BUDGET DEFICITS AND THE NATIONAL DEBT

Definitions: Budget Deficit vs. National Debt

The National Debt is the federal government's total indebtedness at a moment in time. It is the accumulation of previous deficits plus outstanding interest.

The difference is the same as the difference between flows and stocks. An analogy is to think of water filling into a pool. The rate at which the water is pouring out of the spicket is comparable to the budget deficit. The total amount of water in the pool at any point in time is the national debt. How much debt are we in? Currently, we have approximately a $5 trillion national debt. This amounts to $19,000 per person living in the U.S. Click here to see a table of the gross federal debt.

Our budget deficit in 1996 was approximately $107 billion, down from approximately 170 billion in 1995. Click here to see a table of the federal deficit.

Why the Debt and/or Deficit Burden May be Overstated

1. Much of debt (about 25%) is owned by the U.S. government itself. When one branch of the government runs a surplus and simply buys federal securities with the excess revenue, the total debt doesn't really rise (except on the books). We could have just as easily apportioned the surplus tax dollars of one program to a budget category that was in deficit and eliminated the need to borrow. This is the current situation now with the surplus in the social security trust fund.
2. The deficit/GDP ratio may be a more accurate measure of the "true" size of the deficit. A nation's debt is in many ways similar to an individual's debt. Suppose that each of two people in a given year run a deficit of $10,000 and each racks up $10,000 in credit card debt. The first person has an annual income of $20,000, so the deficit to income ratio is 0.50. The second person has an annual income of $100,000. This person's deficit/income ratio is 0.20. Obviously, the second person's debt load is much lighter than the first. Similarly, the US can carry much larger deficits than Italy, for example, because our economy is larger. Note that exactly the same argument holds true for the Debt/GDP ratio.
3. Inflation makes the real interest payments smaller. When the government borrows money, it pays the money back at a later point in time. The purchasing power of that money is less than when the government first borrowed it because of inflation. What we really want to measure is the government's real debt so we must correct the deficit for the effects of inflation.
4. Many state and local governments run surpluses. If we are adding up total government deficits/debts, why not subtract the size of the state and local government surpluses?
5. The accounting rules for the federal government are different than the rules for private businesses. Accounting methods in the private sector separate current expenditures (generally expenditures in which the purchase is used up within one year) from capital expenditures (long-term purchases or investments). For example, when HSU purchases paper, this is a current expenditures whose costs is fully deducted as an expense in the year the paper was purchased. But if HSU purchases a new building that will last 100 years, the full cost of that building does not show up on that year's expenses. Only a portion of the building can be deducted as an expense. The building is depreciated over time, perhaps ten years. When the federal government purchases a new building, however, the full amount of that purchase is deducted in the year the building was purchased. There is no separate capital account in federal accounting. This makes the federal government's expenses look higher than they otherwise might.

Structural vs. Cyclical Components of the Deficit

A structural deficit is the deficit that we would have if the economy were at potential output. A cyclical deficit is the portion of the deficit attributable to the business cycle. The two parts sum to equal the total deficit,

Structural deficit + cyclical deficit = total deficit.

When an economy goes into recession, the budget deficit rises. This occurs for two reasons. First, a recession means that GDP and hence aggregate income is falling. Therefore, less tax revenue is generated. Second, government outlays rise during recessions. Demand for welfare, food stamps, Medicaid, and other transfer programs increases as incomes fall. The combined effect of spending increases and falling tax revenues increases the budget deficit.

In general, economists agree that cyclical deficits are good. Cyclical deficits help to stabilize the business cycle. Imagine if the government reduced expenditures when the economy went into recession to balance the budget! This would amplify the recession and magnify the economic hardships that people feel during downturns in the business cycle. It is the structural portion of the deficit that gives concern to most economists. The structural deficit has increased substantially in the last 20 years.

Myths about the Deficit and Debt

1. The deficit imposes a net burden on future generations. This was a major theme of Ross Perot when he was running for the Presidency in 1992. There is some truth to this statement, but not much. This statement conjures up an image that the younger generation(s) has this huge tax bill hanging over their heads which must be paid off entirely. But countries never die (or at least they never plan on dying). Therefore, there is no reason why our children and their children's children cannot keep passing on the debt forever. In fact, so long as the economy continues to grow, future generations can continue to pass on ever-larger debts. Simarlarly, if I lived forever, I would never have to pay off my credit card debt entirely - just service the monthly interest payments.

   Moreover, payers and recipients of the debt are both primarily U.S. citizens, so income is simply redistributed from one group to another. Suppose Ross Perot was elected President and decided to pay off the national debt once and for all over a period of say, 5 years. How would he do it? He would have to raise taxes and cut spending so that we ran significant surpluses (on the order of $1 trillion per year). The government would then take the funds directly from the tax payers and indirectly from the citizens who lose the benefits they used to receive from government services, and pay off the bond holders. Does the money leave the country? No. It is simply transferred from all tax payers to the bond holders. In fact, many bond holders may find that the value of their bonds were offset by the higher taxes and/or lower level of government services.

   There is one case where the net burden argment may hold some weight. Right now, about 15% of US debt is held by foreign investors. To the extent that future generations must pay off this debt, and the income leaves the country, future generations are burdened with the current generation's run-up in debt. Fortunately for the US, the foreign-owned portion of the debt is still fairly small.

2. The national debt will bankrupt the nation. Huge debts have bankrupted some nations, but we are far from that scenario. The main difference is that most of our debt is internally owned. Also, the government never has to pay the entire debt off at one time since the government never "dies." Furthermore, the government has an enormous power to raise revenue via taxation.

True Costs of the Deficit

Having discussed what is not true about large deficits, let's discuss what the potentially harmful effects are.

1. Crowding Out of Private Investment. The government competes in the loanable funds market just like any private citizen. When it needs to borrow lots of funds, it drives up interest rates, CROWDING OUT, or lowering private investment. If the government uses the borrowed funds for current expenditures (i.e. welfare, medicaid, armed forces) rather than for investment purposes (i.e. highways, R&D for clean technology, etc.), then our total investment as a nation is reduced. The lower rate of investment reduces our rates of economic growth in the future, slowing the rate of increase in our living standards. This seemingly small effect adds up to surprisingly large amounts very quickly. Those who are living two or three generations down the road may have significantly lower standards of living than they otherwise would have without the crowding out effect.

   The size of the crowding out effect depends on where the economy is in the business cycle. The closer the economy is to full employment, the more severe is the crowding out. In times of deep recession, the deficit can actually "crowd-in" or increase investment by stimulating Aggregate Demand and making some investment worthwhile. In this case, large deficits will perhaps increase the standard of living for future generations.

2. Income Redistribution. As mentioned above, income is redistributed from all taxpayers to bondholders when all or part of the deficit is paid off. If and when taxes rise to pay off some of the debt, all taxpayers must pay higher taxes, but only some U.S. citizens receive the income from the debt.
3. Net burden on future generations of foreign-owned debt. Again, as stated above, the net burden argument does hold for the portion of debt that is foreign-owned, assuming the foreigner takes the income from the US government bond out of the country.
4. Could be inflationary. Large deficits are the result of large amounts of government spending. This increases Aggregate Demand and could lead to price level rises. Again, the impact on prices will largely depend on where the economy is in the business cycle. If the deficits are driven by a recession, it is unlikely that inflationary pressures will be large.
5. International Effect. Large deficits could lead to high interest rates (through crowding out) which leads to a strong dollar because many foreign investors wish to purchase U.S. government bonds. The strong dollar hurts U.S. exports and makes imports in the U.S. more attractive, so net exports fall weakening Aggregate Demand.

Overall Assessment of Current Deficits and Debt

The general consensus of economists on the current state of US deficits and debt may be summed up as follows. Is there an impending crisis? No, if by crisis we mean that today's deficits unduly harm prospects for future economic growth. Could there be in the future? Yes. The large deficits since the mid-1980s are harmful if they crowd out private investment and replace that investment with government consumption spending. However, there is disagreement over how large the crowding out effect is and whether or not crowding out is even occuring.

There are PowerPoint slides to accompany this lesson.