Federal Debt and Deficits

1
Federal Debt and Deficits

• Chapter 15

2
Indebtedness of the Worlds Governments
3
Ratio of U.S. govt debt to GDP
1.2
1
0.8
0.6
0.4
0.2
0
1791
1815
1839
1863
1887
1911
1935
1959
1983
2007
4
The Fiscal Future

• The U.S. population is aging.
• Health care costs are rising.
• Spending on entitlements like Social Security and
  Medicare is growing.
• Deficits and the debt are projected to
  significantly increase

5
Percent of U.S. population age 65
23
Percent of pop.
actual
projected
20
17
14
11
8
5
1950
1960
1970
1980
1990
2000
2010
2020
2030
2040
2050
6
U.S. government spending on Medicare and Social
Security
Percent of GDP
7
CBO projected U.S. federal govt debt in two
scenarios
300
250
200
Percent of GDP
150
100
50
0
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
8
Measurement Problems

• Inflation to keep real debt constant, debt must
  grow by
• ?D/D ?
• or
• ?D ?D
• Put differently, part of government expenditure
  is interest on debt, which includes inflation
  component
• iD rD ?D
• Thus, deficit overstated by ?D

9
MEASUREMENT PROBLEM - Inflation

• Correcting the deficit for inflation can make a
  huge difference, especially when inflation is
  high.
• Example In 1979,
• nominal deficit 28 billion
• inflation 8.6
• debt 495 billion
• ? D 0.086 ? 495b 43b
• real deficit 28b ? 43b 15b surplus

10
Capital Assets, Potential Liabilities and
Business Cycles

• Capital budgeting sale of asset reduces deficit
  under current system but not with capital
  budgeting
• Problem which expenditures are capital and how
  valued?
• Unfunded obligations Social Security, Medicare
• Guaranteed securities contingent liability
• Fannie, Freddie, etc.
• Automatic stabilizers
• Cyclically adjusted or full employment budget

11
The cyclical contribution to the U.S. Federal
budget
12
Traditional view of debt

• For growth increase in deficit that increases D
  crowds out I - reduces growth in short run and
  long-run living standards
• In short run, fiscal expansion increases demand
  out put increases temporarily, prices increase in
  long run
• Global effect reduction in national saving
  leads to capital inflow reduces crowding out of
  investment, but exchange rate appreciation crowds
  out exports

13
Ricardian Equivalence

• Current borrowing implies future taxes so
  saving increase as long as agents care about
  future generations
• However, individuals may not think about future
  (myopia), or may be liquidity constrained
  (borrowing constraints) so shift of taxes to
  future allows increases consumption today
• What is motive for bequests?
• Strategic bequest motive children visit more
• Residual bequests due to uncertainty
• Reagan tax cuts crowded out exports not
  equivalence

14
Balanced Budget vs. Optimal Fiscal Policy

• Balance budget every year
• Optimal policy
• Smooth taxes
• Stabilize output
• Redistribute income across generations if
  justified

15
Other issues

• Do debt and deficits affect monetary policy?
• Debt shifts burdens to future taxpayers who are
  not represented argues for balanced budget
• High level of debt may cause trade deficits
  and/or encourage capital flight
• International lender status may increase global
  influence but debtor status has not hurt U.S.

16
CASE STUDYInflation-indexed Treasury bonds

• Starting in 1997, the U.S. Treasury issued bonds
  with returns indexed to the CPI.
• Benefits
• Removes inflation risk, the risk that inflation
  and hence real interest rate will turn out
  different than expected.
• May encourage private sector to issue
  inflation-adjusted bonds.
• Provides a way to infer the expected rate of
  inflation

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CASE STUDYInflation-indexed Treasury bonds
6
5
4
percent (annual rate)
3
2
1
0
2003-
2003-
2003-
2004-
2004-
2005-
2005-
2006-
01-03
06-27
12-19
06-11
12-03
05-27
11-18
05-12