2013 -- lecture summary for Chapter 16

Federal budget deficit and the national debt.

Definitions:

The budget deficit (federal expenditure minus federal revenue) is what the federal government borrows (by selling securities, bonds etc) each year; it is a flow concept. The government borrows by having the Treasury sell bonds to the public; this has no effect on the money supply.

The national debt is what the government owes in total, i.e. the accumulated deficits of the federal government, or the total value of outstanding government bonds and other securities. It is a stock concept.

The net federal debt is what the federal government owes other than to itself -- much of the total debt is held by various agencies of the federal government, e.g. social security trust funds.

The "monetized debt" is the federal debt owned by the Federal Reserve System, i.e. the Central Bank, and therefore the assets backing "high-powered money," currency and commercial bank reserves (deposits with the fed), which are liabilities to the Fed. The Fed is not allowed to buy bonds directly from the Treasury; but if the Treasury sells bonds to the public, and then the Fed buys them from the public, that part of the debt has been monetized.

[Numbers on these things are in the textbook; net debt as a percentage of GDP (the relevant measurement) was highest this century in 1945 (about 127%), fell to a low (about 20%) around 1973, and has risen since to over 40%. The deficit as a percentage of GDP is currently less than zero, i.e. there is a small surplus; it has declined from below 3% when the textbook was published. Obviously, right now the deficit as a percent of GDP is less than the growth rate of GDP, which means debt as a percentage of GDP is falling again.

Effects of Debt on the economy:

1) If the debt is held externally, i.e. by foreigners:

When foreigners acquire the debt, i.e. we borrow from them, then borrowing can pay for imports greater than current exports, so the economy has more real resources available to it at the time of the borrowing, so potentially there could be more capital investment;

However, servicing (paying interest, repaying principal) debt owned by foreigners has a real cost to the economy, because that gives foreigners claims on our economy (i.e. exports will have to be larger than imports, or foreigners acquire US assets). Thus if foreign borrowing is used to finance consumption, not investment, that will mean fewer resources available to US residents in the future.

2) If the debt is held internally, i.e. by US residents:

There is no increase in resources available to the economy as a whole -- the borrowing just transfers purchasing power from one group (those who buy government bonds) to another (the Federal government). Similarly, when internally-held debt is serviced, the service is also a transfer (from tax payers to holders of debt), which does not reduce total resources available to the economy except to the extent (1) that there are resource and deadweight (efficiency loss) costs of higher taxes and (2) there is any effect on capital formation, i.e. investment.

Effects on investment of government borrowing:

"Traditional view": Borrowing reduces capital formation because (1) drives up interest rate reducing investment ["crowding out"] and (2) government bonds are seen as wealth, and therefore owning more government bonds tends to increase consumption (the public feels richer than they really are, because they view bonds as wealth but the bonds do not represent real capital stock). Effect of borrowing on interest rate is reduced by inflow of foreign funds, but this implies foreign acquisition of US assets which implies future real cost.

"New Classical view": Because government borrowing will have to be serviced, i.e. more government borrowing now implies higher taxation in the future to service it, the (negative) present value of future taxes to service the borrowing offsets the value of the bonds to their owners and the net impact on investment is zero, because the public save more in order to be able to pay the higher future taxes. Hence effect of government spending on private investment is the same whether the spending is financed by taxes or borrowing ("Ricardian equivalence").

Empirical evidence is mixed and subject to differing interpretations. Very few people believe in complete Ricardian equivalence, but it is also unlikely that there is complete crowding out.

The interest cost of servicing the debt has been increasing (see numbers in text book); such increase cannot continue for ever, but in fact it is now falling again because the debt has ceased to grow and interest rates have been declining. However, note that the proportion of US federal debt held by foreigners is relatively low; and the size of total federal debt, and of interest payments on that debt, compared to GDP, is also relatively low compared to other high-income industrialized countries (e.g. Canada). Again, there are numbers in the text book.

Remember, the federal debt never has to be repaid; when the bonds fall due, the government can just sell new ones to raise the money to pay off the old ones. This is called "rolling over" or refinancing the debt, and the government is doing it all the time (in part to try to minimize interest costs). So long as the US and its federal government continues in being, there is no reason why the debt ever has to be paid off.

Is the size of the US federal debt exaggerated?

Probably it is, for three reasons:

(1) State and local governments tend to run surpluses, so that the total debt of the whole government sector is smaller than that of the federal government alone. [State and local governments typically are acquiring assets net, because pensions for their workers must be "funded" and because of population growth their pension funds are growing. Federal pensions are not "funded," they are paid from current revenue].

(2) By convention, the US Federal government does not separate recurrent expenditure from capital expenditure, although some government spending clearly finances capital accumulation (e.g. building highways). The capital stock acquired from government spending to some extent offsets the debt, but conventional US accounting does not recognize the existence of any real US assets. [Note: This is a US idiosyncrasy; most countries do recognize capital and recurrent expenditures separately, and some (e.g. New Zealand) even require all government entities to prepare asset and liability statements as well as revenue and expenditure accounts].

(3) Inflation distorts the measurement of the size of borrowing, the interest cost of debt, and the debt itself. Inflation reduces the real value of the outstanding debt [because it is expressed in dollars, and inflation means the purchasing power of the dollar is falling], but exaggerates the servicing cost of the debt [because nominal interest rate = real rate plus inflation; in an inflationary period, part of the interest cost is really early repayment of principal]. Of course, unanticipated inflation [reducing the price (because nominal interest rates increase) and the real value of existing bonds] transfers wealth from bondholders to taxpayers.

Does a deficit implies inflation? Only if either (1) it implies excess aggregate demand (intersection of AD and SRAS to the right of LRAS) or (2) it is monetized. Neither is very likely to be a big problem in the US. [Although it can and has been in other countries, e.g. Russia, Ukraine, Serbia right now].