Macroeconomics

N. Gregory Mankiw

Government Debt
and Budget
Deficits

Modified for ECON 2204

by Bob Murphy

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

§ about the size of the U.S. government’s debt

and how it compares to that of other countries
§ problems measuring the budget deficit
§ the traditional and Ricardian views of the
government debt
§ other perspectives on the debt

1
Indebtedness of the world’s governments
Country Government Debt as a Percentage of GDP
Greece 149.1
Italy 129.9
Japan 125.5
Portugal 104.7
Belgium 96.5
United Kingdom 91.8
Spain 83.0
United States 81.3
France 79.0
Netherlands 40.6
Germany 39.9
Canada 31.0
Switzerland 5.5
Australia −15.3
Ratio of U.S. government debt to GDP
 The U.S. experience in recent years
Early 1980s through early 1990s
§ debt–GDP ratio: 25.5% in 1980, 48.9% in 1993
§ due to Reagan tax cuts, increases in defense
spending & entitlements
Early 1990s through 2000
§ $290b deficit in 1992, $236b surplus in 2000
§ debt–GDP ratio fell to 32.5% in 2000
§ due to rapid growth, stock market boom, tax
hikes

CHAPTER 19 Government Debt and Budget Deficits 4

 The U.S. experience in recent years
Early 2000s
§ the return of huge deficits due to Bush tax cuts,
2001 recession, Iraq war
The 2008-2009 recession and its aftermath
§ fall in tax revenues
§ huge spending increases (bailouts of financial
institutions and auto industry, stimulus package)
§ a weak recovery did not stop the debt–GDP ratio
from rising further

CHAPTER 19 Government Debt and Budget Deficits 5

 The troubling long-term fiscal outlook

§ 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…

CHAPTER 19 Government Debt and Budget Deficits 6

U.S. population age 65+, as a percentage of the
population age 20-64
U.S. government spending on Medicare and Social
Security, 1948-2014
 Problems measuring the deficit
1. Inflation
2. Capital assets

3. Uncounted liabilities
4. The business cycle

CHAPTER 19 Government Debt and Budget Deficits 10

 MEASUREMENT PROBLEM 1:
Inflation
§ Suppose the real debt is constant, which implies a
zero real deficit.
§ In this case, the nominal debt D grows at the rate
of inflation:
ΔD/D = π or ΔD = πD
§ The reported deficit (nominal) is πD
even though the real deficit is zero.
§ Hence, should subtract πD from the reported
deficit to correct for inflation.
CHAPTER 19 Government Debt and Budget Deficits 11
 MEASUREMENT PROBLEM 1:
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
πD = 0.086 × $495b = $43b
real deficit = $28b − $43b = $15b surplus

CHAPTER 19 Government Debt and Budget Deficits 12

 MEASUREMENT PROBLEM 2:
Capital Assets
§ Currently, deficit = change in debt
§ Better, capital budgeting:
deficit = (change in debt) − (change in assets)
§ EX: Suppose govt sells an office building and
uses the proceeds to pay down the debt.
§ under current system, deficit would fall
§ under capital budgeting, deficit unchanged,
because fall in debt is offset by a fall in assets.
§ Problem w/ cap budgeting: Determining which
govt expenditures count as capital expenditures.
CHAPTER 19 Government Debt and Budget Deficits 13
 MEASUREMENT PROBLEM 3:
Uncounted liabilities
§ Current measure of deficit omits important
liabilities of the government:
§ future pension payments owed to
current govt workers
§ future Social Security payments
§ contingent liabilities, e.g., covering federally
insured deposits when banks fail
(Hard to attach a dollar value to contingent
liabilities, due to inherent uncertainty.)

CHAPTER 19 Government Debt and Budget Deficits 14

 MEASUREMENT PROBLEM 4:
The business cycle
§ The deficit varies over the business cycle due to
automatic stabilizers (unemployment insurance,
the income tax system).
§ These are not measurement errors but do make
it harder to judge fiscal policy stance.
§ E.g., is an observed increase in deficit
due to a downturn or an expansionary shift
in fiscal policy?

CHAPTER 19 Government Debt and Budget Deficits 15

 MEASUREMENT PROBLEM 4:
The business cycle
§ Solution: cyclically-adjusted budget deficit
(aka full-employment deficit) based on estimates
of what govt spending & revenues would be if
economy were at the natural rates of output and
unemployment.

CHAPTER 19 Government Debt and Budget Deficits 16

The actual and cyclically adjusted U.S. federal budget
surpluses/deficits
 The bottom line

We must exercise care

when interpreting
the reported deficit figures.

CHAPTER 19 Government Debt and Budget Deficits 18

 Is the govt debt really a problem?

Consider a tax cut with corresponding increase

in the government debt.
Two viewpoints:
1. Traditional view
2. Ricardian view

CHAPTER 19 Government Debt and Budget Deficits 19

 The traditional view

§ Short run: hY, iu

§ Long run:
§ Y and u back at their natural rates
§ closed economy: hr, iI
§ open economy: hε, iNX
(or higher trade deficit)
§ Very long run:
§ slower growth until economy reaches new
steady state with lower income per capita

CHAPTER 19 Government Debt and Budget Deficits 20

 The Ricardian view
§ due to David Ricardo (1820),
advanced more recently by Robert Barro
§ According to Ricardian equivalence,
a debt-financed tax cut has no effect on
consumption, national saving, the real interest
rate, investment, net exports, or real GDP,
even in the short run.

CHAPTER 19 Government Debt and Budget Deficits 21

 The logic of Ricardian Equivalence

§ Consumers are forward-looking,

know that a debt-financed tax cut today
implies an increase in future taxes
that is equal – in present value – to the tax cut.
§ The tax cut does not make consumers better off,
so they do not increase consumption spending.
Instead, they save the full tax cut in order to repay
the future tax liability.
§ Result: Private saving rises by the amount public
saving falls, leaving national saving unchanged.
CHAPTER 19 Government Debt and Budget Deficits 22
 Problems with Ricardian Equivalence

§ Myopia: Not all consumers think so far ahead;

some see the tax cut as a windfall.
§ Borrowing constraints: Some consumers
cannot borrow enough to achieve their optimal
consumption, so they spend a tax cut.
§ Future generations: If consumers expect that
the burden of repaying a tax cut will fall on future
generations, then a tax cut now makes them feel
better off, so they increase spending.

CHAPTER 19 Government Debt and Budget Deficits 23

 Evidence against Ricardian Equivalence?

Early 1980s:
Reagan tax cuts increased deficit.
National saving fell, real interest rate rose,
exchange rate appreciated, and NX fell.
1992:
Income tax withholding reduced to stimulate economy.
§ This delayed taxes but didn’t make consumers
better off.
§ Almost half of consumers increased consumption.

CHAPTER 19 Government Debt and Budget Deficits 24

 Evidence against Ricardian Equivalence?

§ Proponents of R.E. argue that the Reagan tax cuts

did not provide a fair test of R.E.
§ Consumers may have expected the debt to be
repaid with future spending cuts instead of
future tax hikes.
§ Private saving may have fallen for reasons
other than the tax cut, such as optimism about
the economy.
§ Because the data are subject to different
interpretations, both views of govt debt survive.
CHAPTER 19 Government Debt and Budget Deficits 25
 OTHER PERSPECTIVES:
Balanced budgets vs. optimal fiscal policy
§ Some politicians have proposed amending the
U.S. Constitution to require balanced federal
govt budget every year.
§ Many economists reject this proposal, arguing
that deficit should be used to:
§ stabilize output & employment
§ smooth taxes in the face of fluctuating spending
§ redistribute income across generations when
appropriate

CHAPTER 19 Government Debt and Budget Deficits 26

 OTHER PERSPECTIVES:
Fiscal effects on monetary policy
§ Govt deficits may be financed by printing money
§ A high govt debt may be an incentive for
policymakers to create inflation (to reduce real
value of debt at expense of bond holders)
Fortunately:
§ little evidence that the link between fiscal and
monetary policy is important
§ most governments know the folly of creating
inflation
§ most central banks have (at least some) political
independence from fiscal policymakers
CHAPTER 19 Government Debt and Budget Deficits 27
 OTHER PERSPECTIVES:
Debt and politics
“Fiscal policy is not made by angels…”
– N. Gregory Mankiw, p.575
§ Some do not trust policymakers with deficit spending.
They argue that:
§ policymakers do not worry about true costs of their
spending, since burden falls on future taxpayers.
§ since future taxpayers cannot participate in the
decision process, their interests may not be taken
into account.
§ This is another reason for the proposals for a balanced
budget amendment (discussed above).
CHAPTER 19 Government Debt and Budget Deficits 28
 OTHER PERSPECTIVES:
International dimensions
§ Govt budget deficits can lead to trade deficits,
which must be financed by borrowing from
abroad.
§ Large govt debt may increase the risk of capital
flight, as foreign investors may perceive a
greater risk of default.
§ Large debt may reduce a country’s political clout
in international affairs.

CHAPTER 19 Government Debt and Budget Deficits 29

 CASE STUDY:
Inflation-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…
CHAPTER 19 Government Debt and Budget Deficits 30
 percent (annual rate)

-1
0
1
2
3
4
5
6
2003-01-01
2003-09-01
2004-05-01
2005-01-01
CASE STUDY:

2005-09-01
2006-05-01
2007-01-01
2007-09-01
2008-05-01
implied expected inflation rate

2009-01-01
2009-09-01
2010-05-01
2011-01-01
rate on indexed bond

2011-09-01
rate on non-indexed bond

2012-05-01
Inflation-indexed Treasury bonds

2013-01-01
2013-09-01
2014-05-01
2015-01-01
 CHAPTER SUMMARY

1. Relative to GDP, the U.S. government’s debt is

moderate compared to that of other countries.
2. Standard figures on the deficit are imperfect
measures of fiscal policy because they:
§ are not corrected for inflation.
§ do not account for changes in govt assets.
§ omit some liabilities (e.g., future pension
payments to current workers).
§ do not account for effects of business cycles.

32
 CHAPTER SUMMARY
3. In the traditional view, a debt-financed tax cut increases
consumption and reduces national saving. In a closed
economy, this leads to higher interest rates, lower
investment, and a lower long-run standard of living.
In an open economy, it causes an exchange rate
appreciation, a fall in net exports (or increase in the
trade deficit).
4. The Ricardian view holds that debt-financed tax cuts do
not affect consumption or national saving and therefore
do not affect interest rates, investment, or net exports.

33
 CHAPTER SUMMARY

5. Most economists oppose a strict balanced budget

rule, as it would hinder the use of fiscal policy to
stabilize output, smooth taxes, or redistribute the tax
burden across generations.
6. Government debt can have other effects:
§ may lead to inflation
§ politicians can shift burden of taxes from current to
future generations
§ may reduce country’s political clout in international
affairs or scare foreign investors into pulling their
capital out of the country

34