BUDGET DEFICITS AND DEBT Definition Budget Deficit BD for a given year Gov t outlays tax revenues Keynesian model BD G TR ty For US fiscal year 2011 Outlays 3 6T 24 of GDP Tax Rev 2 3T 15 BD 1 3T 9 National debt total stock of gov t liabilities At end of FY11 Net ND owed to public 10 2T 68 BD for a given year ND for that year NOTE interest payments on ND counted as part of TR principle repayments on ND is not counted as G or TR Example ND 10T at end of FY11 Suppose in FY12 gov t outlays 3T revenue 3T BD 0 Gov t would roll over expiring part of existing ND but issues no new ND ND remains the same Rolling Over issue new debt to pay off principle on expiring ND Suppose ND 10T outlays 3T revenue 2 5T BD 5T ND at end of FY12 10 5T If gov t runs deficit ND In this case the gov t rolls over all expiring ND and it issues 5T of new ND to finance this years BD If gov t runs surplus ND In this case the gov t uses surplus to pay off expiring ND without rolling over Deficit in recent years G outlays Revenues Debt ratio ND Nominal GDP Notice according to handout 1 BD Debt ratio are countercyclical rise during recessions fall during boom Top figure BD rose during recession of early 80s early 90s now Bottom figure Debt GDP ratio spikes up during 1974 75 stagflation early 80s now a Why are BD and ND countercyclical i Built in tendency for BD s to rise during recession even if gov t is not pursing Keynesian policies WHY Holding gov ts fiscal policies fixed tax revenues in the Keynesian model will automatically fall in recession due to y Most revenue are proportional to economic activity and during recessions activity Example t 25 MPC 8 multiplier 2 5 stock A 100 holding G TR t fixed BD G TR ty BD G TR ty G TR ty 0 y 2 5 100 250 Therefore BD 0 0 25 250 62 5 1 In general holding fiscal policy fixed deficits will tend to rise during recessions because y tax revenue ALSO in real world TR tends rise automatically in recession food stamps UR tax BD is not entirely under control of Gov t given fiscal policy choices G TR t BD will tend to rise anytime a bad shock to economy occurs ii When the Gov t peruses Keynesian style fiscal policies to counteract recession G TR t this will further increase BD beyond automatic increase due to recession Obama Keynesian President NOTE expansionary policies will increase BD but by less than 1 1 due to offsetting effects on y and thus tax revenue Example G 100 G 100 t 25 y 250 TR fixed impact BD G t y BD 100 25 250 37 5 2 Aside from recessions and Keynesian response to recessions BD and ND also depend on long term non Keynesian fiscal policy a Wars increase BD and debt ratio G b Tax cuts will increase BD and debt ratio 1981 2001 GWBush c Tax increase and spending cuts decrease BD and debt ratio 1990 1993 BD 1990s surpluses 1998 2001 3 Debt ration ND NGDP can fall over time for two reasons a Run budget surplus 1998 2001 ND will fall b Even if BD 0 or if BD 0 but small Debt ration can fall due to growth in NGDP growth in RDGP or i 1947 1973 low BD s ND was growing slowly didn t have to run surplus to decrease debt ratio NGDP grew quickly WHAT ARE THE CONSEQUENCES OF CHRONIC HIGH DEFICITS DEBT 1 High deficits debt ratio can lead to DEFAULT on ND a Could the US pay the entire ND today NO ND NGDP 68 b REALITY US will never have to pay entire principle of ND unlike a person countries don t die As long as investors are confident that the US can repay the interest on ND debt service ever year they will keep rolling over principle on ND AD infitinitum SOLVENCY depends on whether a country can reliable meet its debt service obligations pay interest on national debt Example 2011 US Debt Service 215B 1 5 of GDP tax receipts 15 no threat In general Best indicator of Solvency is Debt Service i x National Debt Debt Service NGDP i x debt ratio ND NGDP A countries solvency depends on two factors 2 1 Debt ratio ND NGDP a higher debt ratio makes default insolvency more likely bigger monthly i by increasing debt service payments Interest rate i on ND higher i makes default more likely increases on ND debt service payments 2 Currently in US debt ratio 68 of GDP high but not as high as late 40s 50s i on ND in FY11 interest payments 215B ND 10T so for the US today August i on ND 2 15 one of the lowest in the world Currently in Italy debt ratio 120 of GDP ND over 7 The debt ratio and interest rate on ND are interrelated 1 High debt scares investors who then demand high i to compensate for risk 2 When i on ND is high gov t has to spend more on debt service debt service is part of gov t outlays higher dent service increases current BD more ND higher debt ratio in future Death Spiral Debt ratio too high investors fear default i increases on ND debt service increases outlays increase BD increases ND increases debt ratio too high Self fulfilling prophecy could a Death Spiral happen in US YES Extended Baseline Scenario shows projections under current law spending and revenue grow together in long run debt ratio stable The problem is that it may be unrealistic under current law because All of Bush s tax cuts in 2001 and 2003 expire at end of 2012 tax on both rich and middle class More people will have to pay AMT alternate minimum tax Alternative Fiscal Scenario assumes both tax cuts extended for middle class assumes AMT relief Revenues stay at 20 of GDP in future while spending would keep growing as a share of economy Debt ratio explodes overtime almost 200 of GDP If this passes we will likely see a death spiral by 2035 i Projection of gov t y Rise in G TR mostly driven by healthcare NGDP Two Issues 1 Life expectancy while retirement age is not therefore people are spending a larger portion of life retired on Medicare and Medicaid 2 Healthcare prices consistently rise faster than inflation other countries pay less for better quality healthcare RECALL PROBLEMS WITH DEFICITS First Solvency depends on whether a country can reliable meet its debt service obligations pay interest on national debt 2 Inflation US is debtor owes and most ND is at a fixed i Unexpected inflation would reduce real value of US ND repayments Tempting for US or any other high debt country to inflate 3 o Can lead to extreme hyperinflation o Even …
View Full Document
Unlocking...