Debt and Deficits - Economic and Political Issues Government Debt

IV. GOVERNMENT DEBT What Are the Problems With Government Debt? Most economists agree that some government debt is necessary and not harmful to an economy, but opinions change when debt levels rise. What are some of the problems that can arise as a result of too much government debt? The first is that debt has to be repaid, and this repayment comes in the form of interest payments on bonds. 2 This is called debt servicing, and is part of the yearly government budget. Figure 9 illustrates the interest payments on debt as a percentage of Federal spending. Current debt servicing as a percentage of GDP is relatively low. This is due to low interest rates—interest rates, as the graph shows, have been falling since the mid 1980's, with particularly low rates since 2008. When the Treasury Department can sell a treasury bond for a low interest rate, the payments are lower, much like when you borrow to buy a house at a low interest rate. Figure 9. Interest Payments as percent of Federal Spending Source: BEA.gov Table 3.2 During the first three quarters of 2013 the 10-year Treasury bond averaged 2.22% (see Figure 10 for historical 10-year treasury graph). Many economists believe that with historically low interest rates, it is a good time for government to run a budget deficit and accumulate debt, because it is cheap. This is especially true if government can spend on things that benefit the economy, and have a high multiplier effect. For instance, if the 2 It is possible for governments to print money to pay off debt, or simply default (fail to pay the debt). These however are not desirable options, since they have very damaging consequences for the economy. government spending multiplier for infrastructure spending is 2, then 100 billion in deficit spending would create 200 billion in total economic activity. With low interest rates the revenue gain from the multiplier effect is likely to be larger than the cost of future debt payments, making the net gain positive (see Box 1). Figure 10. 10-Year Treasury Rate Source: St. Louis Federal Reserve Bank The second issue with accumulating too much debt is that borrowers, both domestic and international, may at some point start to believe that the debt cannot be repaid. In this situation, investors who do not like the additional risk will sell the bonds, driving their price down and their yield up.3 When the government issues new debt, it must pay a much higher interest rate, making borrowing more expensive. In extreme cases, it is possible that nobody will be willing to buy the newly issued debt. There is an inverse relationship between a bond’s price and its yield. The yield is the percentage return an existing bond promises at a given price. It depends on the bond’s interest rate at inception. So, given a fixed interest rate on a specific bond, the higher the price of the bond, the lower its yield. If, for example, a 10 year Treasury bond has a face value of $1,000 with a 5 percent interest rate (i.e., paying $50/year), buying the bond at $800 would result in a yield of $50/$800 = 6.25%, while buying the same bond for $1200 instead yields $50/$1,200 = 4.17%. 3 Box 1: Deficit Spending to Maximize the Multiplier Effect Mark Zandi, economist at Moody's, testified before Congress in 2008 about his empirical multiplier calculations, shown in Table 3 below. According to Keynesian theory, deficit spending in a recession can replace falling investment and promote recovery. If used correctly, government spending can employ people, which gets them spending money, which would then employ more workers who spend money. If the goal in a recession is to maximize the efficiency of government spending, what should government spend money on? Table 3 Tax Cuts Nonrefundable Lump-Sum Tax Rebate Refundable Lump-Sum Tax Rebate Temporary Tax Cuts Payroll Tax Holiday Across the Board Tax Cut Accelerated Depreciation Permanent Tax Cuts Extend Alternative Minimum Tax Patch Make Bush Income Tax Cuts Permanent Make Dividend and Capital Gains Tax Cuts Permanent Cut Corporate Tax Rate Spending Increases Extend Unemployment Insurance Benefits Temporarily Increase Food Stamps Issue General Aid to State Governments Increase Infrastructure Spending Multiplier 1.02 1.26 1.29 1.03 0.27 0.48 0.29 0.37 0.30 1.64 1.73 1.36 1.59 Keynes argued that in general the multiplier is highest when counterrecessionary money goes to those who have the highest marginal propensity to consume (mpc). This means spending should go to those who are unemployed or who are poor, because those without much income generally spend every penny of it. Zandi's multiplier calculations illustrate this, with unemployment benefits, temporary food stamps, aid to state governments (to prevent layoffs), and infrastructure spending all having high multiplier effects. Keynesian theory also suggests spending money on schools, parks, and roads to both employ people who need work and to build things that improve society. This is why infrastructure spending was an important part of the 2009 Obama stimulus package. The lowest multiplier effects are associated with entities with the lowest mpc, such as cutting the corporate tax rate and extending the Bush tax cuts. These policies get less "bang for the buck," and are supplyside policies that are not expected to increase spending in the short run. Source: U.S. House Committee on Small Business, July 24th, 2008. 22 https://www.economy.com/mark-zandi/documents/Small%20Business_7_24_08.pdf. An example of interest rates rising when bond holders begin to doubt the ability of the government to pay back the debt occurred in Greece during the recent European financial crisis. Staring in the summer of 2010, Greece's low growth and high debt levels created concern among holders of Greek bonds. This is apparent in Figure 11. Bond holders who are worried about the ability of a government to repay the debt, or worry about government policy that impedes on the ability to repay the debt are called "bond vigilantes." These "bond vigilantes" are simply bond holders who see too much risk and either sell, or require a higher interest rate to justify taking the risk of holding the bond. Figure 11. Greece 10-Year Treasury Rate Source: Bank of Greece This is a bigger issue in countries that are significantly less wealthy than the highly industrialized countries. When a financial crisis hits, countries that do not have a large share of global GDP are less able to fix their debt problems or convince bond holders that as debt increases due to a recession, that they can continue to make interest payments on their debt. The Argentine debt default in 2002 is another example of a less wealthy country with fewer options in responding to a financial crisis. The third issue concerns to how the debt gets repaid. A country has two ways to repay debt or service interest payments: through tax revenues, and through “monetizing” the debt. Increasing taxes to meet debt servicing requirements can hurt GDP, as taxes can reduce both consumption and investment. Debt can only be repaid if the budget is balanced or running a surplus, and even in this scenario paying off the total debt can take some time. Cutbacks in government spending, also needed to balance the budget, can depress the economy further. This painful process has caused extreme political conflict in Greece and other highly indebted nations. Monetizing the debt means, in effect, printing money. To monetize the debt, the Treasury department would sell Treasury bonds. The Federal Reserve would buy these Treasury bonds, and the Treasury would pay interest on the debt. The Federal Reserve would return the interest on the debt to the Treasury, less operating expenses. Since Congress does not control the Federal Reserve, this is how government can in effect “print money” to pay off debt. Many economists believe that monetizing the debt raises the threat of creating inflation because of the increase in money supply. However, other economists believe that a small increase in inflation can be a positive thing for the economy because in a depressed economy inflationary forces can counter the threat of deflation—falling prices that can further depress business activity. The option of monetizing the debt, however, is only open to countries that control the currency in which their debt is denominated. It was not available to Greece, whose debt was in euros, nor to Argentina, whose debt was primarily in dollars. Who Owns the Debt? Figure 12 illustrates that while one third of the U.S. debt is held by entities located outside the country, the larger part is owned by U.S. citizens—in some cases directly, as individuals, but more often through citizens' ownership interests in social security, pension funds, state and local governments, and the Federal Reserve. While national and international insurance companies and banks are also holders of U.S. debt, the reality is that we actually owe most of the debt to ourselves! The category accounting for the highest percentage of government debt (aside from the foreign countries in aggregate) is the so-called "intra-government debt," which is the social security trust fund and the Medicare trust fund, both “off- budget” items that have their own sources of funding. These funds buy treasury bonds as a way to gain riskfree revenue for the trust fund. The Federal Reserve holds 11% of outstanding treasury bonds as part of its policy of conducting open market operations.4 Pension funds and “Open market operations” is the name given to the process of the Federal Reserve buying and selling short term debt to manipulate and control the Federal Funds rate. The Federal Funds rate is the rate at which banks borrow from other banks to meet their overnight reserve requirements. 4 mutual funds each own 5% of the debt. U.S. Treasury bonds give people looking to retire a safe, risk free return that is a part of almost every retirement portfolio. Foreign entities own 33% of the debt; an exact itemization by country is found in Table 4. Table 4 lists the largest holders of U.S. debt as a percentage of the total debt. It shows that China is the largest holder of treasury bonds internationally holding 7.3% of U.S. debt, followed closely by Japan at 6.9%. Oil exporters rank third, because countries that sell oil in dollars use the same dollars to buy treasury bonds to maintain their dollar liquidity and safely store their excess savings. Figure 12. Debt Ownership 2012 Source: www.fms.treas.gov/bulletin/b2012_2ofs.doc International Comparisons of Debt/GDP ratios Although in absolute terms the U.S. debt is by far the highest in the world, it is a different story when we consider debt relative to GDP. Table 5 illustrates international debt/GDP ratio comparisons. Table 4: Largest Holders of U.S. Treasury Bonds as a Percentage of Total U.S. Debt 2012 Largest Foreign Holders of U.S. Treasury Bonds China Japan Oil Exporters Brazil Caribbean Banking Centers Taiwan Russia Switzerland Rest of World Percentage of Total U.S. Treasury Bonds 7.3% 6.9% 1.6% 1.5% 1.6% 1.2% 1.0% 1.1% 11.1% Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfhhis01.txt Table 5. Debt/GDP Ratios Year 2006 2007 2008 2009 2010 2011 2012 Canada France Germany Italy 70.4 66.7 71.2 82.4 84.0 87.8 92.8 71.2 73.0 79.3 91.2 95.8 98.6 102.4 69.8 65.6 69.8 77.4 86.8 87.2 87.3 116.7 112.1 114.6 127.7 126.5 119.7 128.1 Japan 166.7 162.4 171.2 188.8 192.7 205.5 219.1 United United Kingdom States 46.0 66.4 47.2 67.0 57.4 75.9 72.4 89.7 81.9 98.3 97.9 102.7 97.2 103.6 Source: www.oecd.org Japan has had a very high debt to GDP ratio, resulting from depressed economic conditions starting in the 1990's, and currently has a debt to GDP ratio of 219%. Japanese bonds are still bought and traded, and Japan is not on the edge of disaster. Italy is second in this list with 128.1%, followed by the United States as 108.6%. Notice how debt levels in the U.S. skyrocketed from 2007 to 2011 as a result of the recession. As government revenue fell and expenditures increased, the government accrued more debt to bridge the difference. Discussion Questions 1) What does it mean that most of the U.S. debt is owned by its own citizens? Who is buying this debt, for what reason, and are they likely to continue doing so? 2) What are the advantages and disadvantages of having a government debt? Does the debt pose immediate dangers to the economy? How does the answer differ for different countries such as the U.S. Greece, and Japan? V. POLITICAL ECONOMY OF DEFICITS U.S. Global Hegemony and Global Imbalances Generally, in the bond market the riskier an asset becomes the higher the yield on the bond. But is there a point where investors will simply refuse to buy newly issued debt? This is improbable but possible, at which point the government will simply not be able to borrow (see Box 2). This is especially unlikely in the United States, which has the world's biggest economy, the largest tax base, and can monetize the debt without constraints. There is an apparently insatiable demand for U.S. treasury bonds because of the role that the U.S. and the dollar play in the world economy. The U.S. is what is known as a "global hegemon," which means that the U.S. is the dominant military and economic power in the world. Because of the economic dominance of the U.S. and its currency, countries around the world are forced to store dollars for international transactions, such as the trade of goods, the purchase of oil and other commodities that are priced in dollars, as well as for exchange rate intervention and manipulation of their own currency. For this reason most countries have a large stockpile of dollar reserves. But instead of just holding dollars they hold treasury bonds, which are liquid, dollar denominated assets that bring a small return. Thus the high demand for U.S. dollars creates a high demand for U.S. treasury bonds. The U.S. is one of the few countries that can sell all of its bonds in its own currency. This gives the United States the advantage of being able to run large budgets deficits and still be seen as a safe, risk-free investment. In fact, if the U.S. stopped issuing treasury bonds, the world financial system, which is dollar based and dollar reliant, would have to change significantly. Box 2. When Do People Stop Buying Government Bonds? You have probably heard talk on news programs about the possibility of foreign countries or private investors not being willing to buy U.S. debt. This has been a common argument by non-economists. Does the U.S. have so much debt that no one trusts Treasury bonds anymore? To answer this question we need to understand how bonds are assessed for risk. All bonds sold on the open market are rated by rating agencies, whose job it is to assess the riskiness of various assets, including government bonds, and to provide each a risk rating. The three rating agencies are Moody's, S&P, and Fitch. A top bond rating from S&P and Fitch would be AAA, and ratings go all the way down to D. Moody's has as similar scale but has different letters, such as Aaa for their top rating and C for their worst rating. These agencies rate government debt so that investors can make informed decisions about the level of risk they are taking. A high-risk bond has to yield more than a low-risk bond in order to persuade borrowers to take on the additional risk, so AAA bonds generally have a lower yield, and bonds rated BBB have a higher yield. Rating agencies rate government bonds based on the ability and political commitment of the government to repay their debt to the bond holders. For instance, the 10 year Treasury bond has historically been rated AAA because the U.S. has the largest tax base, the political commitment to pay back the debt, and ultimately the ability to monetize the debt as a last resort. Generally the threat of monetization is treated negatively by the bond market as it begins to anticipate inflation, which will reduce the return on bonds. By comparison to the U.S., Greece, like other less wealthy, less powerful countries, suffers from having a much smaller tax base, a population that is significantly divided on the desirability of repaying their debt, and no ability to use monetary policy to help them do so. During the European debt crisis Greece's bond ratings have been very low, making it necessary for Greece to offer high interest rates to attract any buyers. This has created a situation in which issuing new debt becomes a very expensive way to alleviate short term macroeconomic problems. In 2011, several rating agencies including S&P downgraded the U.S. Treasury bond. S&P changed their rating from AAA to AA+ due to high budget deficits, high debt levels, and the inability of Congress to raise the debt ceiling (discussed further in Section V below). Despite this, the U.S. Treasury bond was in high demand, as shown by the 10 year treasury yield falling from 3.20 in the first quarter of 2011 when the downgrade occurred, to a quarterly low of 1.95 in the first quarter of 2013 (note that an increase in bond demand drives price up and yield down). The downgrade was based not so much on economic factors as on the perceived inability of the Congress and President to agree on the budget and debt management, leading to a danger of default. Despite renewed political conflict and temporary government shutdown in October 2013, it seemed by early 2014 that the deadlock was easing, and with deficits also falling, concern about the ability of the U.S. to manage its debt was reduced. The United States established its hegemonic position in the aftermath of World War II. Since the early 1980's the global imbalance problem has accelerated and has created several important problems in the United States and the world. One of the causes of the global imbalance problem, specifically with trade deficits, is that since the 1970's the U.S. manufacturing base has eroded. This has happened for several reasons, including lower labor costs abroad and a strong demand for the U.S. dollar. A strong dollar makes U.S. goods more expensive to the rest of the world, but makes foreign imports cheaper. This less expensive foreign competition has added to the erosion of the U.S.'s manufacturing base and is one of the reasons that foreign goods such as Chinese imports are so cheap. The strong dollar also hurts U.S. exporters by making their goods more expensive on world markets. As a result of these factors, the U.S. has run trade deficits for almost 30 years. Because U.S. manufacturers saw diminishing profit opportunities, the U.S. economy gradually moved towards finance and services sector activities. Because the U.S. does not export what it used to, it runs a large trade deficit, which means that the U.S. is buying more than it is selling. The U.S. funds that gap by borrowing cheaply from other nations, which contributes to the budget deficit. When other countries collect dollars from the goods they sell to the U.S., they simply fund the purchases by buying Treasury bonds with those dollars. This has allowed to U.S. to run both trade deficits and budget deficits for the last 30 years. The cost has been accumulated debt and the erosion of the manufacturing sector in the U.S. This is part of what is called the problem of "global imbalances." Global imbalances are the sustained existence of large current account deficits in one country and large current account surpluses in another country. If one country continually runs a current account deficit, it must be financed from either increased domestic savings, or in the case of the United States, borrowing from other countries in the form of Treasury bonds. The way we keep track of the financing flows is through the capital account. The capital account shows the net financial flows of stocks, bonds, loans, foreign direct investment (FDI), and reserves for a particular country. The United States has a large current account deficit, which is financed through a large capital account surplus, which means the U.S. borrows from foreigners to buy more than it sells. Other countries like China have large current account surpluses due to the nature of their export driven economy. The United States buys much of what China produces. China takes that money and buys U.S. treasury bonds, allowing the U.S. to run large budget deficits. Because so many countries, including China, are dependent on the U.S. buying its exports, because the U.S. is used to buying low priced imports, and because of the international demand for the U.S. dollar, this system of global imbalances is likely to persist and potentially worsen. Many economists see this as one of the fundamental issues in the world economy today. Austerity vs. Expansion: The Debate over the Deficit in the U.S. Since the financial crisis and budget shortfalls brought about by the world recession, the political debates in countries across the world have centered around austerity vs. fiscal expansion. Austerity is a policy of deficit cutting that reduces public expenditures to balance the budget, whereas fiscal expansion is the policy of increasing budget deficits using Keynesian fiscal policy principles to alleviate short term economic problems. Austerity measures are often undertaken in the context of falling revenues, or during difficult economic times. This has been an important political debate in the United States and in the rest of the world, with conservatives generally arguing for the cutting of social programs to balance the budget. Liberals generally argue for the expansion of social services in bad economic times because that is when the demand is highest for services such as unemployment, health programs, and general assistance programs. Keynesians argue that when private spending falls government must increase spending to close the gap and prevent the economy from further weakening. This fiscal stimulus can encourage business and consumer optimism and shift out aggregate demand. Reducing government spending, however, has the opposite effect. This can be seen in terms of the basic macroeconomic equation: Y = C + I + G + (X-M) where Y is GDP, C is consumption, I is investment, G is government spending, and (XM) is net exports. In a recession, investment and consumption are both falling due to decreased business expectations for businesses and high unemployment rates for consumption. If both C and I are falling, and (X-M) is difficult to control, the only option left to stabilize GDP is government spending. If government spending were also cut, that would mean that C, I, and G would be falling at the same time! This would cause a drastic reduction in aggregate demand, pushing the economy further into a recession. The debate over austerity has been between those who believe that it is essential to improve fiscal balance, even in bad economic times, and those who argue that promoting economic recovery is more important, and may actually be more effective in lowering budget deficits in the medium to long term, due to increased tax revenues from a growing economy. European Sovereign Debt Crisis The European sovereign debt problem developed in a similar way to the 2008 financial crisis in the United States. A real estate bubble and excess bank leverage and speculation caused a financial collapse when real estate prices could no longer sustain themselves. Governments, forced with the choice of complete financial collapse or the bailout of banks with public money, chose the latter. The recession resulting from the financial crisis caused government revenues to fall and expenditures to rise, increasing the deficit and debt levels. Austerity policies then reduced demand further, worsening recessionary conditions. European governments have been faced with problems similar to the U.S., including falling tax revenues, increased expenditures, and a continued banking crisis, but Europe has been slower to recover. Some argue that this slow recovery is a result of austerity policies in Europe, in contrast to stimulative policies in the U.S. European deficits are shown in Figure 13. Figure 13. European Budget Deficits Source: www.oecd.org There is a significant difference between the financial crisis, recession, and deficit issues faced by the United States compared to the members of the European Union. The European Union has a monetary union that conducts monetary policy for every country collectively, but not a fiscal union that would allow similar coordination of Keynesian, austerity, or other such policies. European countries conduct fiscal policy independently, but must maintain a budget deficit of less than 3% of GDP and debt/GDP ratio of less than 60% in order to meet the entry requirements for membership in the European Union.5 The United States has no membership requirements to uphold and can run the deficits necessary to boost short term aggregate demand. Because of this agreement, members of the European Union have intense political pressure to impose austerity measures to keep deficits and debt down. The United States also has the privilege of having dollar hegemony, as well as a Federal Reserve that is not accountable to other countries, and has a dual mandate to fight both inflation and unemployment. The U.S. has the ability to employ countercyclical fiscal policy and to use monetary policy such as lower interest rates and quantitative easing to try to spur economic activity. The European Central Bank (ECB), in contrast, is responsible for monetary policy that affects many countries, and has been focused on fighting inflation, not promoting economic recovery. Monetary policy that is good for Italy may not be good for Germany. For instance, suppose Italy has high unemployment and Germany has low unemployment. If the ECB lowered interest rates for everyone it would benefit Italy, but might burden Germany's strong economy with inflation. Because of this the European Central Bank follows a singular mandate to control inflation and avoid country favoritism, but it has done relatively little to stem extremely high rates of unemployment, especially in the Southern European countries: Spain, Portugal, Italy, and Greece. When deficits started to increase as a result of recessionary forces, bondholders became increasingly worried about the low growth rates in countries like Spain, Italy, Portugal, Greece, and Ireland. These bondholders are those who were defined above as "bond vigilantes." As a result of what bond holders perceived as danger of default, potential buyers required a higher yield to compensate for the risk on government bonds. This made issuing and rolling over debt very expensive, which added to the fiscal problems of these countries. Low growth rates and high debt/GDP ratios mean that countries may not be able to pay back their debt. Many countries find that the only means of lowering interest rates is to impose austerity to balance the budget. This can initiate a vicious cycle, because as austerity is imposed, growth rates worsen, which accelerates the risk and inhibits the ability of the government to raise revenue and pay interest on debt. Austerity measures have created extensive social unrest, particularly in Greece from 2010-2012 as many voters reacted negatively to social programs being cut while public money was used to bail out banks due to the financial crisis. Many citizens would rather see their country default on their debt than have retirement pension and social programs cut as a result of a banking crisis for which they were not responsible. 5 This is according to the European Union’s Stability and Growth Pact. Balanced Budget Amendment and PAYGO Currently it is not legally required for the U.S. Congress to balance the budget. This means that Congress has the ability to run deficits as it sees fit. Since the creation of the Constitution there has been discussion about creating a constitutional amendment to prohibit Congress from running deficits. Before 1929, deficits generally only existed during wartime, so there was no political will to enact an amendment. Since the Great Depression and the "invention" of macroeconomics, deficit spending has been commonplace in the U.S. and around the world. The first attempt at a constitutional amendment came in 1936, as an effort to curb New Deal deficit spending. A constitutional amendment seems to become politically popular every time deficits get too large. Proponents of a balanced budget amendment argue that it would force Congress to keep the budget balanced, and would prevent potentially inflationary effects of deficit spending. The negative outcome would be that the Federal Government could not use countercyclical policy to fight recessions. Most states have a balanced budget amendment and have the disadvantage of having to cut services and government employees during a recession. Often the Federal Government will provide state aid to allow states to minimize the cost cutting in an attempt to prevent the economy from getting worse. A balanced budget amendment would impose these same constraints upon the Federal Government. Under a balanced budget amendment, when a recession hits and revenue falls because of less tax collection, the Federal Government would be forced to cut services and spending when people need it most. A balanced budget amendment essentially imposes austerity on the Federal Government. One potential benefit of a balanced budget amendment would be that government cannot imprudently run deficits in good economic times, which can have an inflationary effect by shifting out the aggregate demand curve to the right, pushing prices higher. Another option that does not require a constitutional amendment, and that has been used in the past is the PAYGO, or “Pay As You Go” system. As described above in Section 3, PAYGO requires new spending to be offset either by other spending cuts or by new revenues. PAYGO was instituted in 1990 during the George H.W. Bush administration and continued during the Clinton administration, but abandoned during the George W. Bush administration as a result of recession and tax cuts which led to rising budget deficits. PAYGO was enacted again by a Democratic Congress in 2007, but as the 2007-9 recession hit, PAYGO once again became unrealistic. Since PAYGO seems ineffective and a balanced budget amendment seems too drastic, the debate over how to limit deficits continues, often with great political acrimony. Deficit Projections and Solutions Every year the Congressional Budget Office creates budget forecasts based on economic trends, expiring or new tax laws, and off-budget program projections, in order to forecast the future fiscal needs of the country. The Congressional Budget Office forecasts are widely used to help Congress and other interested parties make decisions about government budgets. The CBO estimates that by 2015 the deficit will reach 2% of GDP, which is below the historical average of 3.1% over the past 40 years. Much of this reduction in the deficit is due to the recovery of the business cycle. However, deficits are expected to stay relatively high after 2015 due to several long term trends. Figure 14. CBO Deficit Projections Source: CBO Updated Budget Projections: Fiscal Years 2013 to 2023 (May 2013) http://www.cbo.gov/publication/44195 The CBO identifies four primary reasons that the deficits will increase, assuming that major laws or the budget do not change. The four factors are an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on the federal debt. Three of these four factors are health care related, which illustrates the importance of health care in any budgetary reforms. As the baby boom generation gets older, a significant portion of the population will have higher health care costs. General health care costs have been rising faster than other costs which strains programs like Medicaid, Medicare, and even Social Security. Recent health care reforms (the Affordable Health Care Act of 2010), have allocated more spending to health care to try to cover the current 50 million (approximately) uninsured U.S. citizens, but have also included some cost controls. When debt levels increase, political pressure intensifies to balance the budget. After the 2008 financial crisis ballooned the fiscal deficits of the U.S., in 2010 President Obama commissioned a non-partisan budget committee whose responsibility it was to provide deficit reduction solutions. The committee was called the National Commission on Fiscal Responsibility and Reform, also known as the Simpson-Bowles plan after the two people who ran the commission, and is summarized below in six points:6 1) Reduce discretionary spending by $200 billion per year by reducing defense procurement by 15%, closing one third of overseas bases, eliminate all earmarks from congressional bills, and cut the Federal workforce by 10%. 2) Increase revenues by $100 billion per year through an increase in the Federal gasoline tax of $0.15 per gallon, and the elimination of deductions and exemptions from the tax code. 3) Lower healthcare costs by capping Medicaid. 4) Reduce Social Security costs by raising the retirement age and increasing the income exemption cap on social security taxes (currently you do not pay social security over $106,800 on your income). 5) Eliminate farm subsidies, military federal pensions, and student loan subsidies. 6) Cut the corporate tax rate to 26% from 35%, and lower and simplify the income tax brackets. The plan was not approved by Congress due to the large cuts to entitlement spending and the disagreement over raising tax revenues, closing loopholes, and cutting corporate and income tax rates. Box 3: You Cut the Budget Using several budget cutting plans, the New York Times put together a "deficit puzzle" that allows people to try to cut the deficit themselves. It's easy to talk about balancing the budget, but anything you cut affects someone or some governmental organization. So what's it going to be? Try to think about your political constraints, and how groups of voters will view you. Do your budget cuts hurt people? Do they affect your electability? The puzzle was made in 2010, so as time passes the numbers will change. But the ideas of what to cut, and the problems involved in cutting them will not. What would you do? 6 http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth 12_1_2010.pdf Debt Ceiling, Fiscal Cliff, and Budget Sequestration In recent years the debt ceiling has become an important economic and political topic. A debt ceiling is a restriction on the amount of national debt that can be issued by the Treasury department. Since Congress authorizes spending through legislation, the debt ceiling does not restrict deficits or Congress’s ability to spend; it only restricts the Treasury Department’s ability to pay for the expenditures that have already been incurred. In 2011, Congress was unable to reach an agreement to raise the debt ceiling due to concerns about deficit spending and political deadlock between a Republican House and a Democratic President and Senate. This near default on U.S. treasury debt resulted in a downgrade of the U.S. credit rating (see Box 2) and had the potential to cause domestic and international financial turmoil. Congress finally raised the debt limit with the Budget Control Act of 2011 which delayed the debt ceiling until December 31st, 2012. This date became known as the fiscal cliff, a combination of tax rate increases (mainly the expiration of the Bush tax cuts) and decreases in government spending, which according to the Congressional Budget Office would have potentially led to renewed recession. The fiscal cliff solution came in the form of the American Taxpayer Relief Act of 2012, which was enacted January 2nd 2013. The act made several changes to the tax code, including: 1) Individuals making over $400,000 ($450,000 for married couples) had their tax rate increased from 35% to the pre-Bush levels of 39.6%. 2) The top marginal tax rate on long term capital gains increased to 20% from the Bush levels of 15%. 3) The top marginal tax rate on dividends, which had pre-Bush levels of 39.6%, were instead increased from Bush levels of 15% to 20%. 4) The elimination of deductions for higher income earners. 5) The estate tax increased from 35% to 40% over the value of $5,120,000. When President Obama signed the Budget Control Act of 2011 to avert the debt ceiling crisis, part of this act required a "super committee" be formed to provide deficit reduction legislation to reduce the deficit by $1.2 trillion over 10 years. The super committee was unable to agree on a final proposal which activated another part of the Budget Control Act requiring automatic cuts to kick in across the board (both in defense spending and domestic spending) if new legislation was not created. These automatic across-the-board cuts are known as budget sequestration. The "sequester", as it become known, began in March of 2013 and has been a source of economic and political tension due to its indiscriminate nature. In late 2013, lawmakers reached a budgetary agreement that relaxed some parts of the sequester. Conclusion Policy makers face difficult decisions in the coming years in dealing with deficit and debt related issues. All of the policy decisions imply tradeoffs that make simple solutions more complicated than they seem. To reduce the deficit now means imposing austerity programs that hurt current GDP and economic recovery. Expanding debt indefinitely means a higher percentage of spending in the future goes to servicing the debt, which could result in higher taxes. Each member of Congress has their own political constrains and constituents’ issues to take into account, which adds to the difficulty of creating a bi-partisan deficit and debt solution plan. These are some of the reasons that as of early 2014, no clear short or long term solution has yet emerged to the debt and deficit issues; indeed there is not even a clear consensus on the extent of the problem. Fortunately, the rapid reduction in the deficit during 2013 lessened the economic and political pressures associated with these issues. Economic analysis, as presented in the discussion above, suggests that the debt and deficit problem are both manageable and solvable as long as policy makers take a long term perspective in their legislation and that they are willing to compromise. Discussion Questions 1) Explain how global imbalances are in part caused by the U.S. dollar being used as the world reserve currency. What are the advantages and disadvantages this gives to the U.S.? 2) In your opinion, is the austerity debate about economics or about politics? Explain how the austerity debate could be largely political. Make sure to include all arguments from the section. 3) What are the fundamental differences between the ability of the U.S. to handle the financial crisis and the European Union to handle the crisis? Why does this put extra pressure on Europe for austerity? KEY TERMS austerity: a policy of deficit cutting that reduces public expenditures and/or raises taxes to balance the budget automatic stabilizers: programs of government spending that automatically increase during downturns in the business cycle budget deficit: the total amount at a given time that the Federal Government has borrowed and still owes budget sequestration: automatic cuts to Federal spending budget surplus: the amount by which revenues exceed expenditures in a given year countercyclical policy: the budgeting strategy where deficits are run in bad economic times and surpluses are run in good economic times, ideally balancing the budget over several years crowding out: a reduction in the availability of private capital resulting from federal government borrowing to finance budget deficits crowding in: the process by which government spending increases expectations of the economy due to multiplier effects, thereby inducing investment cyclical deficits: the portion of the deficit that is caused by fluctuations in the business cycle current account: consists of the trade deficit or surplus (exports minus imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers capital account: shows the net financial flows of stocks, bonds, loans, foreign direct investment (FDI), and reserves for a particular country debt ceiling: a restriction on the amount of national debt that can be issued by the Treasury department debt service: the combination of interest and principal repayment on a debt discretionary spending: spending that requires an appropriations bill from congress endogenous money: an economic theory stating that the money supply is determined within the economic system, and not solely by the Central Bank fiscal expansion: a policy of increasing budget deficits to alleviate short term economic problems fiscal cliff: an increase in tax rates and a decrease in government spending due to the Budget Control Act of 2011, modified by the American Taxpayer Relief Act of 2012 global hegemon: the dominant military and economic power in the world global imbalances: the existence of large current account deficits and large current account surpluses in different parts of the world, which many economists believe to be unsustainable mandatory spending: spending on existing programs that are required by law such as Social Security and Medicare monetize the debt: when a central bank buys government debt as it is issued (equivalent to printing money) multiplier effect: the aggregate effect of a change in an economic variable on total output national debt: the total amount borrowed and owed by the Federal Government off budget expenditures: government funded programs that are exempt from the normal budgeting process because they have their own sources of funding separate from congressional appropriation on budget expenditures: all federal expenditures that rely on general tax revenue subject to congressional approval each year structural deficits: the portion of the deficit (or surplus) that results from tax and spending policy dictated by the president and Congress at their discretion REVIEW QUESTIONS 1) What is the difference between the national debt and a deficit? 2) What is the difference between discretionary spending and mandatory spending? 3) What is the difference between off budget and on budget expenditures? Provide examples of each. 4) What years were debt/GDP levels the highest in the United States? What years were the lowest? 5) What years were deficits/GDP the highest in the United States? What years were the lowest? 6) What is a cyclical deficit? What is a structural deficit? How are they different? 7) What is crowding out? How specifically does crowding out happen? Explain. 8) What is crowding in? 9) What is endogenous money? How does this relate to crowding out? 10) What was Hamilton's vision for the U.S. national debt? Why did he feel it was so important? 11) What was the opposing view of Jefferson, Adams, and Madison? How did they argue against the creation of a national debt? 12) What was the New Deal, and how did it relate to deficit spending? 13) What are the two aspects of Reaganomics? 14) Describe the “starve the beast” strategy. Do you think this would be an effective strategy for reducing government spending? 15) What are the 4 reasons that the surplus of the Clinton administration turned into a deficit in the following Bush administration? 16) Summarize some of the problems with government debt. 17) Refer to Box 1. What are the benefits of running budget deficits? 18) Why did Greece's bond rates get so high after 2010? 19) What does it mean to monetize the debt? 20) According to Table 4, who had the highest debt/GDP ratio in 2012? 21) What is a global hegemon? 22) When did the U.S. become the global hegemon? 23) What is austerity? What is fiscal expansion? How are they at odds? 24) According to the Simpson-Bowles plan, what are the six broad ideas for cutting deficits over the next 10 years? 25) What are the pros and cons to a balanced budget amendment? 26) What is the debt ceiling? What is the fiscal cliff? How are they related? EXERCISES 1) List the percentage of each given government expenditure: Expenditure Social Security Defense Non-Defense Medicare Income Security Medicaid Retirement and Disability Percentage 2) What is countercyclical policy, and how can government use it to both balance the budget and combat economic recession? 3) Suppose country A had government debt of 12 trillion dollars, and country B had a government debt of 8 trillion dollars. Is it correct to say that country A has the worse debt problem? Why or why not? 4) Draw a business cycle graph and show in general what happens to interest rates at different points in the cycle. Assume that everything else in the economy is held constant. 5) During the 2008-2010 recession, budget deficits were very high yet interest rates were low. According to crowding out theory, interest rates should be rising as a result of high budget deficits. What other factors may affect interest rates in a recession besides a budget deficit? 6) True or False: a) Alexander Hamilton though that a national debt would provide aristocratic bondholders with a financial incentive for the U.S. to succeed as a nation. b) James Madison was strongly in favor of repaying revolutionary war debt. c) The U.S. Government almost always ran budget deficits before 1929. d) In 1933, Franklin D. Roosevelt ran on a platform of budget deficits to help the economy. e) George W. Bush balanced the budget during his presidential tenure (2000-2008). 7) Refer to Table 2, showing surplus or deficit levels since the Great Depression, to identify the Presidential terms with the highest deficits, and also the brief periods of surplus. What do you think accounts for these variations? 8) Draw and the label a Laffer curve. Now use the graph to explain the argument that cutting taxes can actually increase government revenue. What are some problems with this analysis? 9) Who was the global hegemon before the U.S.? This will require you to do some reading or internet searches outside of this module. 10) Refer to Box 3, and complete the NY Times exercise by balancing the budget. In 23 paragraphs, explain what you cut, why you cut it, and what the potential political fallout will be (remember, you have to get re-elected). What groups will you anger? Who are you hurting economically?