Macroeconomics Theory through Applications Chapter 14 Balancing the Budget

Chapter 14 Balancing the Budget 149587 ) is a big number . It is the total amount of US government debt outstanding as of June 11 , 2011 . This number , which changes every day , is reported by the US Treasury Department at the Treasury Direct website ( The debt of the United States is the subject of a growing political storm in Washington . Indeed , in August 2011 there seemed to be a very real possibility that the US Congress would refuse to raise the debt ceiling upper limit on the size of the government debt . Had that occurred , the government would no longer have been able to all its obligations . Many commentators believe that the US government is facing a crisis with respect to its budget , the fact that the government is running persistent budget . The issues are not the stuff of dry academic debate . If you are a typical reader of this book , you will be working and paying taxes over the next 50 is the future generation that will be called on to deal with debates about government today are debates about your standard of living . If deficits matter to anyone , they should matter to you . Just like a household , a government has income and . If a household exceed its income , then it must borrow to its spending . And if a household borrows repeatedly , it builds up debt . The same is true of governments . If a government spends more than its income , then it is running a deficit that must be by borrowing . Repeated government lead to the existence of a stock of government debt . In recent decades , the US federal government has run a much more often than not . The federal government has been in for all but years between 1960 and 2011 . As a consequence , the stock of debt outstanding in the United States has increased from 290 billion to more than 14 trillion . Most of us can not really conceptualize what this sum means . We can try visual images if we stacked up 14 trillion dollar bills , we would get a pile half a million miles than twice the distance to the moon . But it is easiest to get a handle on the if we divide by the number of people in the economy to obtain the debt per person . As of August , 2011 , according to the US National Debt Clock ( debt clock ) this number is . This means that if the government wanted to pay off its debt today , each and every woman , man , and child in the United States would have to be taxed by this amount , on average , to pay off the obligations of the government . US citizens hold more than half of the 60 percent . So if the government were to pay off its debt , the majority would end up being redistributed in the economy from taxpayers to holders of US government bonds . Foreigners hold the remaining 40 percent , so this money would be transferred from US taxpayers to citizens of other countries . The US government is not proposing to pay off the existing debt , however . To the contrary , the government is projected to run budget for the foreseeable future , meaning that the stock of debt , and the obligation of future generations , will continue to grow . URL books 521

In response to concern over government deficits , one proposal has arisen over and over again a amendment to the US Constitution . Such a measure would simply make deficits illegal . A amendment came within one vote of passing in a 1997 US Senate vote , and one was passed by the US House of Representatives in 1997 . Another bill was introduced by a group of US House members in 2003 . Here is part of the text of the 2003 bill SECTION . Total for any year shall not exceed total receipts for that fiscal year , unless of the whole number of each House of Congress shall provide by law for a specific excess of over receipts by a vote . The limit on the debt ofthe United States held by the public shall not be increased , unless of the whole number of each House shall provide by law for such an increase by a vote . SECTION . Prior to each year , the President shall transmit to the Congress a proposed budget for the United States Government for that year in which total do not exceed total receipts . The Tea Party , which rose to some political prominence in the United States in 2010 , campaigned in favor of a amendment as well . In July 2011 , the House of Representatives passed 2560 , called the Cut , Cap , and Balance Act , which ( among other things ) called for a constitutional amendment to balance the budget to be transmitted to the states for their consideration . This bill was not passed by the Senate . Whether this political activity will ever generate a constitutional amendment remains an open question and a point of debate in the 2012 election . The discussion of constitutional limits on budget is not limited to the United States . In 2009 , Germany amended its constitution to limit federal budget to of by 2016 . This limit applies when the German economy is operating near its potential output . The regulations allow the German government to run during but require surpluses in times of high economic activity . Should the government be forced to balance its budget each year , as such measures suggest ?

There are certainly good reasons why households sometimes incur pay for a house , a new car , or advanced education . Perhaps the same is true of governments . We should not presume that deficits are harmful without first trying to understand why they occur . Others have even argued that are neither good nor bad but are simply unimportant . Indeed , Vice President Cheney is reported to have said that President Reagan proved that don So are bad for the economy , good for the economy , or just irrelevant ?

Our goal in this chapter is to understand the economic effects of government budget so that we can evaluate competing claims such as these and ultimately help you answer the following question . Should the government be forced to balance its budget ?

URL books 522 Road Map We go through five steps in our evaluation of the merits of a amendment . We make sure that we know what we are talking about . Debt and are technical terms with precise meanings . We go through their carefully . We examine the causes of the in an accounting sense . Specifically , we examine how and why the budget deficit depends on the state of the economy . We can then explore the in an accounting a law . We progress to a deeper understanding of why occur . We examine why governments choose to run . At this point , we examine possible of deficits to the economy . We examine why might be harmful to the economy . We examine the argument for why might be irrelevant . These forecasts are available from the Congressional Budget ( Although such bills are typically termed amendments , they often , as is the case here , permit surpluses . US House of Representatives , a Amendment to the Constitution of the United States , February 13 , 2003 , accessed July 20 , 2011 , ov ?

The Cut , Cap , and Balance Bill is presented at Bill Text Versions Congress ( 2012 ) THOMAS The Library of Congress , accessed September 20 , 2011 , ov ?

For ongoing discussion , read Mike , Balanced Budget Amendment Caucus , accessed July 20 , 2011 , content article . The fiscal situation in Germany is described in Reforming the Constitutional Budget Rules in Germany , Federal Ministry of Department , September 2009 , accessed September 20 , 2011 , Quoted in Ron , The Price of Loyalty George Bush , the White House , and the Education of Paul ( New York Simon and ) 291 . and Debt LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the difference between the deficit and the debt ?

What are the links between the and the debt ?

URL books 523 . What are the budget constraints faced by the government ?

We begin by being careful and precise about terminology . The terms and debt are sometimes used sloppily in everyday discourse as a consequence , much nonsense is spoken about policy . We must first make sure that we understand exactly what these terms mean . Budget The government is the difference between government and government revenues . and are part of the circular of income . Revenues to the government when it imposes taxes on households and firms and when it collects money through various other fees . For our purposes here , we do not need to distinguish all the different kinds of taxes , and we do not worry about whether they are paid by firms or by households . All that matters is that , in the end , some of the income generated in the economy to the government . Money out in the form of government purchases of goods and services and government transfers . Government purchases include things like roads , schools , and missiles . They also include wage payments for government is , the purchase of the services of teachers , soldiers , and civil servants . also occur when government gives money to households . These are called transfer payments , or transfers for short . Examples include unemployment insurance , Social Security payments , and Medicare payments . Finally , transfers include the interest payments of the government on its outstanding obligations . The of the government and its revenues are not always equal . The difference between government purchases and transfers and government revenues represents a government deficit , as set out in the following government deficit revenues government purchases transfers tax revenues government purchases ( tax revenues transfers ) government purchases net taxes . Often we it useful to group taxes and transfers together as net taxes and separate out government purchases , as in the last line of our . When are less than , then we say there is a government . In other words , a negative government is the same thing as a positive government surplus , and a negative government surplus is the same thing as a positive government deficit government surplus deficit . A government surplus is sometimes called government When the government runs a , borrowing from the financial markets funds such spending . When the government runs a surplus , these funds into the markets and are available for firms to borrow . URL books 524

To illustrate the calculation of the , we examine some numbers in Table Calculating the Deficit . Our equation the tells us that we can calculate it two ways . Look , for example , at year . The level of government spending is 200 , tax receipts are 160 , and transfers are . We can add together purchases and transfers to get total of the government , which is 220 . Then we can subtract revenues of 160 to find that the is . We can subtract transfers from tax receipts to get the amount of net taxes . Here , net taxes are 140 . We subtract this from purchases of 200 to a deficit of 60 . Obviously , we get the same answer either way it is just a matter of how we group the different terms together . It might seem natural to group transfers with government expenditures ( since they are both ) Conceptually , though , transfers are more like taxes , in that they represent a of dollars that is not matched by a of goods or services . The difference is that taxes from into the government transfers the other way . Government expenditures are very different they represent purchases of real gross domestic product ( real ) produced in the economy , thus contributing to the overall demand for output . Table Calculating the Year Tax Transfers Net Purchases Revenues Taxes 50 30 10 20 30 100 160 40 120 200 160 20 140 60 200 220 20 200 140 160 20 140 In Table Calculating the Deficit , the varies considerably over time . It is low in year , negative in year ( in other words , there is a surplus ) high in year , and zero in years and . Between year and year , government purchases and transfers increased , but tax revenues increased even more . In fact , they increased sufficiently to turn the into a surplus . Between years and , government purchases increased , and transfers decreased . However , the decrease in transfers was less than the increase in government purchases , so total government increased substantially . Tax revenues stayed constant , so the government went back into deficit . In years and the government ran a balanced budget . If we compare year to year , we see that the budget could be balanced by raising taxes ( from 160 to 220 ) and leaving unchanged . Conversely , by comparing year to year , we see that the budget could be balanced by cutting spending and leaving taxes unchanged . A balanced budget is consistent with high taxes and high spending or low taxes and low spending . It is the combination of low taxes and high spending that give us a . Table Calculating the makes it clear that changes in the can be explained only by examining all components of the government budget constraint . The Government Budget Constraint URL books 525

We begin with the government budget constraint as it operates in a single year . This budget constraint can be seen in terms of the into and from the government sector in the circular , as shown in Figure The Government Sector in the Circular Flow ( which explicitly shows that taxes come from households and ) Later we discuss a second government budget constraint that links spending and revenues over longer periods of time . Figure The Government Sector in the Circular Flow Government purchases Government a Taxes borrowing I I I I I I institutions I I I I The into the government sector come from taxes and borrowing from the sector . The comprise government purchases and government transfers . You might be wondering how it is possible for the government to have that exceed its revenues . The answer is given by the government budget constraint . The government budget constraint says that the , which is the difference between and revenues , must be financed by borrowing . If exceed revenues in a given year , then the government must somehow make up the difference . It does so by borrowing from the public . In this sense , the government is no different from a household . Each of us can , like the government , spend more than we earn . When we do , we must either borrow from someone or draw on our savings from the past . The government borrows by issuing government debt . This debt can take several forms . The government has many types of obligations , ranging from Treasury Bills to bonds . For our analysis , we do not need to distinguish among these different assets . Toolkit Section The Government Budget Constraint and Section The Circular Flow of Income URL books 526

You can review the government budget constraint and the circular of income in the toolkit . The Recent Experience Table Recent Experience of and Surpluses ( Billions of Dollars ) shows some actual numbers for the United States receipts , and the federal budget deficit in current dollars for fiscal years 1990 to 2010 . Table Recent Experience of Deficits and Surpluses ( Billions of Dollars ) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source Historical Budget Tables , Congressional Budget Office , January 2011 , accessed September 20 , URL books 527

In the early , the government ran a of about billion every year . Note that a negative number in the last column corresponds to a government . In the , however , the began to decrease . Both and receipts were increasing , but receipts were increasing more quickly . By 1998 , the federal budget was in surplus , and it reached a peak of 236 billion in 2000 . Thereafter , revenues decreased for several years , while spending continued to increase . By 2002 , the budget had gone back into deficit again , and by the middle of the decade , the deficit was at record levels . As is evident from Table Recent Experience of Deficits and Surpluses ( Billions of Dollars ) the budgetary picture changed dramatically with the onset of the severe recession in 2008 . Revenues decreased and increased so that the budget widened considerably , to more than trillion in both 2009 and 2010 . If you look at data on the government budget , you will see that the federal budget is divided into and items . Table , and Total Surplus , 2010 ( Billions of Dollars ) shows these numbers for fiscal year 2010 . The Congressional Budget Office items as follows . Spending or revenues excluded from the budget totals by law . The revenues and of the two Social Security trust funds ( the Federal and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund ) and the transactions of the Postal Service are The transactions of the US Postal Service are not that important , so you can essentially think of the items as being the Social Security system . Since the Social Security system was in surplus over much of this period , the deficit is larger than the total . From Table , and Total Surplus , 2010 ( Billions of Dollars ) the total government of billion in 2010 an and a small budget surplus . The idea behind the separate budgeting is that Social Security represents a known set of future government obligations . For this reason the government has , in effect , set aside a separate account for Social Security revenues and ( much as you , as an individual , might decide you want a separate account for your savings ) At least in theory , this separates the debate about Social Security from the debate about current government spending and receipts . Many policy discussions do focus just on the accounts . In the end , though , all these monies either into or from the federal government . The humorist Dave Barry once remarked that what distinguishes items is that these are written down on a completely piece of paper from the regular What is more , there are other known future obligations , such as Medicare , that are not treated separately . The distinction is really no more than an accounting , and in terms of the overall economic effects of the , it is better to focus on the total . Table , and Total Surplus , 2010 ( Billions of Dollars ) Receipts Surplus or Deficit ( URL books 528

Total ' Source US Treasury , Financial Management Service , October 2010 Statement , accessed September 20 , 2011 , There are mixed messages to take away from Table Recent Experience of and Surpluses ( Billions of Dollars ) The experience of budget surpluses in the tells us that budget balancing is possible . At the same time , more recent experience suggests that substantial changes in receipts or are now needed to balance the budget . To explore this somewhat further , look at Table Federal , 2010 ( Billions of Dollars ) which shows various for 2010 . As we already know , total spending for that year was trillion . National defense , Social Security , and programs together account for trillion , or about 63 percent of the total . Other nondiscretionary largely such as retirement payments to federal employees , unemployment insurance , housing assistance , and food for a further 401 billion . Interest payments account for 196 billion . These categories together account for more than 80 percent of federal . Table Federal , 2010 ( Billions of Dollars ) Item Amount Total ( Defense 689 Nondefense Discretionary Spending 658 Social Security 701 Health Care Programs ( including 810 Medicare and Medicaid ) Other Nondiscretionary Spending 401 Interest Payments 196 Total Source Compiled from data in , The Budget and Economic Outlook An Update , August 2011 , accessed September 20 , Totals do not add up because of rounding errors . Just looking at those numbers should make it clear that it is very difficult to balance the budget simply by cutting federal spending . Almost everyone agrees that there is waste in the federal government , and there are programs that could and almost certainly should be abolished . This is not to say that you could find even a single program that everyone would want to abolish . Every program benefits someone , after all . But there are certainly programs that most people would agree are wasteful . However , the vast majority of the budget is taken up with either essential functions of government or programs that enjoy huge political popularity . Few politicians would sign up for closing the public schools , the abolition of unemployment insurance , or the cancellation of veterans benefits . URL books 529

The budget accounts distinguish between mandatory and discretionary spending . Many of the big items listed in Table Federal , 2010 ( Billions of Dollars ) fall into the mandatory is , that are required by existing law . Less than 40 percent of in 2010 were discretionary , and half of those were national defense spending . The remaining were mandatory spending or payment of interest on the outstanding debt . If the government were to pass a amendment , in other words , the hard job of cutting spending or raising taxes would remain . Recall Section of the amendment that we quoted in the chapter opener the President shall transmit to Congress a proposed budget in which total do not exceed total Even with a amendment , the president would still have to propose either major cuts in existing popular programs or increases in taxes . However , such an amendment might provide political cover for the president and Congress they could explain their support for unpopular spending cuts or tax increases by saying that the amendment gave them no choice . The Government Budget Constraint We discussed in Section The Government Budget Constraint that the government budget constraint links spending and revenues to the deficit ( or surplus ) of the government each year . There is a second constraint faced by the government , called the budget constraint , linking in one year to deficits in other years . When you take out a loan , you will ultimately have to repay it . The same is true of the government when it takes out a loan , it will ultimately have to repay the loan as well . If the government chooses to pay for its expenditures today by borrowing instead of through current taxes , then it will need additional taxes at some point in the future to pay off its loan . The budget constraint is just a fancy way of saying that , like everyone else , the government has to pay off its loans at some point . As a consequence , tax and spending decisions at different dates are linked . Although governments can borrow or lend in a given year , the government total spending over time must be matched by revenues . To express the budget constraint , we introduce a measure of the deficit called the . The primary is the difference between government , excluding interest payments on the debt , and government revenues . The primary surplus is equal to the minus of the primary and is the difference between government revenues and government , excluding interest payments on the debt . In our example in Table Calculating the Deficit , the in year was 30 . If payment of interest on outstanding debt was , then the primary would be 25 , and the primary surplus would be . The budget constraint says that if the government has some existing debt , it must run surpluses in the future so that it can ultimately pay off that debt . Specifically , it is the requirement that current debt outstanding discounted present value of future primary surpluses . URL books

This condition means that the debt outstanding today must be offset by primary budget surpluses in the future . Because we are adding together in the future , we have to use the tool of discounted present value . If , for example , the current stock of debt is zero , then the budget constraint says that the discounted present value of future primary surpluses must equal zero . Toolkit Section Discounted Present Value You can review the meaning and calculation of discounted present value in the toolkit . Linking the Debt and the The stock of debt is linked directly to the government budget . When the government runs a budget deficit , it finances the by issuing new debt . The deficit is a , which is matched by a change in the stock of government debt change in government debt ( in given year ) deficit ( in given year ) If there is a government surplus , then the change in the debt is a negative number , so the debt decreases . The total government debt is simply the accumulation of all the previous years deficits . From this equation , the stock of debt in a given year is equal to the deficit over the previous year plus the stock of debt from the start of the previous year . In this discussion , we leave aside the fact that the government may part of its by issuing new money . In the United States and most other economies , this is a minor source of funding for the government . To see the interactions between deficits and the stock of debt in action , examine Table and Debt , which takes the numbers from Table Calculating the Deficit and calculates the corresponding debt . We suppose that there is initially zero debt at the beginning of year . The of 30 in the first year means that there is outstanding debt of 30 at the end of that year . In the second year , there is a budget surplus of 20 . This reduces the debt , but it is not sufficient to bring the debt all the way back to zero . Outstanding debt at the end of the year is 10 . In the third year , the deficit of 60 must be added to the existing debt of 10 , so the debt at the end of the year is 70 . Table and Debt Year Debt ( Start of Debt ( End of Year ) Year ) 30 30 30 10 60 10 70 70 70 70 70 URL books 531

In years and , the government runs a balanced budget the is zero . But the stock of debt stays unchanged . The debt is equal to the accumulation of all the . Eliminating deficits ( for example , by a amendment ) means that the debt stays at its existing level . Eliminating is not the same thing as paying debt . 70 , no Surplus om , Deb ! il ) 77 ii , In 20 , if , 20 ( I ! 2001 EDI ! Figure US Surplus and , Source Congressional Budget . The experience of the US and debt held by the public since 1962 is summarized US Surplus and Debt , The surplus is shown in the upper figure , and the level of debt is shown in the lower . All values are in current dollars . At the far left of the graph , we see that the US government ran relatively small deficits ( negative surpluses ) in the and early . As a result , the debt increased slowly . From the to the , deficits were substantial , so the amount of debt outstanding grew rapidly . As we saw earlier , there was a brief period of surplus in the late and a corresponding decrease in the debt , but deficit spending during the George Bush administration ( The debt increased again . Although an analysis of and debt is often presented using data similar to those US Surplus and Debt , this figure is incomplete in two ways ( these numbers are not corrected for ( they are current dollar figures ) and ( there is no sense of how large the and the debt are relative to the aggregate economy . Figure US Surplus and Debt as a Fraction of , remedies both defects by showing the surplus and the debt as a fraction of nominal . Because nominal is also measured in dollars , these ratios are just numbers . We see that the has been a relatively stable fraction of , averaging about percent of . The debt level has averaged about 36 percent over the period . Figure US Surplus and Del ) as ( 196 URL books 532

Surplus ( billions ) 4000 4500 ( 200 201 I Year Dish ! billions ) Will ) 301 ! Source Congressional Budget and Economic Report of the President . The federal debt is now in excess of 14 trillion . So if the United States were to pass a amendment binding on the federal government , to take effect in 2012 , say , the stock of debt would thereafter remain at well over 14 trillion . To reduce the stock of debt outstanding , the must be negative the change in the stock of debt will be negative only if the government runs a surplus . Moreover , the government must pay interest on its outstanding debt . Recall that when the government runs up debt , it is borrowing from the general public . The debt of the government is an asset from the perspective of households it is one of the ways in which people can hold their saving . Holders of government bonds earn interest on these assets . Look again at Table Federal , 2010 ( Billions of Dollars ) In the United States , interest payments on the debt amounted to 184 billion in 2005 . Interest payments on the debt amount to more than half of the deficit . Balancing the budget therefore means that , once we exclude interest payments , spending plus transfers would have to be much smaller than tax revenues . If there is outstanding debt , a balanced budget means that the government must run a primary surplus . To summarize , we have discovered three things about a balancing the budget URL books 533

. A balanced budget means that the equals zero . A balanced budget means that the debt is constant . If there is existing debt , a balanced budget means that the government must run a primary surplus . Holds the Debt ?

Given that the US government makes such large interest payments on outstanding debt , who receives those payments ?

US government debt is held by households , and governments in many countries . Table Foreign Holdings of US Treasury Securities as of August 2008 ( Billions of Dollars ) lists some of the foreign countries holding US Treasury securities ( bills , bonds , and notes ) in two different months August 2008 and May 2011 . Table Foreign Holdings of US Treasury Securities as of Au ust 2008 ( Billions of Dollars ) Country Holding as of Holdings as of May August 2008 2011 Japan China oil exporters Mexico Canada total Source Major Foreign Holders of Treasury Securities , US Department of the Treasury , July 18 , 2011 , accessed July 20 , 2011 , In May 2011 , the total foreign ownership of US Treasury securities was more than 45 percent of the total privately held US public debt ( privately held means we are excluding debt held by the Federal Reserve System ) As you can see from Table Foreign Holdings of US Treasury Securities as of August 2008 ( Billions of Dollars ) the ownership of US debt has changed over the past few years . Japan was the largest holder of US debt in August 2008 , but more recently China has taken its place . You might wonder how these countries came to hold such a large fraction of US debt . Part of the answer goes back to the interaction between trade and capital between the United States and the rest of the world . The key is the link between trade deficits and borrowing from abroad borrowing from other countries imports exports trade . This equation tells us that whenever a country runs a trade , it must finance that deficit by borrowing from abroad . The United States has been running trade since the early . Consequently , foreign countries have been accumulating US assets , and government debt is one important such asset . URL books 534

Observers sometimes comment on the fact that a substantial fraction of government debt is owed to ourselves ( that is , it is held by US citizens ) and therefore less of a cause for concern than the fraction that is owned by foreigners . Does this reasoning make sense ?

The answer is not very To see why , consider a US citizen who owns some US government bonds . Now imagine that she sells those bonds to a German bank and uses the proceeds to buy some General Motors ( shares that are currently owned by a French investment bank . All that has happened here is some of portfolios . One individual decided to shift her assets around , so she now owns shares instead of government bonds . Likewise , the German bank decided it wanted more US bonds in its portfolio , whereas the French investment bank decided it wanted fewer shares . These kinds of transactions go on all the time in our economy . Our hypothetical citizen is just as wealthy as she was before she is simply holding her wealth in a different form . The same is true for the German and French financial institutions . Yet foreigners hold more of the national debt than previously . Domestic or foreign ownership of the debt can change with no implications for the overall indebtedness of individuals or the country . It is more meaningful to look at the amount of foreign debt that has been accumulated by a country as a result of its borrowing from abroad . Foreign debt represents obligations that will have to be repaid at some future date . Commentators sometimes express worry over the fact that foreign central those of Japan and substantial amounts of US debt . There is a legitimate concern here if one or more of those banks suddenly decided they no longer wanted to hold that debt , then there might be a large change in US interest rates and resulting instability . But the real issue is not that the debt is foreign owned . Rather , it is that a large amount of debt is held by individual institutions big enough to move the market . At the same time , the Chinese are equally concerned about the value of the US government debt they hold . In their view , they traded away goods and services for pieces of paper that are claims to be paid by the US government . These claims are in nominal terms ( in dollars ) Hence any change in the exchange rate changes the value of this debt to the Chinese . If , for example , the dollar relative to the Chinese ( then the real value ( in terms of Chinese goods and services ) of this debt is reduced . The dollar exchange rate was in January 2000 . A holder of a US dollar bill could obtain in exchange . This rate was in January 2006 . However , by June 2011 , the exchange rate was . This means that someone who exchanged for dollars in 2000 and then sold those dollars for in June 2011 lost about 20 percent in nominal terms . KEY TAKEAWAYS . The is the difference between government and government revenues . It is a . The debt is a measure of the stock of outstanding obligations of the government at a point in time . The change in the debt between two dates is equal to the incurred during the time between those two dates . URL books 535

. The government faces a constraint that its must be financed by issuing new debt . The government also faces an budget constraint that its debt at a point in time must equal the discounted present value of future primary surpluses . Checking Your Understanding . What is the difference between the budget deficit and the primary ?

If the government runs a surplus , does this mean the stock of debt must be negative ?

Is it legal for residents of other countries to hold US debt ?

Table Recent Experience of Deficits and Surpluses ( Billions of Dollars ) is in current dollars . What does that mean ?

The ( has a glossary of terms on its web page . The government also collects Social Security payments , which are discussed in more detail 13 Social Security . These are just another kind of tax . Government budget numbers in the United States are reported for a year , which runs from October to September . Thus fiscal year 2000 ran from October , 1999 , to September 30 , 2000 . Congressional Budget Office , Glossary , accessed October 19 , 2011 , 14 We discussed the Social Security Trust Fund , as this account is called , in Chapter 13 Social Security . Dave Barry , The Method , March 24 , 1991 , accessed August 28 , 2011 , Budget and Economic Outlook Historical Budget Data , Congressional Budget Office , January 2011 , accessed July 20 , Actually , there is one way in which the government is different from private individuals . For practical purposes , we expect that the government will go on forever . This means that the government could always have a stock of outstanding debt . However , there are practical limits on this one thing , households will not lend unlimited amounts to the government . Thus it is generally fair to say that additional borrowing by the government will have to be repaid . See Chapter 11 Big and Small for more discussion . More precisely , then , every year , change in government debt change in money this way , the URL books 536

equation tells us that the part of the that is not by printing money results in an increase in the government debt . The Causes of Budget LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . How does policy affect the budget deficit ?

How does the state of the economy affect the budget ?

How do we determine whether a budget results from policy or the state of the economy ?

Now that we have defined budget , budget surpluses , and the government debt , it is time to examine what determines these economic variables . The budget deficit two forces the stance of fiscal policy and the state of the economy . Fiscal policy refers to the choice by the government of ( its levels of spending on goods and services , its transfers to households , and ( the tax rates it sets on households and . Most countries have different levels of government , so some tax and spending decisions are made for the whole country , whereas others are made locally . In principle , we can include all levels of government in our discussion . This means that , in the United States , government can refer to the totality of local government , state government , and the federal government . In practice , though , it is the decisions of the federal government that have the main impact on the overall policy of the country . The same is true in other government decisions are not usually very important for the overall stance of fiscal policy . Tools of Fiscal Policy There are two aspects of fiscal policy government spending and policy . These fiscal policy choices determine the . Government Spending Over long periods of time , government spending increases as an economy gets richer . Over shorter periods of time , however , the level of government spending is not closely by the overall level of economic activity . For this reason , we typically suppose that government spending is an exogenous variable that is determined outside our framework of analysis . We illustrate this in Figure Government Spending . Figure ( oi , URL books 537

Purchases ( Purchases Real We suppose that government spending is independent of the level of gross domestic product ( which means that it shows up as a horizontal line . Taxation Our interest here is in and the debt rather than the details of taxation , so we take a very simple approach to taxation . We assume that there is a constant tax rate that applies to all levels of income and abstract away from all the other complexities of the tax schedule . This View of the tax and transfer system is summarized by the following equation net taxes tax rate income . We illustrate this relationship in Figure The Tax Function . The slope of the line is the tax rate . In other words , for every dollar increase in income , net tax receipts increase by the amount of the tax rate . Figure The Tax Function URL books 538

Net Tax Receipts Tax Receipts Real 2000 4000 Net tax receipts depend on the state of the economy . When income is higher , the government collects more in taxes and pays out less in transfers . Taxes depend positively on income because of the way the tax code is written . Conversely , transfers ( such as unemployment insurance or Medicare payments ) tend to depend negatively on income when people are richer , they are less likely to need transfers from the government . The tax rate in the captures the overall effect higher income increases net tax revenues both because people pay more taxes and because they receive fewer transfers . Table Tax Receipts and Income provides an example of tax receipts at different levels of income , when the tax rate is 10 percent . At the level of an individual household , taxes increase and transfers decrease as the households income increases . At the level of the entire economy , exactly the same thing is true . As real increases , tax receipts increase and transfers decrease . Increased income , holding the tax rate fixed , leads to increased tax receipts . At the same time , increases in the tax rate lead to higher tax receipts at each level of income . Thus there are two factors determining tax receipts in the economy the tax rate and the overall level of economic activity . Table Tax Receipts and Income Income Tax Rate Tax URL books 539

Receipts 100 10 500 50 100 200 500 The Budget and the State of the Economy As the level of economic , the tax receipts of the government also increase . To determine the deficit , we need to know both the current fiscal policy ( as summarized by the level of government purchases and the tax rate ) and the level of economic activity . Building on the example in Table Tax Receipts and Income , suppose that government purchases are 200 and the tax rate is 10 percent . The relationship between the level of economic activity ( and the deficit is given in Table and Income . In this example , the level of must reach before the budget is in balance ( Figure Government Spending and Tax Receipts ) Table Deficit and Income Government Tax Purchases Receipts 200 200 100 200 10 190 500 200 50 150 200 100 100 200 200 200 500 UL books 540

( Tax Receipts lux Rev ci ( ha ( Figure ( Spending and Tax Receipts Tax receipts increase as income increases , whereas government spending is by the level of . The dependence of the on real and the stance of fiscal policy are summarized in Figure Surplus and , which graphs the numbers from Table and Income . The surplus is measured on the vertical axis , and real is measured on the horizontal axis . The surplus line is drawn for a given tax rate . As real increases , the deficit decreases . Thus the line in Figure Surplus and has a negative slope . Figure I ) and URL books 541

Tax Receipts Purchases Real 2000 Surplus Linc Surplus The equals government purchases minus net tax receipts . The is positive when is low , but the budget goes into surplus when is high . The surplus is the difference between the level of government purchases and the level of receipts . There is a particular level of economic activity such that the budget is exactly in balance . In our example , this level of is . The is zero when income is because that is the point at which government purchases equal tax revenues . For levels of income in excess of this level of , the government budget is in surplus . In Figure Surplus and , we see that the budget surplus line crosses the horizontal axis when is . Increases in government purchases or reductions in the tax rate are examples of policy . Decreases in government purchases or increases in the tax rate are called ' policy . Expansionary fiscal policy increases the for a given level of real . An increase in government spending shifts the line upward , as shown in Figure Expansionary Fiscal Policy . With a decrease in the tax rate , by contrast , the intercept stays the same , but the line rotates upward . The effect is still to increase the at all positive levels of income . URL books 542

Figure ) Fiscal ' 200 ( I I ) Linc Expansionary policy causes the to increase at all levels of income , so the line shifts upward . This picture illustrates the case of an increase in government purchases . Cyclically Adjusted Budget Given that the depends on both the level of real and the stance of fiscal policy , it is useful to have a way to distinguish these two . Put differently , it is helpful to know if the deficit is large because of the level of economic activity or because of the choices of government spending and taxes . This distinction came to the forefront in the 2004 presidential election in the United States . One of the issues raised in the debates between President George Bush and Senator Kerry was how the forecasted surplus from 2000 turned into the massive of 2004 . Were the caused by the state of the economy or the policy decisions undertaken by President George Bush ?

To answer such questions , we need to decompose changes in the into changes due to policy and changes due to the level of economic activity . The Congressional Budget Office ( produces a measure of the budget , called the adjusted budget , for this purpose . The first calculates a measure of potential level of when the economy is at full employment . Then it calculates the and revenues of the federal government under the assumption that the economy is operating at potential . The is calculated by subtracting revenues from . For obvious reasons , the cyclically adjusted budget is also sometimes called the . Figure The Cyclically Adjusted Budget illustrates this idea . We calculate the level of potential output and then use the deficit line to tell us the cyclically adjusted budget deficit or surplus for the economy . The shows two possibilities . In the first case , there is a government when actual output is equal to potential output . In the second case , there URL books 543

is a government surplus when output is equal to potential output . Of course , the practical calculations are somewhat trickier than this picture suggests , but the idea is straightforward . URL books 544 ( a ) bi ) Surplus Linc Surplus Surplus Figure The ( To determine the cyclically adjusted or surplus in an economy , calculate the level of potential output and then use the line to determine what the or surplus would be at that level of output . In panel ( a ) the economy has a cyclically adjusted , whereas in panel ( it has a cyclically adjusted surplus . Figure Cyclical Deficit and Figure Structural Deficit show that there are two distinct reasons why a government might go from surplus into happened in 2002 , for example . Suppose that , last year , the economy was at potential output and there was a cyclically adjusted surplus ( point A ) Now imagine that this year there is a government deficit . One possibility is that the economy went into recession , as in Figure Cyclical Deficit , point . This is called a cyclical because it is due to the state of the business cycle . Another is that the stance of policy has example , because of an increase in government spending , as in Figure Structural Deficit , point The calls this a standardized ( or structural ) Figure Cyclical ( URL books 545

Budget ( thus Real GI ) Budget Surplus ( last year ) Linc Surplus The economy went from surplus ( A ) to ( because of recession . Real declines , tax receipts decrease , and the budget goes into . The economy moves along the line . Figure Structural Deficit URL books 546

Budget ( this year ) Real Budget Surplus ( last year ) Surplus Linc Surplus The economy went from surplus ( A ) to ( because of changes in policy . Real does not change it is at potential output in both cases . The line shifts upward . Cyclical and a Requirement We have two factors that determine the size of the the stance of policy and the state of the economy . We can use this information to learn more about the effects of a amendment on the economy . Suppose that the economy is at potential output . A requirement would say that the economy must be neither in surplus nor in at this point . In other words , a requirement describes the overall stance of policy . The surplus line must be shifted to ensure that it passes through the horizontal axis at potential output , as shown in Figure Requirement . URL books 547

Actual Output Potential ( Surplus Surplus Figure ( A requirement implies that the must be zero . The line must pass through zero when real equals potential output . Now suppose that , for some reason , the economy goes into recession . In Figure Recession with a Amendment , this means that output goes from potential output to some lower level . We know that this leads to a , which is shown as a shift from point A to point . Under a rule , the government is not allowed to let this situation persist . Instead the government must respond by increasing taxes or cutting spending , moving the economy from point to point Similarly , if the economy went into a boom , this would tend to lead to a surplus . The government would be forced to cut taxes or increase spending to bring the budget back into balance . A amendment would force the government to conduct fiscal policy . Figure ( 11 with ( URL books 548

) iI . Surplus I Inc Surplus If the economy were to go into recession , a requirement would force the government to increase taxes or cut spending to bring the budget back into balance . KEY TAKEAWAYS . At a given level of , an expansionary policy increases the budget deficit , and a policy decreases the budget . As the level of economic activity increases , tax revenues increase , transfers decrease , and the budget deficit decreases . By examining the cyclically adjusted budget , it is possible to evaluate how much of the budget deficit is due to the state of the economy and how much is due to the stance of policy . Checking Your Understanding . In Table and Income , why do tax receipts increase with real ?

What do we know about fiscal policy if the cyclically adjusted budget is negative ?

If the budget is in , what do we know about the level of real compared to potential ?

In other chapters we examine the effects of government spending on the aggregate economy . For example , Chapter The Great Depression explained how changes in government spending can sometimes be used to stimulate the overall economy . URL books , 549 The Cyclically Adjusted and Standardized Budget Measures , Congressional Budget , April 2008 , accessed July 20 , A key simplification in these pictures is that the level of potential is independent of taxes and government spending . Chapter 12 Income Taxes explains why potential output itself might be affected by the tax code . In fact , the effects of a amendment would be even worse . The policy would cause to decrease even further , thus requiring even bigger cuts in spending or increases in taxes . The of LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . When do countries run government budget deficits ?

Why might a country incur a government budget ?

To evaluate the merits of a amendment , we need to know why governments run in the place . After all , governments may have good reasons for these policies . We have seen one explanation for deficits governments run because of economic . Reductions in gross domestic product ( other things being equal , lead to increases in the budget . We are more concerned with why governments choose to run persistent structural deficits , though . We look to history for clues . Government Debt A Historical Perspective URL books 550

Figure Ratio of US Debt to , NU no 17 ) I ) Source Debt data from data from . Figure Ratio of US Debt to , shows the ratio of US federal government debt to from 1791 to 2009 . The US Civil War in the , World War I in 1917 , and World War II in the early all jump out from this figure . These are periods in which the stock of US federal debt soared . During the Civil War , the stock of debt was in 1860 and peaked at in 1866 . The debt level was more than 40 times higher in 1866 than in 1860 . In 1915 ( after World War I had started but before the United States had entered the war ) the stock of debt was , not much more than the level in 1866 . By 1919 , the level of the debt was , an increase of almost 800 percent . During World War 11 , there was again a buildup of the debt . In 1940 , the level of debt outstanding was , or about 42 percent of . By 1946 , this had increased by about 527 percent to , In 1946 , the outstanding debt was 121 percent of . There are two other periods that show a significant buildup of the debt relative to . The first is the Great Depression . This buildup was not due to a big increase in borrowing by the government . Rather , it was largely driven by the decline in the level of ( the denominator in the ratio ) The second is the period from the to the present . The buildup of the debt in the was unprecedented in peacetime history . Figure Ratio of US Debt to , also shows a dramatic asymmetry in the behavior of the ratio . Although the increases in this ratio are typically rather sudden , the decreases are much more gradual . Look again at the rapid increase in the ratio around the Civil War . After the Civil War ended , the ratio decreased but only slowly . As seen in the figure , the ratio decreased for about 45 years , from 1870 to 1916 . Part of this decrease was due to the growth in over the 45 years , and part was due to a decrease in nominal debt outstanding until around 1900 . Do Governments Run ?

It is evident that during periods of war the debt is higher . What underlies this relationship between wars and deficits ?

War is certainly expensive . Take , for example , the in Iraq URL books 551 and Afghanistan . Congress has already appropriated about trillion for these wars , and a Congressional Budget Office study projected the would eventually cost the United States about trillion . When government purchases increase due to a war , a government can either increase taxes to pay for the war or issue government debt . Remember that when the government runs a to pay for a war , it is borrowing from the general public . The government budget constraint reminds us government debt is ultimately paid for by taxes in the choice is really between taxing households now or taxing them later . History tells us that deficits have been the method of choice governments have chosen to tax future generations to pay for wars . There are two arguments in favor of this policy . Fairness . Any gains from winning a war will be shared by future generations . Hence the costs should be shared as well the government should the war with debt so that future generations will repay some of the obligations . To take an extreme case , suppose a country is for its right to exist . If it wins the war , future generations will also . Tax smoothing . A good policy is one where tax rates are relatively constant . In the face of a rapid increase in spending , such as a war , the best policy is one that pays for the spending increase over many periods of time , not in one year . Taxation is expensive to the economy because it distorts economic decisions , such as saving and labor supply . The amount people want to work depends on their real wage , after taxes . So if tax rates are increased to finance government spending , this reduces the from working . Put differently , increased income taxes increase the price of consumption relative to leisure . The fact that people work less when taxes increase is a effect of taxation . Instead of bunching all this taxation into a short amount of time , such as a year , it is more for the government to spread the taxation over many years . This is called tax smoothing . So by running a budget , the government imposes relatively small distortions over many years rather than imposing large distortions within a single year . Toolkit Section The Labor Market For more analysis of the choice underlying labor supply , you can review the labor market in the toolkit . Similar arguments apply to other cases in which governments engage in substantial spending . Imagine that the government is considering putting a large amount of resources into cancer research . The discovery of a successful cancer treatment would , of course , many generations of citizens . Because households would share the gains in the , the costs should be shared as well . By running a budget deficit , the government is able to distribute the costs across generations of citizens in parallel with the benefits . From the perspective of both fairness and , there are some gains to spending . More generally , we might want to make a distinction among different types of government purchases , just as we do among private purchases . We know that the national accounts distinguish consumption purchases ( broadly speaking , things from which we get URL books 552

, such as food and movies ) from investment purchases ( things that bring , such as factories and machinery ) Likewise , we might want to distinguish between government consumption , such as wages of employees at the Department of Motor Vehicles , from government investment , such as spending on cancer research . We could then argue that it makes more sense to borrow to government investment rather than government consumption . Although a very nice idea in principle , this approach to the government accounts often founders on the practicalities and the politics of implementation . First , it is not at all clear how to classify many government expenditures . Was a launch of the space shuttle consumption or investment ?

What about the wages of teachers in the public schools ?

What about the money spent on national parks ?

Second , politicians would have a strong incentive to classify expenditures as investment rather than consumption , to justify deferring payment . Another benefit of is that they can play a role in economic stabilization . In the short run , the level of economic activity can deviate from potential . As a consequence , aggregate expenditures play a role in determining the level of output . Fiscal policy the level of aggregate expenditures . Changes in government purchases directly affect aggregate expenditures because they are a component of spending , and changes in taxes indirectly affect aggregate demand through their effect on consumption . Hence spending can help to stabilize the economy . In summary , there are several arguments for allowing governments to run . We would forswear these benefits if we were to adopt a amendment . But we conclude by noting that there is a further , much less benign , reason for government deficits they may politicians even if they do not the country as a whole . allow politicians to provide to constituents today and leave the bill to future generations . If politicians and voters care more about current benefits than future costs , then they have a strong incentive to incur large and let future generations worry about the consequences . around the World Do other countries also run in the way that the United States does ?

Table Budget Deficits around the World , 2005 summarizes the recent budgetary situation for several countries around the world . With the exception of Argentina , all the countries were running deficits in 2005 . Table Budget around the World , 2005 Country Revenues Expenditures Argentina China France 108 Germany 113 Italy Data are in millions of US dollars . URL books 553

Source CIA Fact Book , France , Germany , and Italy are of particular interest . These three countries are part of the European Union ( EU ) In January 1999 , when the Economic and Monetary Union was formed , a restriction on the budget of EU countries went into effect . This measure was contained in legislation called the Stability and Growth Pact . Its main component is a requirement that member countries keep below a threshold of percent of . This threshold is not set to zero to allow countries the ability to deal with in real . In other words , although the EU does not impose a strict requirement , it does impose limits on member countries . In recent years , however , these limits have been exceeded . For example , in 2005 , Germany deficit was more than percent of its . During the past few years , Germany has been in a recession and , as highlighted by Figure Surplus and , its deficit grew considerably . Instead of imposing fiscal policies to reduce its , Germany allowed its to grow outside the bounds set by the Stability and Growth Pact . The economic crisis of 2008 and subsequent recession that impacted many of the world economies had a further effect on the budget deficits of countries in Europe , contributing to severe debt crises and bailouts in Greece , Ireland , and Portugal . KEY TAKEAWAYS . Countries run government budget deficits when faced with large expenditures , such as a war . By running a deficit , a government is able to spread taxes over time . Also , a allows a government to allocate tax obligations across generations of citizens who all from some form of government spending . Finally , stabilization policy often requires the government to run a . Checking Your Understanding . What does it mean to say that a tax is ?

What is the political to spending ?

When does fairness provide a basis for running a ?

Chapter The Great Depression spelled out in detail the role for policy in stabilizing output . One of the arguments for an explicit exception ( and the only such exception ) written into the bill from that we quoted earlier . The table deliberately does not express the relative to any measure of economic activity in the country . Thus it is hard to say whether these deficits are large or small . An Economics Detective exercise at the end of the chapter encourages you to look at this question . URL books 554

This pact is discussed in detail in Stability and Growth Pact , European Commission Economic and Financial Affairs , accessed September 20 , economy index . We examine what happened in these countries in Chapter 15 The Global Financial Crisis . The Costs of LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the effect ?

When is the effect of government large ?

We now turn to the costs of spending . Although we refer to this as spending , the same arguments apply if we analyze the effects of a reduction in the government surplus . First , we need to understand what happens in the financial sector of the economy if the government runs a deficit . Savings and Investment Earlier , we examined the circular of income in the government sector . Now we turn our attention to the circular in the sector , which is shown in Figure The Financial Sector in the Circular Flow . As with all sectors in the circular , the into and from the sector must match . In the case of the government sector earlier in the chapter , the balance of these is another way of saying that the government must satisfy its budget constraint . The rules of accounting tell us that , in the sector , the in must likewise match the out , but what is the underlying economic reason for this ?

The answer is that the are brought into balance by adjusting interest rates in the economy . We think of the financial sector of the economy as a large credit market in which the price is the real interest rate . Figure The Scalar in the ( Flow URL books 555

. I I I ( I I I I I I a Government borrowing Private savings I I I I I Borrowing from abroad Rest of . theworld I I I Funds into the sector as a result of household savings and borrowing from the rest of the world . Funds from the government sector ( to the government ) and to the sector to investment . Toolkit Section The Credit ( Loan ) Market ( Macro ) You can review the credit market in the toolkit . The Credit Market The supply of loans in the credit market comes from ( private savings of households and firms , savings or borrowing of governments , and ( savings or borrowing of foreigners . Households generally respond to an increase in the real interest rate by saving more . Higher real interest rates also encourage foreigners to send funds to the domestic economy . National savings are as private savings plus government savings ( or , equivalently , private savings minus the government deficit ) The total supply of savings is therefore equal to national savings plus the savings of foreigners ( that is , borrowing from other countries ) The demand for credit comes from who borrow to finance investment . URL books 556

As the real interest rate increases , investment spending decreases . For , a high interest rate represents a high cost of funding investment expenditures . The matching of savings and investment in the aggregate economy is described by the following equations investment national savings borrowing from other countries or investment national savings lending to other countries . The response of savings and investment to the real interest rate is shown in Figure The Credit Market . In equilibrium , the quantity of credit supplied equals the quantity of credit demanded . We have assumed that the country is borrowing from abroad , but nothing at all would than the way we describe the supply the domestic economy were instead lending to other countries . Real rate Supply mic Demand for credit Quantity of credit Equilibrium quantity of credit Figure The Credit Market URL books 557

Adjustment of the real interest rate ensures that the into and from the sector balance . The supply of loans comes from national savings plus borrowing from abroad . The demand for loans comes from seeking funds for investment . Crowding Out Armed with this framework , we can determine what happens to saving , investment , and interest rates when the increases . Figure Crowding Out begins with the credit market in equilibrium at point A . The increased government is shown as a leftward shift of the national savings line . At each level of the real interest rate , the increased government means that national savings is lower . Figure Crowding Out Real interest rule Supply New equilibrium quantity of credit Old equilibrium ' for credit Quantity Old equilibrium equilibrium interest rate interest rate An increase in the means a reduction in saving , so the saving line shifts leftward and the new equilibrium entails a higher real interest rate and a lower level of investment . The equilibrium decrease in saving and investment is less than the initial decrease in government saving . This shift in the savings line implies that the market for loans is no longer in equilibrium at the original interest rate . Real interest rates increase in response to the excess of investment over savings until the market is once again in equilibrium , at point Crowding Out . to , we can see there are two consequences of the government ( URL books 558

real interest rates increase , and ( the amount of credit , and hence the level of investment , is lower . The reduction in investment spending caused by an increase in government spending is called crowding out . In addition , household spending on durable goods also decreases when interest rates increase this is also an example of crowding out . To the extent that household spending on and investment are sensitive to changes in real interest rates , the effect can be substantial . Crowding out also operates through net exports . From Figure Crowding Out , we know that an increase in the deficit leads to an increase in interest rates . Increased interest rates have three effects . They cause investment to decrease . This is the effect . They cause private saving to increase . Higher interest rates encourage people to save rather than consume . They attract funds from other countries . Investors in other countries see the higher interest rates and decide to invest in the domestic economy . The second and third effects explain why the supply of credit slopes upward in Figure Crowding Out . As a result , the decrease in investment is not as large as the increase in the deficit . The decrease in government saving is partly offset by an increase in private saving and an increase in borrowing from abroad . Increased borrowing from abroad must result in a decrease in net exports to keep the into and from the foreign sector in balance . To understand these linkages , imagine that the United States sells additional government debt , some of which is purchased by banks in Europe , Canada , Japan , and other countries . These purchases of government debt require transactions in the foreign exchange market . If a bank in Europe purchases US government debt , there is an increased demand for dollars in the euro market for dollars , which leads to an appreciation in the price of the dollar . When the dollar appreciates , US citizens that European goods and services are cheaper , whereas Europeans find that US goods and services are more expensive . US imports increase and exports decrease , so net exports decrease . To summarize , an increased government deficit leads to the following . An increase in the real interest rate . An appreciation of the exchange rate . A reduction in investment and in purchases of consumer . An increase in the trade Table Investment , Savings , and Net Exports ( Billions of Dollars ) shows the US experience during the , when the US federal government ran a large budget deficit ( the negative entries in the federal budget surplus column ) The table also reveals that the United States ran a sizable trade starting in 1983 . This phenomenon became known as the twin . Table Investment , Savings , and Net Exports ( Billions of Dollars ) Year Investment Trade National Budget Error Surplus Saving Surplus URL books 559

1980 1981 1982 1983 1984 875 1985 895 1986 1987 1988 1989 Source Economic Report of the President ( Washington , 2004 ) table . Even though recent years have also seen high in the United States , interest rates have not increased , so we have not seen crowding out . This is because the Federal Reserve has also been operating in credit markets to keep interest rates low . Although crowding out is associated with fiscal policy , it also depends on what policies the monetary authority chooses to pursue . When crowding out does occur , its consequences may be significant . Lower investment translates , in the long run , into a lower standard of living . An increase in government spending means that the country has chosen to consume more now and less in the future . Similarly , crowding out of net exports means that the economy is borrowing more from other countries . This again means that the country has chosen to consume more now in exchange for debt that must be paid back later . The effect is perhaps the most powerful argument in favor of a requirement . KEY TAKEAWAYS . Crowding out occurs when government lead to higher real interest rates and lower investment . The high interest rates can also cause the domestic currency to appreciate , leading to a decrease in net exports . The effect is large when spending by households on and investment spending are sensitive to variations in the real interest rate and when exports are sensitive to changes in the exchange rate . Checking Your Understanding . Why do higher interest rates cause the currency to appreciate ?

In using the credit market to study the effects of government on real interest rates , what did we assume about household saving ?

URL books 560 We also examined this sector in Chapter Globalization and Competitiveness . Chapter Global Prosperity and Global Poverty explained how investment feeds into economic growth . The Perspective LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the theory about the effects of deficits on interest rates and real gross domestic product ( What is the evidence on the theory ?

Buried in our analysis of the effect is a critical assumption . We argued that an increase in the government deficit would reduce national savings at every level of the interest rate . Implicitly , we assumed that the change in government behavior had no direct effect on private savings . Instead , there was an indirect effect savings increased when the interest rate increased . But at any given level of interest rates , we assumed that private saving was unchanged . Perhaps that is not the most reasonable assumption . Consider the following thought experiment . The government sends you and everyone else a check for , representing a tax cut . The government finances this increase in the deficit by selling government bonds . The government announces that it will increase taxes next year by the amount of the tax cut plus the interest it owes on the bonds that it issued . What will be your response to this policy ?

A natural reaction is just to save the entire tax cut . After all , if the government cuts taxes in this fashion , then all it is doing is postponing your tax bill by one year . Your lifetime resources have not increased at all . Hence you can save the entire tax cut , accumulate the interest income , and use this income to pay off your increased tax liability next year . The Lifetime Budget Constraint The household lifetime budget constraint tells us that households must equate the discounted present values of income and expenditures over their lifetimes . We use it here to help us understand how households behave when there are changes in the timing of their income . In general , the budget constraint must be expressed in terms of discounted present values discounted present value of lifetime consumption discounted present value of lifetime disposable income . URL books 561

When the real interest rate is zero , life is simple . It is legitimate simply to add together income and consumption in different years . In this case , the lifetime budget constraint says that total lifetime disposable income total lifetime consumption . The measure of income used in the households budget constraint is lifetime disposable income . You can think of discounted lifetime disposable income as the difference between the discounted present value of income ( before taxes ) and the discounted present value of taxes . The effect of a government tax policy is through the discounted present value of household taxes . Toolkit Section The Model of Consumption You can review the model of consumption in the toolkit . Private Savings and Government Savings In our earlier thought experiment , the increase in the government was exactly offset by an increase in private savings . This implication is shown in Figure Equivalence nothing happens . The composition of national savings changes , so public savings decrease , and private savings increase . But these two changes exactly offset each other since the private sector saves the entire amount of the tax cut . As a result , the supply curve does not shift . Since national savings do not change , the equilibrium remains at point A , and there is no effect . Economists call this idea , after David Ricardo , the century economist who first suggested such a link between public and private saving . equivalence occurs when an increase in the government deficit leads to an equal increase in private saving and no change in either the real interest rate or investment . Figure URL books 562

Real interest rate Supply of credit Equilibrium rate Demand for credit Quantity of of credit An increase in the government is equivalent to a decrease in government savings , which shifts national savings leftward . In a world , private savings increases by an amount , so result is no change in national savings . The perspective can be summarized by two related claims . The timing of taxes is irrelevant . If government purchases are unchanged , tax cuts or increases should have no effect on the economy . These claims follow from the government budget constraint and the households lifetime budget constraint , taken together . The government constraint tells us that a given amount ( that is , a given discounted present value ) of government spending implies a need for a given ( discounted present value ) amount of taxes . These taxes could come at all sorts of different times , with different implications for the , but the total amount of taxes must be enough to pay for the total amount of spending . The household lifetime budget constraint tells us that the timing of taxes may be irrelevant to households as well they should care about the total lifetime ( resources that they have available to them . The implications of the perspective are not quite as stark if the increased is due to increased government spending . Households should still realize that they have to pay for this spending with higher taxes at some future date . Lifetime household income will decrease , so consumption will decrease . However , consumption smoothing suggests that the decrease in consumption will be spread between the present and the future . The decrease in current consumption will be less than the increase in government spending , so national savings will decrease , as in the analysis in Section The Costs of Deficits . URL books 563

If the perspective is an accurate description of how people behave , then much of our analysis in this chapter becomes irrelevant . Deficits are not needed to spread out the costs of major government expenditures because households can do this smoothing for themselves . Changes in taxes have no effect on aggregate spending , so there is no effect . As for a amendment , it too would be much less significant in such a world . households effectively undo government taxation decisions . However , the exact effect of an amendment would depend on how the government chose to ensure budget balance . Suppose the economy went into recession , so tax revenues decreased . There are two ways to restore budget balance . One is to increase taxes . According to the perspective , this would have no effect on the economy at all . The other is to cut government purchases . As we have seen , this would have some effects . Evidence The perspective seems very plausible when we consider a thought experiment such as a tax cut this year matched by a corresponding tax increase next year . At the same time , a typical tax cut is not matched by an explicit future tax increase at a date . Instead , a tax cut today means that at some unspecified future date taxes will have to be increased . Furthermore , the perspective requires that households have a sophisticated economic understanding of the budget constraint of the government . It is therefore unclear whether this view is relevant when we evaluate government deficits . Do households understand the government budget constraint and adjust their behavior accordingly , or is this just an academic interesting , perhaps , but of limited relevance to the real world ?

This is an empirical question , so we turn to the data . There are two natural ways to examine this question . The is to determine the relationship between government and real interest rates in the data . The second approach is to examine the relationship between government and private saving . and Interest Rates We want to answer the following question do increases in government interest rates to increase ?

Figure US ( I ) 111 ( Rule , URL books 564 ' I I 965 1975 I 985 2005 2009 Year There is some evidence that declines in the government surplus are associated with higher real interest rates , contrary to the view . Source Economic Report of the President , 2010 , Tables and . Figure US Ratio and Real Interest Rate , shows two series . The first is the ratio of the US budget surplus to , measured on the left axis . Be this is the surplus , not the deficit . The economy is in when this series is negative . The second is a measure of the real interest rate , measured on the axis . The figure shows that interest rates do seem to increase when the surplus decreases . We can compute the correlation between the ratio and the real interest rate . For this data the correlation is . The minus sign means that when the surplus is above average , the real interest rate tends to be below its average value , consistent with the impression we get from the graph . However , the correlation is not very large . The stand out in the figure . During this period , the budget deficit grew substantially , low economic activity as well as tax cuts that were enacted during the early years of the Reagan administration . Starting in 1982 , real interest rates increased substantially , just as the budget was widening . This is consistent with crowding out and contrary to the perspective . We must be cautious about inferring causality , however . It is false to conclude from this evidence that an increase in the deficit caused interest rates to increase . It might be that some other force caused high interest rates and low economic activity . Toolkit Section Correlation and Causality You can review the of a correlation in the toolkit . Government and Private Saving URL books I 565

According to the perspective , increases in the government should be matched by increases in private saving and vice versa . Private and government savings rates for the United States are shown in Figure US Government and Private Savings Rates . The private saving rate equals private saving as a percentage of real . The government saving rate essentially equals the government surplus as a percentage of ( there are some minor accounting differences that we do not need to worry about ) Figure US and Private Savings Rates Private saving me Government saving rate I . 1960 I 964 I 968 1972 I 976 1980 I 984 I 992 I 996 2000 2004 2008 Year There is some evidence that private and government saving move in opposite directions , as suggested by the view . Source Calculations based on Economic Report of the President , Table . Private savings increased from the 1980 to 1985 period and decreased thereafter . Large deficits emerged during the early ( negative government savings ) At this time , there was an increase in the private savings rate . The government savings rate increased steadily during the , and , during this period , the private savings rate decreased . These data are therefore more supportive of the view private and government savings were moving in opposite directions . Turning to international evidence , an Organisation for Economic and Development study that examined 21 countries between 1970 and 2002 found that changes in government were associated with partially offsetting movements in private saving . On average , the study found that changes in private savings offset about to of changes in the government . Figure Government and Private Savings Rates in Spain and Greece and Figure Government and Private Savings Rates in France and Ireland reproduce some from this study . In Spain and Greece , for example , we see patterns of savings that are consistent with the perspective private savings and government savings move in opposite directions . By contrast , the pictures for Ireland and France show little evidence of such an effect . URL books 566

Figure Government and Private Savings Rates in Spain and Greece Spain A ' A . A 1986 1990 1998 2002 2006 2010 Year saving in general net leading in of Greece a A . 1970 1998 2002 2010 Year Source Economic Report of the President , 2010 , Tables and . URL books 557

Ireland I I ( I 2002 2006 Year saving in percent of ( gov in percent of 2002 2006 2010 Year Figure Government and Private Savings Rates in France and Ireland Source Calculations based on Economic Report of the President , Table . The data from the United States and other countries indicate that this is almost certainly one of those questions where the truth is in the middle . We do not observe households behaving completely in accordance with the perspective . As a result , we conclude that do have the real effects on the economy that we discussed at length in this chapter . At the same time , there is evidence suggesting that households pay attention to the government budget constraint . The perspective is more than just an academic curiosity some households , some of the time , adjust their behavior to some extent . KEY TAKEAWAYS . According to theory , a government will be offset by an increase in household saving , leaving real interest rates and the level of economic activity unchanged . The key to the theory is the anticipation of households of future taxes when the government runs a . There is some evidence that interest rates are high when are high , contrary to URL books ' 568

the prediction of the view . But during some periods of large deficits , the household saving rate is high as well . The evidence on equivalence is not conclusive . Checking Your Understanding . If the government cuts taxes , what happens to public saving , private saving , and national saving according to the theory ?

What is the difference between causation and correlation when we examine the relationship between budget and real interest rates ?

Since the perspective says that the timing of taxes is irrelevant , the effect is the same as it would be if the taxes were also imposed today . So one way of thinking about this is to suppose that the government increases spending and finances that increase with current taxes . For example , as explained in Chapter 10 Understanding the Fed , tight monetary policy ( such as that enacted in the ) leads to high interest rates and can push the economy into recession , leading to a . These calculations rely on data from the Economic Report of the President ( Washington , 2011 ) table , accessed September 20 , 2011 , See de , Per Mathis , and Robert Price , Saving Behaviour and the Effectiveness of Fiscal Policy , Economics Department Working Papers No . 397 , Organisation for Economic and Development , July 2004 , accessed September 20 , Material In Conclusion We started this chapter by asking whether the United States should adopt a amendment to the constitution . This question has both political and economic . It is not our purpose in this book to answer this question , or others like it , for you . Most interesting questions do not have easy answers . Instead , they come down to assessments of costs and and judgments about which best describe the world that we live in . Our intent here was to provide you with the ability to assess the arguments about a amendment and , more generally , the effects of spending on the economy . URL books 569

We saw in this chapter that there are certainly both and costs associated with finance . Key benefits include the ability to spread out the payments for large government purchases and the opportunity to use to stimulate economies in recession . The main cost of deficits is that they increase real interest rates , thus crowding out investment and slowing growth . As we also saw , these effects might be tempered by an increase in household savings in response to government . The evidence suggests that the perspective on deficits has partial validity . Changes in government savings are likely to be partially , but not completely , offset by changes in households saving behavior . We also noted that a amendment would not absolve government of the choices involved in balancing the budget . It is one thing to pass a law saying that the budget must be balanced . It is quite another to come up with the spending cuts and tax increases that are needed to make it happen . Meanwhile , time is passing . Go and look again at the size of the debt outstanding reported at the US Treasury ( How much has it changed since you first checked it ?

How much has your share of the debt changed ?

Key Links . The Congressional Budget Office . US Treasury calculation of the public debt . CIA World publications . US national debt clock debt clock . Debate on balancing the budget Concord Coalition issues . Americans for a . Center on Budget and Policy Priorities . The following table is a table of the same form as Table Calculating the Deficit but with some missing entries . Complete the table . In which years was there a balanced budget ?

Year Government Tax Transfers Net Taxes Purchases Revenues 60 10 20 80 100 20 120 20 100 20 140 40 20 140 40 . The following table lists income and the tax rate at different levels of income . In this exercise the tax rate is different at different levels of income . For income below 500 , the URL books

tax rate is 20 percent . For income in excess of 500 , the tax rate is 25 percent . Calculate tax receipts for this case . TABLE TAX RECEIPTS AND INCOME Marginal Tax Receipts Tax Rate 100 500 1000 2000 5000 . Consider the following table . Suppose that government purchases are 500 , and the tax rate is 20 percent . Furthermore , suppose that real gross domestic product ( takes the values indicated in the table . If the initial stock of debt is , the level of debt for each of the years in the table . TABLE EXERCISE URL books Year Debt Debt ( End ( Start of of Year ) Year ) For the example in the preceding table titled Exercise , are the deficits and surpluses due to variations in the level of or fiscal policy ?

Suppose you were told that potential was . Is there a full employment or surplus when actual is ?

Design a policy so that the budget is in balance when real is equal to potential . Draw a version of Figure Surplus and using the data for tax receipts you calculated in the table titled Tax Receipts and Income , and assuming government purchases equal 475 . At what level of is the budget in balance ?

The text says that expansionary fiscal policy increases the given the level of . Would an expansionary fiscal policy necessarily increase the if changes as well ?

Compare Figure Ratio of US Debt to , from 1940 onward ) with Figure US Surplus and Debt , Why do the figures look so different from each other ?

571 . Suppose that investment is very sensitive to real interest rates . What does this mean for the slope of the demand curve in the credit market ?

Will it make the effect large or small ?

Economics Detective . The price of government debt during the Civil War makes for a fascinating case study . Both the Union and the Confederacy were issuing debt to their expenditures . Try to do some research on the value of Civil War debt to answer the following questions . a ) How much did the Union and the Confederacy rely on rather than taxes to finance the war efforts ?

What do you think happened to the value of the Union and Confederacy debt over the course of the war ?

Do you think these values were positively or negatively correlated ?

A starting point for your research is a website ( that summarizes the way in which the North and the South financed their war efforts . What happened to the budget of European Union member countries during the crisis that started in 2008 ?

Were these cyclically adjusted budget ?

Using the as a source , make a table of the budget for the period 1990 to the present in constant rather than current dollars ( that is , obtain figures for real receipts , and ) Describe the behavior of real receipts , real , and the real over this period . Does it differ qualitatively from the description in the text ?

If necessary , check the toolkit for instructions on how to convert nominal variables into real variables . Using the as a source , make a table of the for the period 1990 to the present . Compare these calculations with those reported in Table Recent Experience of and Surpluses ( Billions of Dollars ) Explain the main differences between these tables . Each month , the Congressional Budget Office ( posts its monthly budget review . Look for the most recent monthly budget review . What are the largest and revenues ?

How large are interest payments on the debt ?

We saw that the government budget went from surplus to deficit in 2002 . Based on the discussion in the text , try to find two different things that happened around this time that might explain this change . This exercise builds on Table Budget around the World , 2005 . Find the levels of in 2005 for each country listed in Table Budget around the World , 2005 . Using this information , the ratio of the to for each of the countries . Which country in the world has the highest ratio of debt to ?

How do the countries listed in Table Budget around the World , 2005 compare in terms of the ratio ?

For the countries listed in Table Budget Deficits around the World , 2005 , find the growth rate of real in 2005 . Do countries that grow faster have smaller deficits ?

Hint The CIA Fact Book URL books ( will be useful . Spreadsheet Exercises . Suppose that government purchases are 500 and the tax rate is 20 percent . Create a table to calculate the budget for each level of income from to , increasing by 50 each time . At what level of income does the budget balance ?

Compare your results to those in Table Deficit and Income . Create a spreadsheet to study the debt as in Table Deficit and Debt using the data from Table Calculating the Deficit . But assume that the level of debt outstanding at the start of the period was 100 , not . Assume that the interest rate is percent each year . Add a column to Table Calculating the to indicate the payment of interest on the debt . Calculate the deficit for each year and then the debt outstanding at the start of the next year . Also calculate the primary in your spreadsheet . What happens to these calculations when the interest rate increases to percent ?

URL books ' 573