1. POLITICS, DEFICITS, AND DEBT Deficits

2. Laugher Curve When Albert Einstein died, he met three New Zealanders in the queue outside the pearly gates. To pass the time, he asked what were their IQs.

3. Laugher Curve The first replied 190. "Wonderful," exclaimed Einstein, "We can discuss the contribution made by Earnest Rutherford to atomic physics and my theory of general relativity.”

4. Laugher Curve The second answered 150. "Good," said Einstein, "I look forward to discussing the role of New Zealand's nuclear-free legislation in the quest for world peace.”

5. Laugher Curve The third New Zealander mumbled 50. Einstein paused, and then asked, "So what is your forecast for the budget deficit next year?"

6. This chapter will: Define the terms deficit, surplus, and debt. Distinguish between a passive deficit and a structural deficit. Differentiate between real and nominal deficits and surpluses. Explain why the debt needs to be judged relative to assets. Describe the historical record for the U.S. deficit and debt. Summarize the current debate about Social Security and Medicare and identify the real problem and the real solution.

7. Introduction In 2005 the U.S. had a large budget deficit (a shortfall of revenues over payments), as it had for the past three years. The current deficits are a substantial change from the surpluses from 1998 to 2001. In the long run, deficits are bad because they reduce saving and growth. Long-run surpluses (excesses of revenues over payments) are good because they provide saving for investment.

8. Introduction In the short run, if the economy is below potential, deficits are good and surpluses are bad because deficits increase expenditures moving output closer to potential. Combining the two frameworks gives the following policy directive: Whenever possible, run surpluses, or at least a balanced budget to help stimulate long-run growth.

9. Expansionary Fiscal Policy Real output Price level P0P0 SAS AD 0 Y0Y0 LAS A AD 1 B P1P1 YPYP If the economy is at equilibrium at point A, there is a recessionary gap Y 0 – Y P. AD increases to AD 1 and output returns to potential output Y P and prices increase slightly to P 1. The appropriate fiscal policy is to increase government spending and/or decrease taxes. A

10. Defining Surpluses and Debt A surplus is an excess of revenues over payments. A deficit is a shortfall of revenues over payments.

11. Financing the Deficit The government finances its deficit by selling bonds to private individuals and to the central bank. Bonds – promises to pay back the money in the future.

12. Financing the Deficit A central bank is able to print money to buy its government’s bonds. Potentially, the central bank can print an unlimited amount of money to buy bonds. Printing too much money means inflation which can have a negative effect on the economy.

13. Arbitrariness in Defining Surpluses and Deficits Whether a nation has a deficit depends on what is included as a revenue and what is included as an expenditure. This accounting issue is central to the debate about whether we should be concerned about a deficit.

14. Arbitrariness in Defining Surpluses and Deficits How the Social Security system is accounted for plays an important role in the size of the budget deficit. Social Security System - a social insurance program that provides financial benefits to the elderly and disabled and to their eligible dependents and/or survivors.

15. Many Right Definitions There are many ways to measure expenditures and receipts. There are many ways to measure deficits and surpluses. All definitions are not necessarily correct.

16. Deficits and Surpluses as Summary Measures Deficits and surplus figures are simply summary measures of the financial health of the economy. To understand the summary, you must understand the methods that were used to calculate it.

17. Deficits and Surpluses as Summary Measures What is important is not whether a budget is in surplus or deficit; what is important is the economic health of the economy.

18. Structural and Passive Surpluses and Deficits Not all government expenditures are independent of the level of income in the economy. The budget deficit could result from policies designed to affect the economy or from income deviating from its potential.

19. Structural and Passive Surpluses and Deficits A structural deficit or surplus – the part of the budget deficit or surplus that would exist even if the economy were at its potential level of income.

20. Structural and Passive Surpluses and Deficits A passive deficit or surplus is the part of the deficit or surplus that exists because the economy is operating below or above its potential level of output.

21. Structural and Passive Surpluses and Deficits When an economy is operating above its potential, it has a passive surplus. If the economy is operating below its potential, the actual deficit would be larger than the structural deficit.

22. Structural and Passive Surpluses and Deficits There is a significant debate about what is an economy’s potential income level. There is disagreement about what percentage of a deficit is structural and what part is passive.

23. Actual deficit = structural deficit + passive deficit Passive deficit = tax rate x (potential output – actual output) Structural deficit = actual deficit – passive deficit Structural and Passive Deficits

24. Budget Deficits and Surpluses: Actual, Passive, and Structural (–) Deficit or (+) Surplus 19801990200020012002 Passive -61-100+137+47-5 Plus structural-13-121+99+80-153 Equals actual-74-221+236+127-158