Chapter 12: Deficits, Surpluses, and Debt

We now turn our attention to how government spending is financed, and the economic consequences of these financing decisions. First lets start with some definitions:

I. Deficits, Surpluses and Debt: Definitions and A Brief History

A budget deficit occurs when the government spending exceeds government revenue in a given time period, usually one year:

deficit = government spending — revenue, where spending > revenue.

A budget surplus occurs when government spending is less than government revenue in a given time period:

surplus = revenue — spending, where revenue > spending.

In measuring deficits and surpluses, the government uses its fiscal year (October 1 — September 30), not its calendar year.

The national debt is a running total of all deficits minus all surpluses, since George Washington. The United States has borrowed more that is has saved during its 224 years, so the United States owes its citizens and foreign governments about $5.6 trillion as of 1999. The United States borrows money by having the Dept. of the Treasury issue Treasury bonds, which are IOUs from the federal government. These bonds are purchased by U.S. companies and households, and the foreign governments, companies, and households. Treasury bonds are a very safe investment, which makes them very popular.

Note that the deficit and the debt are NOT the same thing. Journalists and politicians confuse them all of the time, but you know better, now don’t you?

The graph below plots the deficit/surplus from 1930 to 2000:

From 1970 to 1997, the federal government ran a deficit every single year. Starting in 1998, the federal government began running surpluses. In the 1980s the size of deficits exploded, greatly increasing the national debt:

The government’s chronic deficit spending has caused much concern/debate about the causes and consequences of deficit spending. However, as the deficit shrank and turned into a surplus in the late 1990s, this gave way to debates about what should be done with the federal budget surplus. What caused the deficits of the 1980s and 1990s? Why are we now running a surplus? What are the economic consequences of these changes?

II. Fiscal Policy, the Budget, and the Business Cycle

In any given fiscal year the budget consists of spending in two categories: The first category is spending and revenue resulting from decisions/commitments made is prior years. Included in this category are things like Social Security & Medicare, interest payments on the national debt, and veterans benefits. This category is about 80% of federal expenditures. The second category is known as discretionary spending. and it is this category that is determined from year-to-year and includes expenditures on education, crime, transportation. The latter category is altered for fiscal policy, but comprises only 20% of federal expenditures.

Spending of the federal government changes over the business cycle due to automatic stabilizers. These are items in the budget that are countercyclical, i.e. designed to stimulate the economy in a contraction or cool off the economy in an expansion:

• Unemployment benefits, food stamps, and other welfare benefits will automatically increase during a recession and decrease during an expansion.
• Income taxes will automatically decrease during a recession and increase during an expansion

Inflation also affects the deficits by affecting the size of social security payments, federal pension payments, and interest on the federal debt.

Thus, the size of the federal deficit/surplus is sensitive to the business cycle. We expect larger deficits (or smaller surpluses) during recessions and smaller deficits (or larger surpluses) during expansions. The federal surplus today is due mostly to a long economic expansion rather than any fiscal restraint shown by politicians.

III. What are the economic consequences of deficits, surpluses, and the national debt?

The Crowding Out Effect

One concern raised over the deficits in the 1980s and 1990s is the possibility that as the federal government borrows money to finance deficits, there is less money left for the private sector to borrow. This is the opportunity cost of the federal deficits. However, crowding out may not necessarily be a bad thing if the government expenditure is an investment in things like education, job training and infrastructure.

Also, U.S. government debt does have some advantages: Treasury bonds are desirable savings vehicles for households, firms, and foriegn governments because they are very low risk and highly liquid. This means U.S. government debt makes a valuable product available to savers.

What to do with a surplus?

The Congressional Budget Office (CBO) projects huge surpluses over the next 10 years, totaling $5.6 trillion, thanks to a long period of economic growth, which substantially increased tax revenues:

Keep in mind that these are projections. The shaded area above shows the margin of error if the underlying economic forecasts are wrong. CBO forecasts are notoriously optimistic.

The government cannot just take the surplus and start buying stock on Etrade, or put it under a very big matress. The choices facing the federal government today about the use of the surplus include:

• giving it back to the taxpayers (tax cuts)
• increase income transfers (like with a prescription drug benefit for Medicare)
• save it (to pay down our national debt)
• spend it on goods and services (hire more teachers, build more highways or prisons)

Republicans favor tax cuts, while many Democrats want to use the surplus to increase Social Security/Medicare benefits. Both parties want to pay down the debt. However, it is unlikely we can do all of this, so some choices must be made.

Is the debt a burden to future generations?

A debt of $5.6 trillion may sound scary, but let’s put it into perspective. The U.S. has a large national debt, but it also has a large economy, which means that our ability to service our debt is large. A better measure of the debt burden is the ration of debt to GDP. Looking at the graph below, the U.S. debt seems very manageable relative to other countries:

Politicians who argue for paying down the debt are concerned that the debt may hurt the economic well-being of future generations that are stuck with the interest payments.

To understand if this is true, let’s look at who owns the debt (figure 12.4, page 241). Almost 80% of the national debt is held by U.S. households, corporations, and federal/state/local government agencies. The remaining 20% is held by foreigners. So servicing the debt (paying interest, issuing bonds) just redistributes income from taxpayers to bondholders—it does not take anything away. However, it is true that bondholders tend to be a wealthier subset of taxpayers. Even the interest paid to foreigners is likely used to purchase U.S. goods and services.

The true burden of the debt is the opportunity costs of the spending financed by the debt. If the debt is used to build F-18 fighters for the Army, then the opportunity costs are the other goods that could be produced land, labor and capital used to make the jets.

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