Transcript 6-3 The Recent US Government Budget Deficit

Chapter 6
The Government
Budget, the
Government Debt,
and the Limitations
of Fiscal Policy
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Key Questions
• Can fiscal policy rescue monetary policy from
ineffectiveness?
• What are the side effects of running a large budget
deficit?
• Why did the Great Depression last over a decade
(from 1929 to 1941)?
• What are the lessons to be learned for applying
fiscal policy to the Global Economic Crisis?
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The Recent US Government Budget Deficit
• 1998-2001: The U.S. ran a rare budget surplus, but
subsequently reverted back to running deficits.
Why?
– 2001-03: Political philosophy that favored tax cuts  T↓
– Partially in response to 9/11 attacks  Military spending↑
– 2008: The Global Economic Crisis  T↓ while Tr↑
– 2008-10: Large fiscal stimulus package  T↓, Tr↑ and G↑
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Wars and the increasing size of
the government
• Five facts stand out in figure 6.1
1. Government expenditures spike in war years,
with WWII having much greater impact
2. Tax revenues exhibit a spike in wartime.
3. The size of the government increased in war
years.
4. Expenditures increase more than revenues during
1980s causing a persistent budget deficit.
5. Revenues were 28-30% of GDP in 1980s and
1990s but declining back after.
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Figure 6-1 Real Government Expenditures,
Real Government Revenues, and the Real
Government Budget Deficit, 1900–2010 (1 of 2)
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The effect of recessions
• During recessions government revenues decline
and transfer payments increase.
• Before 1980 deficits during recessions takes a
sharp V shape, i.e., the deficits came to zero after
recession.
• Since 1980 deficits did not disappear after
recessions and continued to be large.
• The recession of 2008-09 cause by far the largest
deficit due to fiscal stimulus and bail out
programs.
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Figure 6-1 Real Government Expenditures,
Real Government Revenues, and the Real
Government Budget Deficit, 1900–2010 (2 of 2)
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Automatic stabilization and
discretionary fiscal policy
• Net tax revenues T can be expressed as the net tax
rate t times real income
• T = tY
• Hence government budget can be written as:
• Budget surplus = T - G = tY – G
• There are two main sources of changes in surplus or
deficit
- automatic stabilization (through changes in Y)
- discretionary stabilization (through changes in t and
G)
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• Automatic stabilization
• When Y increases taxes rise and transfer
payments fall.
• This higher surplus or less deficit helps to stabilize
the economy.
• In a recession taxes decrease and transfer
payments increase help to dampen the recession.
• The automatic stabilization effect of Y is illustrated
in figure 6.2
• If G0 and t0 are constant, the slope of the budget
line (BB) is t0 (tax rate)
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• At YN there is a balanced budget. At Y0 there is a
deficit as tax revenues decrease (t0∆Y)
• The budget line shows the budget surplus or
deficit at different Y levels.
• The budget line slopes upward as higher Y raises
tax revenues t0Y causing more surplus or less
deficit.
• Changes in Y causes a movement from along BB
curve
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Figure 6-2 The Relation Between the
Government Budget Surplus or Deficit and Real
Income
Budget
balance
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Discretionary fiscal policy
• Discretionary fiscal policy
• alters tax rates or government expenditures deliberately
to influence real output and the unemployment rate.
• Figure 6.3 shows the effect of discretionary fiscal policy.
• Suppose that government spending increases from G0 to
G1, the budget line shifts down from BB0 to BB1 causing
a lager deficit at Y0.
• There are 3 ways to reduce the deficit
1. Movement from C to D (through expansionary monetary
policy) causing Y to increase to YN.
2. Movement from C to B (decrease G)
3. increase the tax rate t0
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Figure 6-3 Effect on the Budget Line of an
Increase in Government Expenditures
Cyclical deficit
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• As shown in 6.3 the budget can affect the economy and the
economy can affect the budget.
• An in crease in G or a reduction in T shifts the IS to the RHS
causing Y to increase and sift BB upwards and vice versa.
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The natural employment surplus
of deficit
• The natural unemployment surplus (NES) (or deficit NED) is
the government budget surplus or deficit if actual output Y
equals natural output YN.
• NES (NED) = tYN - G
• NES is sometimes called Structural Deficit.
– The CBO uses “Standardized Budget Deficit” for the natural
or structural budget deficit
• The Cyclical Deficit is the amount by which the actual
government budget deficit exceeds the structural deficit.
– The Structural Surplus (or equivalently, the Natural
Employment Surplus (NES)) and the Cyclical Surplus are
the same as the deficit concepts with the signs reversed.
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Figure 6-4 A Comparison of the Actual Budget
and the Natural Employment Budget, 1970–
2010
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Government debt: Basic concepts
• The public debt is the total amount of bonds and other
government liabilities (or securities) that the government has
issued.
– The gross debt is the same as the public debt.
– The net debt subtracts out debt held inside the government
(intra-government debt), including government securities held
by the Federal Reserve and the trust funds of Social Security
and Medicare.
• The public debt is also the sum of all fiscal deficits (and/or
surpluses) over time:
Debt (end of 2011) = Debt (end of 2010)
+ Fiscal Deficit (during 2011)
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The Future Burden of the
Government
• The future burden of the debt depends on the type of spending, i.e.,
consumption or investment.
• The burden of government borrowing for investment projects like
building highways or schools is none, as long as the future return is
greater than the social cost of the project.
– If some investment projects, like a rarely used highway, yield a very
low return, then there will be future costs.
• What about the burden of government borrowing to pay for
consumption items like bullets and food stamps?
– Since government consumption spending has only current benefits,
there will costs to pay in the future.
• Future costs = interest plus debt principal repayment
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Will the Government Remain
Solvent?
• How can we tell if the budget deficit is too high?
– Key variable: Debt to nominal GDP ratio (D / PY)
– Notation: The level of a variable is represented by a capital letter, while the growth rate of the
variable is lowercase.
• The government will be able to afford its debt if the debt to
nominal GDP ratio is stable over time.
– It can be shown that the growth of (D / PY) = d – (p + y)
– For stability of D/PY ratio we need:
d=p+y
– Growth of debt/GDP ration must equal the growth of nominal
GDP.
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– Stability  growth of (D / PY) = 0  d = p + y
(1)
– Note: Additional debt each year = budget deficit = dD
– Multiplying (1) by D on both sides  dD = (p + y)D
(2)
– The allowable deficit equals the rate of growth of nominal GDP
times the debt
• Result: D / PY remains constant if the budget deficit equals the
outstanding debt times the growth rate of nominal GDP!
• The deficit must equal (2) for D/PY to remain constant.
• Example if p+y=5%, D=9000 billion
• dD = (p+y)D= 0.05(9000) = 450 billion.
• The maximum allowable deficit is $450 billion for the debt ratio
to remain constant
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The Solvency Condition
• Note that:
• The basic limitation on the amount of government debt is that
the government must pay interest on its debt. But as long as
• nominal GDP is growing and
• interest rates are low,
the government can borrow more to pay the yearly interest
expense and still maintain a constant D / PY.
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The Solvency Condition
• The solvency condition states that the government can meet its
interest bill forever by issuing more bonds without increasing
the debt-GDP ratio only if the economy’s growth rate (p + y)
equals or exceeds its actual nominal interest rate (r).
• What about the U.S. debt level in 2010?
– D = $9,000B and suppose (p + y) = 5%
– Stability  d = 5%  Allowable deficit = 0.05*($9,000B)
= $450B
– Actual deficit was much higher than $450B  (D / PY) ↑
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International Perspective The Debt-GDP
Ratio: How Does the U.S. Compare?
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Figure 6-5 The Ratio of U.S.
Government Debt to GDP, 1790-2010
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The Fiscal Policy Multiplier Effect
• Recall from Chapter 3 that the multiplier effect of an increase
in G is greater than a cut in T because G has a direct effect on
spending
• Other factors decreasing the multiplier effect include:
– Leakages from the spending stream that reduce induced
consumption
• Income Taxes
• Imports
• Corporate Profits
– Higher interest rates that reduce interest-sensitive spending
– Capacity constraints when the economy is close to full
employment  government purchases push aside private
purchases
• Lesson: Fiscal stimulus is much more appropriate and effective
when the economy is weak.
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Table 6-1 Multiplier Estimates for
Selected Types of Fiscal Stimulus
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The Overall Effectiveness of the
Bush-Obama Fiscal Stimulus
• The overall results from the stimulus are mixed
– Hundreds of billions in tax cuts had little impact on GDP
– Infrastructure spending was rolled out very slowly (only
40% spent by 2010)
– Most effective parts of the stimulus were aid to state and
local governments and unemployment benefit extensions.
• Overall benefit according to one study = 7.8% of
GDP
– Compare to overall cost of 7.6% of GDP
– Result: Overall multiplier = 7.8 / 7.6 = 1.03
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Table 6-2 Size of Fiscal Stimulus
Measures in 2008-10
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Figure 6-6 The Role of Automatic
Stabilizers in the Recession of 2008-09
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Bailouts as Unconventional Stimulus
•
The severity of the 2008-09 crisis necessitated additional policies to prevent
economic collapse.
– These novel policies have been called “financial policies” or “bailout policies.”
– These policies do not count as monetary or fiscal policies because they were carried
out by both the Federal Reserve and the Treasury in cooperation with each other.
•
The core bailout program was the Troubled Asset Relief Program (TARP).
– Initiated two weeks after the fall of Lehman Brothers
– Lent government money to financial institutions on the brink of insolvency due to
insufficient equity capital
– Also prevented the sale of GM and Chrysler Motors
– Initial cost = $700B, but after loan repayment, estimated cost = $100B
•
Measures of success of bailouts
– Risk premium fell from 5.5% (winter 2009) to 2.7% (mid 2010)
– One study: Without bailouts, Y would have been 5% lower and U = 12.5%
•
Controversies persist because…
– Benefits not widely publicized
– Bailout of financial institutions seemed to reward those who caused the crisis!
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• Recall the “Magic Equation” from Chapter 2:
T – G = (I + NX) – S
• The Magic Equation suggests 3 ways to finance a
budget deficit (i.e. T – G < 0)
– Private saving (S) can go up
– Investment (I) can fall
– Foreign investment (NX) can fall
• Because an increase in the budget deficit
increases the total public debt, persistent budget
deficits can lead to higher taxes in the future.
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