The National Debt Chapter #20

Introduction There is limit to how large a national debt a country can support ( if too large, econ could be in fragile state where shocks can push the entire econ into a crisis) Much of discussion on national debt is political discussion about G & T High debt levels were central to European econ crisis after Great Recession The debt is the total amount the government owes as a consequence of past borrowing in years that government spending exceeded tax revenues –Size of the debt relative to the size of the economy is important measure of debt (debt to GDP or debt/Y)

Mechanics of the Debt National debt is accumulation of unpaid past bills. Debt is last year’s debt & current budget deficit: DEBT t+1 = DEBT t + BD t+1 BD = primary deficit + interest payments (Primary or non-interest deficit is under current government control, but interest payments are legacy) DEBT t+1 = DEBT t + primary deficit t + i*DEBT t Funds devoted to interest payments cannot be spend on government programs Interest payments relative to G increased in 1980s & 90s for both increase in debt & i. Although debt grew substantially in Great Recession (07-09) low interest % kept payments down. Interest payments relative to Y around 1.5% since WWII but 3% in 80s & 90s for high i.

Measuring the Deficit Deficit is current revenues minus current outlays  no accounting for depreciation or capital acquisition (Grand Coulee Dam) There is no accounting for assets or unfunded liabilities Debt-to-GDP ratio measures the size of the debt relative to the size of the economy (debt has been rising over time, but so has the economy) A useful mathematical view of the debt is the growth rate4 of the debt-to- GDP ratio: %∆( Debt / Y ) = %∆Debt - %∆Y –If the economy is stagnant for a long period, even small increase in the debt can result in large relative changes –With a growing economy, modest increase in the debt results in a declining debt value relative to GDP

Who Owns the Debt National debt ($16.4T > GDP $15.7T in Jan 2013) owned by: 1.U.S. public 2.International investors 3.Government (liability to one but offsetting asset to another part) 4.Fed - Sum of 1 & 2 ($11.5T in Jan 2013) referred to as “debt held by the public”. - 16% owned by Fed represents open market purchases over the years (effectively no interest payments since most of the interest that Treasury pays to Fed, Fed returns to Treasury). - Interest paid to international Investors leaves US & cannot be used by Americans. - China owns about 13%, followed Japan w/ 9% (combination of prolonged deficit & low US savings %, & safe place to invest)

When Is The Debt a Crisis? Two major consequences of large debt-to-GDP ratio: –Money spent on interest payments cannot be used for desired programs (G) –Regret – need to increase current taxes (intergenerational use of funds & voters) While nations do not have credit limit (as individuals do) markets will stop lending if repayment becomes questionable What happens to nation that lived beyond means & can’t borrow any more? If loans used for payroll & pensions, payments will be cut. State employees & businesses run out of money. Tempted to default on sovereign debt. Related is the size of the government (US G / Y : 23% in 1960, 35% in 2012) Debate (political more than economic): how should society efficiently use scares resources vs education, infrastructure, transfers After Great Recession unsustainable national debt combined with recession in many countries. ↓G &/or ↑T solve the 1 st but aggravate the 2 nd problem. Cost of Fed’s solving the 2 nd problem was worsening of the 1 st problem. Members of EU do not have independent monetary policy & often forced to ↓G &/or ↑T in order to maintain agreed “ratios”. Low debt-to-GDP allows use of expansionary fiscal policy when monetary policy cannot be used.

Debt in the International Arena Causes of the European “debt crisis” 1.A number of countries had run up very high debt ‐ to ‐ GDP ratios. 2.Banking systems in several countries was greatly over extended following fin crisis that had started the Great Recession. Repayment of loans & investments made before the crisis became uncertain. 3.Markets seemed to have anticipated that national debts were somewhat backed by implicit promises from ECB & larger, stronger economies in Europe, notably Germany. 4.Eurozone countries (EU less UK & Scandinavia) don’t have independent monetary policy. Devalued drachma would lower payments on drachma loans & stimulate NX. To compete Greece forced to lower wages – less attractive than pricier foreign goods.