0. Government Debt CHAPTER FIFTEEN
Chapter 15 is short but fun. Lots of policy & real-world relevance, little theory (a nice breather after the analytically challenging chapters 10-13).

1. In this chapter we will learn about
Various aspects of the debate over the economic effects of government debt
the size of the U.S. government’s debt, and how it compares to that of other countries
problems measuring the budget deficit
the traditional and Ricardian views of the government debt
other perspectives on the debt

2. Indebtedness of the World’s Governments
Country
Gov Debt (% of GDP)
Japan
159
Poland 53
Italy
125
Finland
Greece
108
Norway 52
France 77
Denmark 50
Portugal
Spain 49
Canada 69
U.K 47
Austria
Czech Republic 43
U.S.A.
64 (84.3)
Iceland 32
Netherlands 64
Ireland 30
Hungary 63
Ghana
76 (55)
Table 15-1 on p.432; Source: OECD Economic Outlook
Despite all the alarms sounded by politicians and some economists, the U.S. debt-to-GDP ratio is moderate when compared to other countries.
(Of course, the U.S. has the largest GDP, so in absolute terms are debt is a whopper when compared to other countries’ government debts.)
As at end of 2009 Ghana’s debt to GDP was 55%. USA debt to GDP as at end of 2009 was 84.3%.

3. The U.S. Government Debt-GDP ratio
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0.8
0.6
0.4
0.2
1791
1811
1831
1851
1871
1891
1911
1931
1951
1971
1991
2001
World War II
Revolutionary
War
Civil
War
World War I
With the Reagan tax cuts in the early 1980s, the debt-GDP ratio began its infamous rise. This graph suggests that this recent increase is not so horrible when viewed in the larger context of history.
Nonetheless, the debt ratio was higher in the early 1990s than in any preceding peace-time era (and some wars).

4. The U.S. experience in recent years
2005
Debt-GDP ratio: 64% ($4.7 trillion equals)
Compare this to debt of other countries in Table Japan on top of list
Bottom of list; Luxembourg, Australia
Historically the primary cause of increases in U.S. debt is war
Many economists believe the historical pattern is the appropriate way to run fiscal policy
Deficit financing of wars appears optimal for reasons of
Tax smoothing
Generational equity
Early 1980s through to 1995 (long period of substantial budget deficits)
Debt-GDP ratio: 26% in 1980, 50% in 1995
Due to Reagan tax cuts, increases in defense spending & entitlements
Deep recession attributable to tight MP
The increase in govt. debt in the early 1980s caused significant concern among many policy makers.
First U.S. president raised taxes to reduce the deficit, breaking his “Read my lips: No new taxes” campaign pledge and according to some political commentators, it caused him his reelction.
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5. The U.S. experience in recent years
Early 1990s through 2001
$290b deficit in 1992, $236b surplus in 2000
debt-GDP ratio fell to 33% in 2001 from 50% in 1995
Reduction in budget deficit due to the following
Increase in taxes by President Clinton
Rapid economic growth due to IT boom, stock market boom, tax hikes
Budget deficit increased from 33% to 39% of GDP
The return of huge deficits, due to Bush tax cuts and economic slowdown
High tech boom was reversing course
Economy heading back into recession
Increased spending on homeland security
Wars in Afghanistan and Iraq

6. Defining Government Budget Deficit
1. Budget deficit = govt. spending minus govt. revenue
2. Budget deficit also equals the amount of new debt government must issue to finance its operations
Though definition sounds simple, debates over fiscal policy sometimes arise due to disagreements over how the budget deficit should be measured
Some economists believe the deficit as currently measured does not accurately reflect the stance of fiscal policy
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7. Problems Measuring the Deficit
1. Inflation
2. Capital assets
3. Uncounted liabilities
4. The business cycle
Before we assess whether the debt is a problem, we first consider whether the standard measures of the debt & deficit are accurate. It turns out they are not, for these four reasons.

8. Measurement problem 1: Inflation
It is the least controversial of the measurement issues.
Almost all economists agree that the government indebtedness should be measured in real as opposed to nominal terms.
The measured deficit should equal the change in the government’s real debt, not the change in its nominal debt.
The budget deficit as commonly measured does not correct for inflation.
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9. Measurement problem 1: Inflation
To see why inflation is a problem, suppose the real debt is not changing (i.e. in real terms budget is balanced).
Nominal debt must be rising at the rate of inflation, 
D/D = , where D= stock of govt. debt
or D =  D
The reported deficit (nominal) is  D even though the real deficit is zero.
Hence, we should subtract  D from the reported deficit to correct for inflation.

10. Measurement problem 1: Inflation
Correcting the deficit for inflation can make a huge difference, especially when inflation is high.
Example: In 1979,
nominal deficit (U.S.A) = $28 billion
inflation = 8.6%
govt. debt = $495 billion
 D =  $495b = $43b
real deficit = $28b  $43b = $15b surplus

11. Measurement problem 2: Capital Assets
Currently: deficit = change in debt
Many economists believe that an accurate assessment of government’s budget deficit should include govt. assets as well as its liabilities
They propose better method of calculating deficit: Capital budgeting deficit = (change in debt)  (change in assets)
EX: Suppose govt. sells an office building and uses the proceeds to pay down the debt.
Under current system, deficit would fall
Under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets
Similarly, govt. borrowing to finance the purchase of a capital good would not raise the deficit.

12. Measurement problem 2: Capital Assets
Problem w/ cap budgeting: determining which govt. expenditures count as capital expenditures.
Should the Tema motorway count as an asset of the govt.?
Should the spending on education be treated as expenditure on human capital?
These difficult questions must be answered if the govt. is to adopt a capital budget
Policymakers disagree about whether national governments should use capital budgeting
Critics of capital budgeting argue that though the method is superior in principle, it is difficult to implement .
Proponents of the method argue that even an imperfect treatment of capital assets would be better than ignoring them altogether
Similarly, govt. borrowing to finance the purchase of a capital good would not raise the deficit.
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13. Measurement problem 3: Uncounted liabilities
Current measure of budget deficit omits some important liabilities of the government:
future pension payments owed to current government workers
future Social Security payments
Perhaps accumulated future social security payments should be included in govt. liabilities
contingent liabilities: liability due only if a specifies event occurs. E.g. government guarantees of many forms of credit
Student loans, mortgages for low- and moderate income families, deposits in banks and savings and loans institutions
This contingent liability is not reflected in the budget deficit.
These workers provide labour services to the government today, but part of their compensation is deferred to the future. In essence , these workers are providing a loan to government. Their future pension benefits represent a govt. liability not very difficult from govt. debt.
Yet this liability is not included as part of government debt, and the accumulation of this liability is not included as part of the budget deficit.
According to some estimates, this implicit liability is almost as large as the official govt. debt.
Similarly SSNIT- a pension plan; People pay some of their income into the SSNIT system when working and expect to receive benefits when old
Estimates in the USA suggest govt.’s future social security liabilities are 3 times the govt. debt as officially measured.
Off course one might argue that Social Security liabilities are different from govt. debt because the govt. can change the laws determining Social Security benefits. But promises to pay the holders of govt. debt may not be fundamentally different from promises to pay future recipients of Social Security.
A particularly difficult form of govt. liability to measure is the contingent liability, if the borrower pays the loan govt. pays nothing; govt. makes repayment only in case of default.

14. Measurement problem 4: The business cycle
Many changes in the govt.’s budget deficit occur automatically in response to a fluctuating economy.
Recession means less income hence less personal income taxes
Recession means corporate taxes fall
Recession means more people eligible to government assistance
unemployment insurance
Welfare
Govt. spending rises
Without any changes in laws about govt. taxation and spending (T, G) budget deficit increases

15. Measurement problem 4: The business cycle
The automatic changes in the deficit are not measurement errors, but do make it harder to use govt. budget deficit to monitor changes in fiscal policy.
Deficit can rise or fall due to:
Either change in govt. fiscal policy
Or a change in the economy’s direction
Solution: govt. calculates cyclically adjusted budget deficit (aka “full-employment deficit”)-
based on estimates of what govt. spending & revenues would be if economy were at the natural rates of output & unemployment.
Useful because it reflects policy changes and not the current stage of the business cycle.
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16. The bottom line
To evaluate what fiscal policy is doing, policy makers must look at more than just the measured deficit
We must exercise care when interpreting the reported deficit figures.
No economic statistic is perfect, when we see a number reported in the media, we need to dig behind the numbers to know what is included and what is left out.
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17. Is the govt. debt really a problem?
Two viewpoints:
1. Traditional view
2. Ricardian view

18. The traditional view of a tax cut & corresponding increase in govt
The traditional view of a tax cut & corresponding increase in govt. debt
Short run: We use the IS-LM model Chapters 10-11
Tax cut ,  T, implies expansionary shift in IS curve
If no change in monitory policy, shift in IS curve leads to expansionary shift in AD curve
In the SR when prices are sticky, expansion in AD lead to  Y and  UN
Long run:
Over time prices adjust and economy returns to natural level of output and higher AD leads to higher price level
Y and u back at their natural rates
closed economy: r,  I
open economy: Lower real exchange rates would lead to greater net exports
, NX (or higher trade deficit) where  = real exchange rates and NX = Net exports
Very long run:
slower growth until economy reaches new steady state with lower income per capita
The traditional view is just the viewpoint embodied in the models that studied in chapters 3 through 13 of this textbook. This viewpoint is accepted by most mainstream economists.
When real exchange rate is lower, domestic goods are less expensive relative to foreign goods and net exports are greater
Implication of traditional view on National Savings, Public savings and private savings:
Public savings = difference between taxes and government expenditure, so a debt-financed tax cut reduces public savings by the full amount of the tax reduction.
The tax-cut also increases disposal income.; disposable income = Y –T
According to the traditional view, since the MPC (marginal propensity to consume) lies between 0 and 1 (i.e. it is a positive fraction), both Consumption and savings increase with increase in disposable income.
Because consumption rises, private savings increases by less than the tax cut
National savings is the sum of public and private savings
Because public savings falls by more than the rise in private savings, national savings falls.
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19. The traditional view –effect of a tax cut on savings
Public savings = difference between taxes and government expenditure
= T -G
So a debt-financed tax cut reduces public savings by the full amount of the tax reduction.
According to the traditional view;
Since the MPC (marginal propensity to consume) lies between 0 and 1, both Consumption and Private Savings increase with increase in disposable income.
Because consumption rises, private savings increases by less than the tax cut
National savings is the sum of public and private savings
Because public savings falls by more than the rise in private savings, national savings falls.
Implication of traditional view on National Savings, Public savings and private savings:
Public savings = difference between taxes and government expenditure, so a debt-financed tax cut reduces public savings by the full amount of the tax reduction.
The tax-cut also increases disposal income.; disposable income = Y –T
According to the traditional view, since the MPC (marginal propensity to consume) lies between 0 and 1 (i.e. it is a positive fraction), both Consumption and savings increase with increase in disposable income.
Because consumption rises, private savings increases by less than the tax cut
National savings is the sum of public and private savings
Because public savings falls by more than the rise in private savings, national savings falls.
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20. The Ricardian View
due to David Ricardo (1820), more recently advanced by Robert Barro
According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run.

21. The logic of Ricardian Equivalence
Consumers are forward-looking
They base their spending decisions not only on their current income but also on their expected future income
know that a debt-financed tax cut today implies an increase in future taxes that is equal---in present value---to the tax cut.
Thus, the tax cut does not make consumers better off, so they do not raise consumption.
They save the full tax cut in order to repay the future tax liability.
Result: Private saving rises by the amount public saving falls, leaving national saving unchanged.
Changes in fiscal policy influences consumer spending if they influence present and future govt. purchases
The traditional view of govt. debt presumes that when the govt. cuts taxes and runs a budget deficit, consumers respond to their higher after tax income by spending more.
An alternative view is the Ricardian Equivalence, it questions the traditional view

22. Problems with Ricardian Equivalence
Myopia: Not all consumers think that far ahead, so they see the tax cut as a windfall.
Borrowing constraints: Some consumers are not able to borrow enough to achieve their optimal consumption, and would therefore spend a tax cut.
Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.

23. Evidence against Ricardian Equivalence?
Early 1980s: Huge Reagan tax cuts caused deficit to rise. National saving fell, the real interest rate rose, the exchange rate appreciated, and NX fell.
1992: President George H.W. Bush reduced income tax withholding to stimulate economy.
This merely delayed taxes but didn’t make consumers better off.
Yet, almost half of consumers used part of this extra take-home pay for consumption (43%).

24. Evidence against Ricardian Equivalence?
Proponents of R.E. argue that the Reagan tax cuts did not provide a fair test of R.E.
Consumers may have expected the debt to be repaid with future spending cuts instead of future tax hikes.
Private saving may have fallen for reasons other than the tax cut, such as optimism about the economy.
Because the data is subject to different interpretations, both views of govt debt survive.

25. Other perspectives on govt debt
1. Balanced budgets vs. optimal fiscal policy
Some politicians have proposed amending the U.S. Constitution to require balanced federal govt budget every year.
Many economists reject this proposal, arguing that deficit should be used to
stabilize output & employment
smooth taxes in the face of fluctuating income
redistribute income across generations when appropriate

26. Other perspectives on govt debt
2. Fiscal effects on monetary policy
govt deficits may be financed by printing money
a high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders)
Fortunately:
little evidence that the link between fiscal and monetary policy is important
most governments know the folly of creating inflation
most central banks have (at least some) political independence from fiscal policymakers

27. Other perspectives on govt. debt
3. Debt and politics
“Fiscal policy is not made by angels…” - Greg Mankiw, p.449
Some do not trust policymakers with deficit spending. They argue that
policymakers do not worry about the true costs of their spending, since the burden falls on future taxpayers
future taxpayers cannot participate in the decision process, and their interests may not be taken into account
This is another reason for the proposals for a balanced budget amendment, discussed above.

28. Other perspectives on govt debt
4. International dimensions
Govt budget deficits can lead to trade deficits, which must be financed by borrowing from abroad.
Large govt debt may increase the risk of capital flight, as foreign investors may perceive a greater risk of default.
Large debt may reduce a country’s political clout in international affairs.

29. CASE STUDY: Inflation-indexed Treasury bonds
Staring in 1997, the U.S. Treasury started to issue bonds with returns indexed to the CPI.
Benefits:
Removes inflation risk, the risk that inflation – and hence real interest rate - will turn out different than expected
May encourage private sector to issue inflation-adjusted bonds
Provides a way to infer the expected rate of inflation (difference between indexed and non-indexed bonds) pg 451, sixth edition.
This slide and the next correspond to the case study that closes Chapter 15 (see pp ).
It might be worth taking a moment to help your students understand why inflation risk is an undesirable thing.
It’s also a good idea to help your students understand why we can infer the expected inflation rate from the difference between the yields on standard and inflation-indexed bonds of the same maturity.
A simple example might help:
Suppose the inflation-indexed Treasury bond pays 3 percent after inflation, while a standard Treasury bond with the same maturity pays 5 percent. We can infer that the market expects 2 percent inflation during the term of the bond. If people expected less than two percent inflation, then the non-indexed bond would have a higher real return than the indexed bond, so everyone would try to buy the non-indexed bond. But this would drive up its price, and drive down its return, until the difference between the returns on the two bonds just equals expected inflation.

30. CASE STUDY: Inflation-indexed Treasury bonds
Source of data: FRED database, St. Louis Fed.
The expected inflation rate (red line in the graph) is simply the gap between the blue line (nominal rate) and green line (real rate).
From January 2001 through the end of June 2003, the expected inflation rate ranges from about 1.6 to 2.2%.

31. Chapter summary are not corrected for inflation
1. Relative to GDP, the U.S. government’s debt is moderate compared to other countries
2. Standard figures on the deficit are imperfect measures of fiscal policy because they
are not corrected for inflation
do not account for changes in govt assets
omit some liabilities (e.g. future pension payments to current workers)
do not account for effects of business cycles

32. Chapter summary
3. In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit).
4. The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving, and therefore do not affect interest rates, investment, or net exports.

33. Chapter summary may lead to inflation
5. Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations.
6. Government debt can have other effects:
may lead to inflation
politicians can shift burden of taxes from current to future generations
may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country