2. Fiscal Stimulus and the Deficit
A fiscal stimulus package is designed to move the economy out of recession toward full-employment GDP.
Tax cuts or increased government spending, or a combination of the two, increases the size of the budget deficit.
Borrowed funds to finance the stimulus must be paid for in the future by increased taxes or reduced spending, both fiscal restraint tools.
In this chapter the cold hard facts of “we must pay for our spending” come to light.
This previously ignored part of Keynesian economics became a major point of controversy in 2011.

3. Learning Objectives
Know the origins of cyclical and structural debt.
Know how the national debt has accumulated.
Know how and when “crowding out” occurs.
Know what the real burden of the national debt is.
These are the points on which we will base our chapter review.

4. Budget Effects of Fiscal Policy
Using fiscal policy to solve macro problems implies that federal expenditures and federal receipts won’t always be equal.
In fiscal stimulus, G increases or T decreases.
In fiscal restraint, G decreases or T increases.
Budget deficit: amount by which G exceeds T in a given time period.
The concern about budget deficits was brought to Keynes himself.
They told him, “In the long run, they will have to be paid down.”
He dismissed the problem by saying, “In the long run we are all dead.”
Budget deficit = Government spending – Tax revenues > 0

5. Keynes’s View on Budget Deficits
Budget deficits are a routine by-product of fiscal policy, caused by a fiscal stimulus to increase AD.
The goal of macro policy is not to balance the budget but to move the economy to full-employment GDP.
Keynes: Full employment first, then worry about the deficit.
Keynes posited that in good economic times, the government should run a budget surplus and pay off the deficits that were run up in bad economic times. This part of Keynes’s prescription was never incorporated into Keynesian theory.

6. Discretionary vs. Automatic Spending
Discretionary spending: those elements of the budget not determined by past legislative or executive commitments.
Automatic spending: those elements of the budget that are a result of decisions made in prior years; said to be “uncontrollable.”
Make up of the budget:
Automatic (uncontrollable): about 80 percent.
Discretionary (controllable ): about 20 percent.
Most federal government spending has been set up in the past and must be funded. This spending is “automatic.” Until 2011, talk of cutting this spending was taboo in political circles. As for discretionary spending, it is authorized for the coming budget year by the current Congress.

7. Uncontrollable?
The president and Congress can repudiate prior commitments and enact new legislation.
Reduce Social Security benefits.
Refuse to pay interest on the accumulated debt.
Terminate projects approved in prior years.
Reduce payouts for other social welfare programs.
They would face political consequences in doing so.
Discussions of doing this was the “political third rail” for decades. Bring any of this up and your political career is over.
In 2011, however, proposed modifications to many of these commitments surfaced in political discussion about how to deal with deficits and the debt.

8. Automatic Stabilizers
Automatic stabilizer: federal expenditure or revenue item that automatically responds countercyclically to changes in national income (GDP).
As a recession begins, unemployment compensation and welfare payments increase and income tax collections decrease, each stimulating economic growth in a small way.
As economic growth returns, the opposite happens, which puts a small restraint on economic growth.
“Countercyclical” means that when AD is shifting left, these activities automatically go into effect and nudge AD back to the right.
Also, when AD is shifting right, the cessation of these activities automatically nudges AD back left. So they act as a brake on the speed of the AD shift.

9. Cyclical Deficits
Cyclical deficit: that portion of the budget deficit attributable to short-run changes in economic conditions.
The cyclical deficit
Widens when GDP growth slows or inflation increases.
Shrinks when GDP growth accelerates or inflation decreases.
As the economy slows
Tax revenues decline.
Unemployment benefits rise.
Other transfer payments rise.
As the economy grows
Tax revenues rise.
Unemployment benefits fall.
Other transfer payments fall.
Interest rates could rise, increasing debt payments.
Two types of deficits are described here and on the next slide.
Cyclical means the deficit grows as we go into recession and declines when we come out of recovery.
Structural: next slide.

10. Structural Deficits
Structural deficit: federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy.
The structural deficit reflects fiscal policy decisions – that is, discretionary fiscal policy.
Therefore, part of the deficit arises from cyclical changes in the economy; the rest is a result of discretionary fiscal policy.
Structural means Congress created the deficit by drawing up, passing, and implementing fiscal policy.

11. Who Is to “Blame” for Deficit Increases?
The impact of cyclical components (automatic stabilizers) and policy initiatives affect the budget at the same time.
According to the CBO, in 2009 the trillion- dollar budget deficit increase was due in part to the recession ($278 billion) and the rest to discretionary fiscal policy ($675 billion).
We can therefore point fingers at who is to blame for the huge deficits: the recession or Congress.

12. Measuring the Impact of Fiscal Policy
We must focus on changes in the structural deficit, not the total deficit.
Fiscal stimulus is measured by an increase in the structural deficit (or shrinkage in the structural surplus).
Fiscal restraint is measured by a decrease in the structural deficit (or increase in the structural surplus).
Fiscal policy is connected to the structural deficit.

13. Economic Effects of Deficits
Crowding out can occur, especially as the economy closes in on full employment.
Increased government borrowing to finance a growing deficit reduces the availability of funds for private sector spending.
Thus any increase in government expenditures will be offset by reductions in consumption and investment spending.
Tax cuts will increase consumer spending, but near full employment may force cutbacks in investment or government services.
Crowding out was previously discussed.

14. Economic Effects of Deficits
Interest rate movements:
An increase in demand for funds will cause the price of borrowing – the interest rate – to rise.
Rising interest rates make it more costly for consumers or businesses to borrow, and they may cut back.
Rising interest rates also increase the borrowing costs of government, leaving less room in government budgets for financing new projects.
The competition for available funds increases demand for them, and thus the price of borrowing – the interest rate – rises.
This competition has not been a problem in that much of government’s borrowing has come from overseas funds.
However, if government borrowing becomes more risky, overseas lenders may not wish to lend to the government unless they get a higher interest rate to accommodate for the added risk. If the government must fall back on domestic funds only, then crowding out can become a problem.

15. Economic Effects of Surpluses
If the government runs a surplus – that is, tax revenues are greater than government expenditure - it is a leakage to the circular flow. It is a drag on the economy.
Potential uses for a budget surplus:
Spend it on goods and services.
Cut taxes.
Increase income transfers.
Pay off old debt (“save it”).
Keynes wanted surpluses to pay off the deficits. But as you can see, surpluses cause problems, too.
The reason surpluses in the past failed to pay down any debt is that Congress found new ways to spend the money, not save it or pay down the debt.

16. Economic Effects of Surpluses
Spending a surplus increases the size of the public sector.
Cutting taxes or increasing income transfers puts money in the peoples’ hands and enlarges the private sector.
Paying off some accumulated debt puts money in the hands of the debt holders:
They buy more goods and services.
Expands the private sector.
Lowers the demand for funds and the interest rates.
Here rises the controversy: Which is better? Bigger government or private sector as the driving mechanism?

17. The Accumulation of Debt
The national debt is the accumulation of many more years of running budget deficits than budget surpluses.
The U.S. Treasury borrows by issuing Treasury bonds to lenders who want a safe investment paying out interest.
When there is a deficit, the national debt increases.
When there is a surplus, the national debt can be pared down.
This shows the ABCs of the deficits and the debt.
U.S. debt has been considered the safest investment for funds in the world.

18. The National Debt In 2011 the national debt was nearing $15 trillion.
That is an average of more than $50,000 for every U.S. citizen.
A better indicator is the debt-to-GDP ratio.
Except for the Civil War, this ratio was about 10 percent from 1790 to 1917.
During World War II, it rose to 130 percent.
In 2000 it was about 35 percent.
By 2012 it will rise above 100 percent.
Your students might wish to comment on the size of the figures on the slide.
You can link to the debt clock at and to the debt-to-GDP graph at

19. Who Owns the Debt?
The national debt creates as much wealth for bondholders as it does liabilities for the U.S. Treasury.
Who are the bondholders (owners)?
Federal agencies (such as the Federal Reserve and the Social Security Administration) hold 40 percent of all outstanding Treasury bonds.
State and local governments hold 5 percent.
The private sector holds 24 percent.
Foreigners hold 31 percent.
It usually comes as a surprise to students how much of the U.S. debt is owned by federal agencies.
Also, the fact that foreigners own 31% might generate a vivid discussion.

20. Why Hold U.S. Government Debt?
Relative to other investments:
They are safe.
There is no question of the debt being repaid.
They pay interest.
Dollar-denominated assets are generally acceptable in world trade.
Some of the discussions in 2011 brought up the validity of the second point.
If there is a question of the debt being repaid (or if there exists a possibility of interest payments not being made), then bond rating agencies will downgrade the U.S. debt. If that happens, lenders will demand higher interest rates to compensate them for taking higher risk.

21. The Burden of the Debt
Refinancing: the issuance of new debt in payment of debt issued earlier.
When a Treasury bond matures, new funds are borrowed to pay it off.
So the debt remains debt. There is no addition to the debt. Only another deficit adds to the debt.
This is called “rolling over the debt.” It is the typical way maturing bonds are paid off. Borrow more to pay off the bond just maturing.
The major problem with this occurs when interest rates are increasing. Then the new bond pays out higher interest than the maturing bond, and the costs of debt service rise.

22. The Burden of the Debt
Debt service: the interest required to be paid each year on outstanding debt.
Increased interest payments use up funds that cannot be used for other government expenditures.
Debt servicing is a redistribution of income from taxpayers to bondholders.
If interest rates rise (either because of market-based reasons or because the U.S. debt is downgraded in quality), debt servicing becomes an ever-larger expenditure in the federal budget.

23. The Burden of the Debt Opportunity cost:
The true burden of the debt is the opportunity cost of the activities financed by the debt.
Funds spent on government expenditures cannot be used for other (public or private) expenditures.
Resources consumed by a government expenditure cannot be used to produce other goods and services.
The value placed on these forgone goods and services is the opportunity cost, however financed.
Again rises the major discussion of the decade: Who can do it better? The government or the private sector?
Do we tax more or borrow from the private sector to fund government projects? Or do we let the private sector use those resources to fund private sector projects?

24. The Real Trade-Offs
Deficit spending changes the mix of output in the direction of more public sector goods.
The burden of the debt is really the opportunity cost (crowding out) of deficit-financed government activity.
An increase in public sector goods means a decrease in private sector goods. You could have your students draw this in a PPC diagram.

25. The Debt and Economic Growth
If deficit-financed government spending crowds out private investment, future generations will bear some of the debt burden.
We will have smaller-than-anticipated productive capacity.
There will be some question about achieving an optimal mix of output.
The public sector grows at the expense of the private sector.
Reduced private investment (in capital goods) with no offsetting increased public sector investment (in capital goods) means the PPC does not grow outward as fast as it could.
In other words, economic growth is slowed.

26. Repayment
If the U.S. Treasury pays off maturing bonds with taxes, it is a redistribution of income from taxpayers to bondholders.
The heirs of current bondholders receive the payout.
The taxpayers in the future are hit with the taxes to pay off the maturing bonds.
A mind exercise: What if we paid off all government debt with a onetime increase in taxes?
It would take 100% of a year’s earnings to do so. It would be a massive transfer of funds from earners and taxpayers to bondholders.
Even worse, the bondholders prefer holding the bonds. They voluntarily bought them as a safe investment. If they wanted the cash, they could sell them at any time in the bond market, but they don’t.

27. External Debt Borrowing from foreigners eliminates crowding out.
We get more public sector goods without cutting back on private sector production.
Foreigners get the dollars by selling us more imports than they buy of our exports.
We can consume an amount greater than the domestic-only PPC would allow us to consume.
As long as foreigners are willing to hold U.S. debt, external financing imposes no real cost.
At times, foreign bondholders grumble and say they’re going to sell all of the U.S. bonds and invest elsewhere.
Say they did put all their bonds on the market. That’s a massive increase in the supply of bonds.
The price of bonds would drop precipitously. The sellers would take a huge loss on the sale. Therefore, they won’t do that.

28. External Debt
If foreigners no longer want to hold U.S. debt, they will sell their bonds and hold dollars, which they can use to buy dollar-denominated goods and services, mainly U.S. exports.
External debt will be repaid with exports of real goods and services.
If they sell their bonds, they have dollars. They would either spend them or save them – that is, buy dollar-denominated goods or invest in dollar-denominated assets. Or they could convert them to another currency, again at a big loss in value. They won’t do that.

29. Deficit and Debt Limits
The only way to stop the growth of the debt is to eliminate budget deficits.
One way is to balance the budget (G = T).
A gradual way is to impose a debt ceiling that is decreased each year until it reaches zero.
Debt ceiling: an explicit, legislated limit on the amount of outstanding national debt.
This leads to compromises on how best to use budget deficits.
Usually, when the debt ceiling is reached, Congress simply increases it.
You could start a discussion on the merits and demerits of a balanced budget amendment.
Every time Congress has raised the debt ceiling in the past, Congress increases its spending (and thus the deficit) so that the amount of newly available borrowing is used up almost immediately.