Chapter 12 Part 2 National Debt: Myths and Realities 1

Long Run: Deficits and the National Debt Budget deficit (G>T) – when government purchases exceed net tax revenue Consequences of budget deficit – raising interest rates (Loanable funds) – crowding out consumption and investment spending – an increase in the government’s debt 2

Long-run: Deficits and the National Debt National debt is the total amount the federal government still owes to the general public from past borrowing Budget-related figures such as government outlays, tax revenues, or government debt – should be considered relative to a nation’s total income - as percentages of GDP 3

Long-run: Deficits and the National Debt What are Government outlays? – total disbursements by the government for: Government purchases Transfer payments Interest on the national debt Budget surplus = Tax revenue > Outlays Budget deficit = Tax revenue < Outlays 4

Federal Outlays and Revenue, 1965–2025 5

Budget Surplus or Deficit, 1959– Deficits increase during recessions and decrease during expansions

Deficits and the National Debt In a recession – budget deficit automatically increases – transfers rise and tax revenue falls (or the budget surplus decreases) In an expansion – budget deficit automatically decreases –transfers decrease and tax revenue rises (or the budget surplus increases) Because of the automatic-stabilizers we discussed in chapter 11 7

Deficits and the National Debt Budget deficits need to be financed – increase the public’s bond holdings –increase the national debt Budget surpluses – decrease the public’s bond holdings – decrease the national debt Debt ratio – publicly held national debt as a percentage of GDP 8

9 The U.S. Debt Ratio ( ) Reagan Clinton Obama Debt as a percentage of GDP soared during World War II, then fell steadily for several decades. It rose during the 1980s, fell in the 1990s, and then surged from 2009–2011 due to recession and fiscal stimulus policies.

National Debt The total national debt – In 2014, it was approaching $18 trillion – Amount the government owed to the public (~$13 trillion) This has a macroeconomic impact – Amount that one government agency owed to another ($5 trillion) No macroeconomic impact at all mspd/2014/opds pdf mspd/2014/opds pdf 10

A mythical concern about the national debt “One day we’ll have to pay it all back” Don’t have to as long as the nation’s total income (GDP) is rising –The government can safely take on more debt as long as national income grows and tax receipts can cover additional interest payments 11

The Burden of the Debt? The interest payments the government owes and the taxes it must collect to pay that interest. – its measured as the annual interest on the national debt as a percentage of annual GDP – can also be defined as the tax rate (taxes as a percentage of GDP) needed to pay interest on the debt 12

13 Source: Congressional Budget Office.

Why is this a Burden ? Higher tax rates needed to pay interest on the national debt are a burden: – they lead to slower economic growth – they transfer purchasing power to other countries 14

Major Foreign Holders of U.S. Federal Debt, July © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

National Debt: Myths and Realities Can a country’s debt keep rising without imposing any added burden? – yes, as long as the country follows the basic debt guideline Basic debt guideline – total nominal debt should grow no faster than nominal GDP – for example, if NGDP rises by 10% per year, debt should rise by no more than 10% per year. 16

A Growing National Debt with a Constant Debt Burden: GDP and Debt grow at 10% 17 In this example, the government must collect taxes equal to 4% of GDP to pay the interest on the debt

National Debt: Myths and Realities The debt ratio will remain constant as long as the debt grows by the same percentage as nominal GDP The burden of the debt will remain constant if the interest rate doesn’t change NOTE: in this example, the debt grows each year which means the government is continually running a budget deficit 18

Genuine Concern #1: A rising debt burden Allowing debt to grow faster than GDP violates of the basic guideline requires higher and higher tax rates cannot go on forever, because: –100% upper limit, and –Will reduce potential GDP (would you work more or invest in human capital if 90% of your income was taxed?) 19

A Growing National Debt with a Rising Debt Burden: Debt Grows Faster Than GDP: 20% vs. 10% 20

Genuine Concern #1: A rising debt burden Even if the rise in the burden of the debt is temporary, It can create a permanently higher burden, meaning permanently higher taxes 21

A Growing National Debt with a Rising Debt Burden: Debt Grows Faster Than GDP for 3 years. 22 Year 5 $14641 billion $9504 billion 65.0% $760.3 billion 5.2%

How to bring debt burden down after a temporary violation of the guideline 1.Raise the growth rate of nominal GDP above the growth rate of the debt for some time Need to be aware of inflation. Remember in the LR, ability to affect RGDP is limited. With inflation comes inflationary expectation which increases the nominal interest rate. Interest cost on the debt will increase. 23

How to bring debt burden down after a temporary violation of the guideline 2.Lower the growth rate of the debt below the growth rate of nominal GDP for some time which means reduce the deficit which in turn means cut G or increase T Austerity! 24

National Debt: Myths and Realities Genuine Concern #2: A debt disaster – if debt were to rise too rapidly relative to GDP, for too long there is a danger of reaching the nation’s credit limit This is a debt ratio that would make lenders worry about the government’s ability to continue paying interest 25

National Debt: Myths and Realities A small increase in the debt ratio would lead to a cutoff of further lending or very high interest rates The budget would have to be balanced immediately. Fiscal austerity - Significant and sudden drop in government outlays and/or a significant rise in tax rates and cuts in transfer payments 26

National Debt: Myths and Realities When a nation hits its credit limit – it is forced to choose among extremely unpleasant options Each option is likely to impose more economic pain than the country would have faced if it had reduced its debt ratio earlier and more gradually, and not reached its credit limit in the first place 27

National Debt: Myths and Realities Default as an option Simply refuse to repay debt This would reduce the government’s debt and debt ratio But creates a great deal of economic pain – Devastating the wealth of households and businesses that held government bonds Could collapse a country’s own financial system, as well as the systems of other countries that hold its bonds 28

National Debt: Myths and Realities How high can a country’s debt ratio go before it hits its credit limit? –There is no hard and fast rule A country’s credit limit is determined by – Its current debt ratio – Its reputation for honoring its obligations in the past – The likely change in its debt ratio in the near and distant future 29

Case Study: Greece By the early 2000s – after years of spending more than it collected in taxes, Greek government debt was about equal to its annual GDP debt ratio of 100% Up to 2008 Greece was not yet at its credit limit – lenders still lending 30

Greece’s Debt Disaster 31 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Greece’s Debt Disaster In 2008, Europe fell into recession – Greece was particularly hard hit – GDP fell and budget deficits rose – Rapidly rising debt ratio from its already high level Bumping up against its credit limit lenders charged higher interest rates 32

Greece’s Debt Disaster 33 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Greece’s Debt Disaster The vicious cycle began – higher interest rates demanded by lenders added to Greece’s deficit – causing its debt to rise even more rapidly – escalating fears of default – interest rate rose even higher Greece was in the midst of a debt disaster 34

Case Study: Greece Was there a solution? – One option was to print money: – Oops, not an option Gave up control of the money supply when joined the European Monetary Union – A second option was to leave the Eurozone Give up important long-run benefits 35

Case Study: Greece Was there a solution? – A third option was to default If too small, it wouldn’t help much If too large, Greece might be cut off from all further borrowing Threatened financial systems: Europe Lenders would worry that other European countries might default next –Fear that Spain, Italy, Portugal, and Ireland might default next (PIIGS) 36

Case Study: Greece In 2010 and 2011 European governments and international organizations were scrambling to prevent a Greek default Agreed to lend Greece billions of euros at lower interest rates Demanded fiscal austerity from Greece – Higher taxes and government spending cuts 37

The U.S. Long-Term Debt Problem In 2011, the U.S. debt ratio: 72% – The problem: debt ratio projected to rise over the next couple of decades Why? U.S. government’s promises: –Social security benefits when people retire to fund health care for the elderly and the poor Medicare, Medicaid, and related programs 38

The U.S. Long-Term Debt Problem Rising social security and health care payments – aging population, using more health care – new and evermore expensive technologies and procedures – increased from 4% to 10% of GDP from 1971 to 2011 – projected: increase to 17% of GDP by

The U.S. Debt Ratio: Past and Projected 40 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The U.S. Long-Term Debt Problem Rapid debt growth is a looming danger that must be solved by shrinking projected future budget deficits - G ↓ or T ↑ S hrinking deficits too soon, before the economy has sufficiently recovered from its long slump Deepen and prolong the economic slump Or propel the economy into another recession 41