect of running deficits over our entire history. It is the debt on which transfers such as interest payments are made, not the deficit. Such transfers may result in opportunity costs. However, a deficit may reflect expenditures on capital that future generations will need and thus may not be the source of the burden.