PRINCIPLES OF MACROECONOMICS
WEEK "12A": MAKEUP LECTURE NOTES ON FISCAL POLICY
Ranjit Dighe
Tues., April 25, 2000

[These notes are "direct-to-Internet." They constitute a makeup lecture for a sick day that I took a while back. They overlap with material in Case & Fair's Chapters 10 and 16.]

In this lecture:
I. Deficits and debt: Definitions, measurement
II. Problems of deficits and debt
III. The economy's influence on the deficit
IV. Fiscal history
 

I. DEFICITS AND DEBT: DEFINITIONS, MEASUREMENT

Q: What does it mean to say, "The government is running a deficit?"
A: The government is spending more than it takes in.
-- Does this mean the U.S. government a deadbeat? Is it unable to pay its bills?
(No-- it can easily borrow enough to cover its deficit.)

Defn.
BUDGET DEFICIT: the difference between what a government spends and what it collects in revenues in a given period
-- roughly, G - T
-- more precisely, all expenditures, including transfers and interest on the national debt, minus all revenues, including tariffs and user fees).
---- currently is negative, because the government is running a surplus. The government's estimated deficit for the year 2000 is - $167 billion, which is 1.7% of GDP

How does the government pay for its deficit? Options:

1. money financing: could print money (or buy bonds directly from Treasury and pay for them by creating money)
-- "monetizing" the debt, "inflation tax"
-- most common in 3rd World countries; not how the U.S. government pays for its deficits

* 2. debt financing: sell bonds -- what U.S. does, mainly (bonds=debt)
-- When bonds mature, government must pay interest plus principal (original amount borrowed). The main way the government pays off its bondholders is to ... sell more bonds! (In these days of government surpluses, however, the government is able to "retire" some of the national debt, by paying off some of its bond obligations with money from current tax collections.)
-->

Defn. NATIONAL DEBT (federal debt): The total of all accumulated federal deficits minus surpluses over time, or the total amount of U.S. government bonds outstanding.
-- U.S.: currently about $3.5 trillion, or 36% of GDP (estimates for the year 2000)
-- other countries' national debt: Japan, Germany -- slightly smaller as % of GDP; Great Britain -- slightly larger; Italy -- over 100% of GDP!

Current year's deficit = increase in national debt from the previous year

Q: What is the most economically relevant measure of the national debt?
-- (Is it the national debt itself? Five times as large today as in 1980-- should we be 5 times as worried? NO-- measured nominally, doesn't adjust for inflation. Ex.: almost tripled in 1970s, but prices more than doubled and economy grew.)
-- (Is it the national debt in constant, inflation-adjusted dollars? NO-- Consider the case of an individual who's in debt. Compare a recent art history grad with $50,000 in student loan debt with a recent accounting grad with $50,000 in student loans-- who do you think is going to be able to pay off that debt quicker?)
----> The most economically relevant measure of the national debt is the ratio of debt to GDP (debt/GDP). Currently (2000 estimate) that ratio is about 36% and falling (which is a good thing). The real fiscal news of the past decade is not that we have a balanced federal budget for the first time since 1969, but that the debt/GDP ratio has been falling ever since 1993, from 50% (highest since 1950s) to 36%.
-- The debt/GDP ratio normally rises during wars and falls during peacetime, which was the case from 1940 to 1980. The debt/GDP ratio more than doubled during World War II, to nearly 110%, then fell rapidly during the 1950s and 1960s and reached a low of 24% in 1974. A stagnant economy in the mid-1970s caused the debt/GDP ratio to rise slightly, and it was about 26% in 1979.
-- The debt/GDP ratio soared during the 1980s and early 1990s, the first time it had ever done that in peacetime, rising to 41% in 1989 and 50% in 1993-95. The big increase in the national debt and the federal budget deficit during the 1980s was related to the government's experiment with supply-side economics, which will be detailed in class later.
 

II. PROBLEMS WITH DEFICITS AND DEBT

In certain circumstances, such as a severe recession, running a deficit may be the government's best option for jump-starting the economy. And since the current budget deficit is a less economically relevant measure than the debt/GDP ratio, a budget deficit need not be a cause for concern as long as the national debt is growing no faster than GDP. In the mid-1990s, for example, the U.S. government ran deficits, but since the economy grew faster than the national debt, the debt/GDP ratio actually fell.

Still, there are several problems associated with deficits:

(1) In the real world, a deficit typically leads to higher interest rates and the partial crowding-out of investment [refer to notes from Mon., April 24].
-- In the simple multiplier model, Ip is fixed; no "crowding out" effect; could even have "crowding in," if there's a marginal propensity to invest. But in real life crowding out is possible.

(2) Government finances its deficits by borrowing (selling bonds -- national debt), must pay interest on that debt
---> obligation that must be met in future
-- interest on the national debt = $200 billion per year (in every year since 1992. Was only $43 billion in 1979, broke $100 billion in 1984, $150 billion in 1988.)
---- Some people take issue with the notion that interest payments on the debt are a burden to U.S. taxpayers, calling it a popular misconception, because "we owe it to ourselves." They say that higher taxes and spending cuts to pay for interest on the debt are exactly offset by interest payments to American bondholders.
------ They miss two key points, though:
-------- (1) Much of the debt is held by foreigners -- 23%, to be precise.
-------- (2) The (rich) Americans who receive T-bond interest are not exactly the same people who pay the taxes or whose spending programs are cut to pay for that interest.
-- John Maynard Keynes, Mr. Fiscal Policy himself, thought budget should be balanced "over the business cycle." In other words, Keynes thought the government should run deficits during depressions and run surpluses during booms.

(3) Large deficits may be inflationary -- they stimulate aggregate demand (the economy moves northwest along the Phillips Curve, causing demand-pull inflation); also, the government may try to finance its deficit by printing money to pay its debts (monetizing the debt; the U.S. doesn't do this, but many countries do, and it can lead to hyperinflation).

(4) Political: raises questions about the size of government. (Big deficits allow the government to spend more money. If you're a conservative Republican and want government spending to be as low as possible, then you might dislike deficits for that reason.)
 

III. THE ECONOMY'S INFLUENCE ON THE DEFICIT

In simple multiplier models, the economy's influence on the deficit depends on whether tax revenues (T) are exogenous (determined outside the system) or endogenous (determined within the system). Lump-sum tax revenues are unaffected by the level of Y and hence are exogenous; by contrast, income and sales tax revenues go up (causing the deficit to decrease) when Y increases and hence are endogenous.

In the real world, the deficit also shrinks when GDP goes up (relative to its trend level) because:
(1) income (and sales) tax revenues go up
(2) government transfer payments, especially unemployment benefits, go down
-- We call those cyclical effects on taxes and spending "AUTOMATIC STABILIZERS" because they help to stabilize the economy, keeping the unemployment rate closer to the NAIRU. When the economy expands, those two effects mean an automatic tax increase and automatic spending cuts, making it a bit harder for the economy to overheat (i.e., for unemployment to drop below the NAIRU, which would cause inflation to accelerate). In a recession, those two effects keep the consumption of the unemployed from falling too much and provide a sort of aggregate tax cut, thereby helping prevent the recession from turning into a depression.

--> When there is a deficit, some of it may be cyclical (exists because the economy is in a recession); usually, most of the deficit is structural (would exist even if output gap were zero).

Defn. CYCLICAL DEFICIT: The deficit that occurs because of a downturn in the business cycle, i.e. because the economy is in a recession.
-- When the economy is in a recession:
---- tax revenues are less than they would be at potential GDP (the level of GDP that corresponds to the unemployment rate's being equal to the NAIRU; the highest level of GDP that the economy can sustain without causing inflation to accelerate)
---- transfer payments are higher than they would be at potential GDP.

Defn. STRUCTURAL DEFICIT: The deficit that would exist if the economy were at "full employment" (i.e., if the unemployment rate were equal to the NAIRU).

--> Actual deficit = Structural deficit + Cyclical deficit
---- Ex.: 1981: deficit was $79 billion, but the economy was in a very depressed state, with GDP equal to less than 93% of potential GDP --> deficit was entirely cyclical, structural deficit was $0!
 

IV. FISCAL HISTORY, 1789-1980

Alexander Hamilton (first Secretary of the Treasury): "father" of the national debt. The states had debts from fighting the Revolutionary War. Hamilton believed in a strong central government, and proposed the federal government take over those debts. The national government also had various debts from War and afterward, and many people believed those debts would never be repaid. Hamilton said all those debts should be called in, exchanged for interest-bearing government bonds, redeemable at definite dates. Instead of running surpluses large enough to retire all of that debt, Hamilton wanted for there always to be a national debt. He thought this would further his cause of a strong federal government, because it would (1) show the government was no deadbeat and (2) give wealthy creditors a stake in seeing the government survive, so that it could pay off its debts to them.

The federal government's revenues originally came only from tariffs on imports and from excise taxes on alcohol. There was no income tax until 1913.

For about the first 150 years of this country's history, the usual pattern was that the government ran deficits only during wartime, to be paid off by running surpluses in peacetime ==> retire debt. At one point in the 1830s, after two decades of peace and prosperity, the national debt was eliminated completely. But a depression in the late 1830s caused the federal government to slide into deficit, and the national debt began to grow. After the Civil War of the 1860s, the national debt was $2.8 billion.

The idea of deliberate deficit spending to stimulate the economy, to get the economy out of a recession or depression, (that is, expansionary fiscal policy) was never considered by U.S. Presidents or Congresses before the 1930s.
-- Herbert Hoover, who was president in 1929-33, famously did just the opposite: he raised taxes during the Great Depression (in 1932), thereby making the Depression even worse.
-- Franklin D. Roosevelt (FDR), actually ran on a balanced-budget platform in 1932, though he became the first president to openly tolerate deficits during peacetime. Expansionary fiscal policy was seen by Keynes and others as the best remedy for the Depression, and FDR's New Deal programs did involve big increases in government spending and bigger deficits. Many of the New Deal programs were public-works programs that directly put many people back to work. Other New Deal programs built some important automatic stabilizers, like unemployment insurance and anti-poverty relief, into the system, blunting the impact of recessions.
---- But the FDR deficits were modest in relation to size of economy, and were offset by surpluses at state and local level. We can't really say that expansionary fiscal policy failed to get us out of the Depression; rather, we can say that expansionary fiscal policy wasn't tried during Depression. Also, like Hoover, FDR also raised taxes during the Great Depression -- first in 1935, a "soak-the-rich" tax increase that raised the top tax rate to 75%, from 59%, and raised taxes on inheritances and large corporations. He raised taxes again in 1936, this time because he was concerned about the size of the deficit. Then in late 1937, in the midst of severe recession-within-a-depression, FDR cut spending and imposed a big increase in Social Security taxes.
---- FDR reversed course in the spring of 1938, attempting to end the recession with a big increase in spending, and the economy soon began to recover. That experience convinced a lot of people at the time that fiscal policy was important.

World War II brought about a revolution in fiscal policy. The government ran massive deficits during World War II; restoring the economy to "full employment" was a key part of American military strategy and had a big side benefit -- the government's massive deficits to pay for the war ended the Great Depression, and quickly.
-- The combined experience of a decade of depression and then nearly five years of full employment during WW2 greatly changed people's awareness of what the government could do to help the economy. The Employment Act of 1946 committed the government to maintaining "maximum employment" (which really meant high, not "full," employment; even then, many believed full employment would be inflationary). Fiscal policy would be the government's main tool for reaching that goal.

Since the economy performed very well on its own during the quarter century from 1948 to 1973, expansionary fiscal policy was used only sparingly. From 1949 to 1970, the federal budget was either in surplus or the deficit was less than 1% of GDP, in most (15 of 22) years. The government continued the pre-1930s pattern of deficits in wars (Korea, Vietnam) and surpluses in peacetime.
-- The big fiscal triumph during that era was the Kennedy-Johnson tax cut of 1964, which helped jump-start a sluggish economy. The tax cut was a roaring success -- tax revenues fell less (in % terms) than tax rates did, and inflation did not rise significantly.
-- The government ran increasingly large deficits to finance the Vietnam War in the 1960s, but a temporary tax increase to finance the war in 1968-69 and reduced spending on the war resulted in a budget surplus in 1969, the government's last budget surplus until 1998.

The government cut taxes during the 1975 recession, and the economy grew rapidly, but with high and accelerating inflation, from 1976 through 1979.

[See section I for a brief history of deficits and debt in the 1980s and 1990s. This will be covered in more detail in our unit on supply-side economics, which goes with part of Case & Fair's Chapter 18.]