Macroeconomics

Unit 12

Deficits, Surpluses, Debt

Top Five Concepts

Introduction

In this unit we discuss the federal budget process and common budgetary problems.

Does the amount of the federal deficit cause a problem with other sectors of our economy?

Should we have a balanced federal budget? All the time or just when our economy is at full employment?

Concept 1: Budget Surpluses and Deficits

A budget deficit is the amount by which government spending exceeds government revenue in a given time period.

Deficit spending is the use of borrowed funds to finance federal government expenditures that exceed tax revenues.

A budget surplus is an excess of government revenues over government expenditures in a given time period.

Are Budget Deficits Bad?

According to Keynes, the goal of macro policy is to balance the economy at full employment.

A budget deficit that is used to shift aggregate demand towards full employment is acceptable according to Keynes.

Keynes believed that a balanced budget is appropriate only if leakages and injections are in balance and the economy is at full employment equilibrium.

Concept 2: Discretionary & Automatic Spending

The size and scope of the federal budget makes it difficult to control. Because of prior spending commitments, it is difficult to reduce spending in any given year.

The expenditures in the current budget are 80% uncontrollable; they are based upon prior years decisions.

The remaining 20% of the budget is for discretionary fiscal spending. Simply put, only 20% of the budget is “up for grabs” in any given year.

Concept 2: Discretionary & Automatic Spending

Discretionary fiscal spending consists of those elements of the federal budget not determined by past legislative or executive commitments.

Because discretionary spending is only 20% of the budget, changes in spending policy are smaller than possibly desired because of prior commitments.

Many of the uncontrollable expenditures in the federal budget increase or decrease based upon economic conditions.

Concept 2: Discretionary & Automatic Spending

Automatic stabilizers are federal expenditure or revenue items that automatically respond counter cyclically to changes in national income.

Unemployment benefits and income taxes are examples of automatic stabilizers.

Unemployment benefits paid increase as the economy heads into a recession or economic slowdown. They act as an injection. Income tax collections decline in economic slowdowns and increase during growth.

Concept 3: Deficit Types

It should be obvious that the size of the federal deficit is affected by economic expansion or contraction, as well as politics.

Cyclical deficits are that portion of the budget balance attributable to short-run changes in economic conditions.

For example, as unemployment increases, the dollar amount of unemployment benefits paid increases, causing a cyclical deficit.

Concept 3: Deficit Types

Deficits can also occur as a result of policy decisions.

If the economy is at full employment and deficits continue to exist, they exist as a result of discretionary fiscal policy decisions. Excessive spending may be due to war or other external factors, or the inability of elected officials to reduce spending.

Structural deficits occur when federal revenues at full employment are less than federal expenditures at full employment. The federal government is spending more than it is receiving in tax revenue.

Concept 3: Deficit Types

If a structural deficit exists when the economy is at full employment, the likely causes include:

• Excessive federal spending.

• Lower tax rates.

Discretionary fiscal restraint or increased taxes can eliminate structural deficits. The federal government needs to spend less money or raise taxes to cover the current level of spending if a balanced budget is desired.

Concept 3: Deficit Types

Fiscal stimulus (the increase in budget expenditures or decrease in tax revenues) is measured by the increase in the structural deficit (or shrinkage in the structural surplus). In recessionary periods, the structural deficit should be increasing.

Fiscal restraint is measured by the decrease in the structural deficit (or increase in the structural surplus). During times of full employment, the structural surplus should be increasing and/or no structural deficit should exist.

Economic Effects of Deficits

To finance deficits, the government needs to borrow more money from the private sector.

The federal government sells government securities like treasury bills to finance spending.

Because federal government securities are an attractive investment and very secure, the government securities can “crowd out” some of the private securities being sold (bonds from GE, etc.).

Economic Effects of Deficits

Crowding Out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing.

If the government increases its borrowing, private companies may not be able to offer securities for sale. The interest rates necessary to make private investment attractive may be too costly for business. Private investment is then reduced.

Therefore the increase in government spending financed by securities has a lesser effect on economic expansion since private investment and consumption may be reduced.

Economic Effects of Surpluses

Budget surpluses, although rare in recent years, are a unique situation.

The surplus can be:

• Spent by the government on goods and services.

• Given back to the public as a tax cut.

• Used to increase income transfers.

• Used to pay off old debt (the national debt).

If the last option is chosen, crowding in occurs.

Economic Effects of Surpluses

Crowding In is an increase in private-sector borrowing (and spending) caused by decreased government borrowing.

The economic effects of crowding in cause increased borrowing by business to expand investment and increased output.

Less government borrowing also reduces interest rates.

Federal Government Debt

For each year that deficit spending occurs, the annual amount of the deficit is added to the federal government’s total debt.

National debt refers to the total accumulated debt of the federal government from deficit spending.

Most of the federal government debt is in the form of Treasury bonds, bills and Savings bonds.

The level of debt has varied historically.

Concept 4: Issues with the National DebtApproximately 50% of the debt is held by federal agencies like the Federal Reserve and state and local governments.

About 80% of the national debt is internal debt. Internal debt is U.S. government debt that is held by U.S. households and institutions. The remaining 20% is held by foreign governments, institutions, and households. This is external debt.

More information on the national debt can be found at http://www.treasurydirect.gov/govt/govt.htm

National Debt Costs

Interest payments made on the debt use funds that could be used by other programs.

There are opportunity costs associated with the debt. Did deficit spending produce more desired results than having a reduced amount of national debt? The opportunity costs associated with deficit spending tend to be limited to the year in which they occurred.

External debt does not crowd out private-sector borrowing (to some extent), and investment.

Concept 5: Limits on the Debt

Limitations are placed on annual deficits and the national debt.

A deficit ceiling is an explicit, legislated limitation on the size of the budget deficit. A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt.

If you want to reduce the national debt you must first eliminate deficits.

Future Problems – Federal Budget

Will Congress and the President be able to exercise fiscal restraint in the future?

Will deficits be only permitted in times of recession or war?

Should taxes be increased or decreased?

Should the federal government stop spending the Social Security surplus on other programs?

Is government supposed to help companies and individuals during times of economic stress or loss? If so, for how long?

Summary• Deficit spending.• Budget surplus and deficit.• Discretionary spending.• Fiscal restraint and stimulus.• Automatic stabilizers.• Cyclical and structural deficits.• Crowding In and Crowding Out.• National debt; internal and external debt.• Opportunity cost of debt.• Debt and deficit ceilings