Fiscal Policy and Government Debt: Lessons from History and the Global Economic Crisis

1. Chapter 6 The Government Budget, theGovernment Debt, and the Limitations of Fiscal Policy

2. Key Questions Can fiscal policy rescue monetary policy from ineffectiveness? What are the side effects of running a large budget deficit? Why did the Great Depression last over a decade (from 1929 to 1941)? What are the lessons to be learned for applying fiscal policy to the Global Economic Crisis?

3. The Recent Government Budget Deficit 1998-2001: The U.S. ran a rare budget surplus, but subsequently reverted back to running deficits. Why? 2001-03: Political philosophy that favored tax cuts  T↓ Partially in response to 9/11 attacks  Military spending↑ 2008: The Global Economic Crisis  T↓ while Tr↑ 2008-10: Large fiscal stimulus package  T↓, Tr↑ and G↑

4. Effects of a Budget Deficit Recall the “Magic Equation” from Chapter 2: T – G = (I + NX) – S The Magic Equation suggests 3 ways to finance a budget deficit (i.e. T – G < 0) Private saving (S) can go up Investment (I) can fall Foreign investment (NX) can fall Because an increase in the budget deficit increases the total public debt, persistent budget deficits can lead to higher taxes in the future.

5. Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (1 of 2)

6. Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (2 of 2)

7. Budget Deficit (and Surplus) Definitions The Structural Deficit is the what the deficit of the economy would be if the economy were operating at natural real GDP. The structural deficit is sometimes call the Natural Employment Deficit (NED). The CBO uses “Standardized Budget Deficit” for the structural budget deficit The Cyclical Deficit is the amount by which the actual government budget deficit exceeds the structural deficit. The Structural Surplus (or equivalently, the Natural Employment Surplus (NES)) and the Cyclical Surplus are the same as the deficit concepts with the signs reversed.

8. Automatic vs. Discretionary Fiscal Policy Algebraically, the Budget surplus = T – G = tY – G (where t = the average net tax rate) Automatic stabilization of the budget deficit occurs because government tax revenues depend on income If Y T which helps to restrain expansions If Y  T which helps to dampen recessions Discretionary fiscal policy alters tax rates and/or government expenditures in a deliberate attempt to influence real output and unemployment

9. Figure 6-2 The Relation Between the Government Budget Surplus or Deficit and Real Income

10. Figure 6-3 Effect on the Budget Line of an Increase in Government Expenditures

11. Figure 6-4 A Comparison of the Actual Budget and the Natural Employment Budget, 1970–2010

12. Public Debt: Gross vs. Net The public debt is the total amount of bonds and other government liabilities (or securities) that the government has issued. The gross debt is the same as the public debt. The net debt subtracts out debt held inside the government, including government securities held by the Federal Reserve and the trust funds of Social Security and Medicare. The public debt is also the sum of all fiscal deficits (and/or surpluses) over time: Debt (end of 2011) = Debt (end of 2010) + Fiscal Deficit (during 2011)

13. The Future Burden of the Government What is the burden of government borrowing for investment projects like building highways or schools? None, as long as the future return is greater than the social cost of the project! If some investment projects, like a rarely used highway, yield a very low return, then there will be future costs. What about the burden of government borrowing to pay for consumption items like bullets and food stamps? Since government consumption spending has only current benefits, there will costs to pay in the future. Future costs = interest plus debt principal repayment

14. Will the Government Remain Solvent? How can we tell if the budget deficit is too high? Key variable: Debt to nominal GDP ratio(D / PY) Notation: The level of a variable is represented by a capital letter, while the growth rate of the variable is lowercase. The government will be able to afford its debt if the debt to nominal GDP ratio is stable over time. It can be shown that the growth of (D / PY) = d – (p + y) Stability  growth of (D / PY) = 0  d = p + y (1) Note: Additional debt each year = budget deficit = dD Multiplying (1) by D on both sides  dD = (p + y)D (2) Result: D / PY remains constant if the budget deficit equals the outstanding debt times the growth rate of nominal GDP!

15. The Solvency Condition The basic limitation on the amount of government debt is that the government must pay interest on its debt. But as long as nominal GDP is growing and interest rates are low, the government can borrow more to pay the yearly interest expense and still maintain a constant D / PY. The solvency condition states that the government can meet its interest bill forever by issuing more bonds without increasing the debt-GDP ratio only if the economy’s growth rate (p + y) equals or exceeds its actual nominal interest rate (r). What about the U.S. debt level in 2010? D = $9,000B and suppose (p + y) = 5% Stability  d = 5%  Allowable deficit = 0.05*($9,000B) = $450B Actual deficit was much higher than $450B  (D / PY) ↑

16. International Perspective The Debt-GDP Ratio: How Does the U.S. Compare?

17. Figure 6-5 The Ratio of U.S. Government Debt to GDP, 1790-2010

18. The Fiscal Policy Multiplier Effect Recall from Chapter 3 that the multiplier effect of an increase in G is greater than a cut in T because G has a direct effect on spending Other factors decreasing the multiplier effect include: Leakages from the spending stream that reduce induced consumption Income Taxes Imports Corporate Profits Higher interest rates that reduce interest-sensitive spending Capacity constraints when the economy is close to full employment  government purchases push aside private purchases Lesson: Fiscal stimulus is much more appropriate and effective when the economy is weak.

19. Table 6-1 Multiplier Estimates for Selected Types of Fiscal Stimulus

20. Table 6-2 Size of Fiscal Stimulus Measures in 2008-10

21. Figure 6-6 The Role of Automatic Stabilizers in the Recession of 2008-09

22. The Overall Effectiveness of the Bush-Obama Fiscal Stimulus The overall results from the stimulus are mixed Hundreds of billions in tax cuts had little impact on GDP Infrastructure spending was rolled out very slowly (only 40% spent by 2010) Most effective parts of the stimulus were aid to state and local governments and unemployment benefit extensions. Overall benefit according to one study = 7.8% of GDP Compare to overall cost of 7.6% of GDP Result: Overall multiplier = 7.8 / 7.6 = 1.03

23. Bailouts as Unconventional Stimulus The severity of the 2008-09 crisis necessitated additional policies to prevent economic collapse. These novel policies have been called “financial policies” or “bailout policies.” These policies do not count as monetary or fiscal policies because they were carried out by both the Federal Reserve and the Treasury in cooperation with each other. The core bailout program was the Troubled Asset Relief Program (TARP). Initiated two weeks after the fall of Lehman Brothers Lent government money to financial institutions on the brink of insolvency due to insufficient equity capital Also prevented the sale of GM and Chrysler Motors Initial cost = $700B, but after loan repayment, estimated cost = $100B Measures of success of bailouts Risk premium fell from 5.5% (winter 2009) to 2.7% (mid 2010) One study: Without bailouts, Y would have been 5% lower and U = 12.5% Controversies persist because… Benefits not widely publicized Bailout of financial institutions seemed to reward those who caused the crisis!