Deficits and Debt Lecture Note Chapter 2

Figure 15.4 Interest Payments as Percentage of Total Federal Outlays, 1962–2020 Source: Federal Reserve Bank of St. Louis, FRED Economic Database. Figure 15.5 The Interest Rate on 10-Year Treasury Bonds, 1980–2022 Source: Federal Reserve Bank of St. Louis, FRED Economic Database. It may be counterproductive, however, to allow the debt to grow if it is financing “low-multiplier” activities. An example is tax cuts for the wealthy, which, as we saw in Chapter 9, do not produce as much “bang for the buck” as tax cuts that benefit lowerincome families and individuals, or new spending on constructive activities. A useful way of understanding the problem is to imagine the federal government as a private business. Would a business borrow money at an interest rate higher than its expected rate of return? Of course not. The government’s situation is a bit more complicated because it needs to assess the projected “social return” on its expenditures (e.g., a more educated citizenry, better infrastructure). The problem is that it is seldom easy to express the social return in dollars. Another concern with mounting debt is that if debt relative to GDP becomes sufficiently large, lenders might start to doubt the borrowers’ ability to repay. If the doubt were severe and widespread, it could affect the bond market and, as a result, the national economy. Risk-averse investors would sell their bonds, driving bond prices down. When bond prices go down, bond yields (rates of return) go up (as noted in the Appendix to Chapter 11), because the amount that the government has to pay in interest on the bond becomes higher relative to the value of the bond. Any new bonds that are then issued will have to match this higher rate of return, meaning that the government will have to pay more in debt service costs in future. The greater the unease over the borrower’s ability to pay, the higher the interest rate that the borrower must offer in order to attract lenders. In the summer of 2011 Standard and Poor’s, one of the major ratings agencies, downgraded U.S. government debt from AAA to AA+ as a result of a political impasse between the Obama Administration and the Republican Congress that created doubt about the reliability of government debt payments. Fortunately for the United States, even with this downgrade, its debt remained very much in demand. A third potential problem with too much debt concerns exactly how it gets repaid. An indebted country must repay the principal on its debt and service it with interest payments. To do so, it must either engage in new borrowing, raise tax revenues, or, more likely, both. We have seen that increasing tax rates has the potential to reduce consumption and investment, hurting GDP growth and employment. New borrowing carries no such problems, though it does postpone repayment further into the future and increases the total size of the debt over time. It is also possible to finance a federal budget deficit with bonds that are purchased by the Fed from the Treasury. ‡ If the Fed buys new bonds directly from the Treasury upon issuance, it is known as monetizing the debt. In effect, this action combines expansionary fiscal and monetary policy. If, on the other hand, the Fed buys Treasury bonds on the secondary market, it merely amounts to an expansionary monetary policy, as we saw in Chapter 11. monetizing the debt: the purchase of new debt from the Treasury by the Federal Reserve Monetizing the debt risks causing inflation, especially if the increase in the money supply is large and continues over a long period. If such inflation does occur, the bond markets would then demand higher interest rates on new debt to compensate for the anticipated loss from inflation. How serious is this danger? Some economists believe that a mild to moderate increase in inflation is not necessarily a problem, especially if it occurs in a depressed economy facing a looming threat of deflation. As we saw in Chapter 10, deflation would in most circumstances be more dangerous than inflation, while mild inflation has historically been associated with economic recoveries and gains in domestic employment. Severe inflation, however, would be very damaging to ‡ This process is often described – or depending on one’s viewpoint, derided – as “printing money.” the economy, and other economists point to this as a possible long-term result of increasing government debt. Even moderate inflation carries significant economic risk. The Federal Reserve is likely to respond to observed inflation by raising interest rates—as described in Chapter 12—thereby restraining economic activity and possibly pushing the economy into recession. Discussion Questions 1. How many different “types” of debt can you think of? Which one do people usually mean when they speak about the “national debt”? 2. What are some potential problems with excessive federal debt? How can the debt be managed or repaid? 4 Political Economy of the Debt 4.1 Who Owns the Debt? We have already seen that when the federal government goes into debt, it sells government bonds. But who buys these bonds? It might surprise you to see how ownership of the gross federal debt is divided up. Federal Reserve and U.S. government holdings account for over one third of the debt (Figure 15.6). We might, in other words, say that the US government owes one-third of its debt to itself. Social Security is the largest of the government accounts that hold federal debt. Among many other funds, the principal ones are the funds for federal employee retirement, federal hospital insurance, and federal disability insurance. State and local governments, perhaps surprisingly, account for another 2.9 percent of Federal debt. States and municipalities with budget surpluses will often buy federal debt because it is considered mostly risk free. The domestic private sector owns 15.7 percent of the federal debt in the form of bonds, which are found in a variety of locations: banks, insurance companies, and mutual funds, among others. Private and public pensions together account for another 5 percent of the total, and individuals, companies, and trusts hold 11.6 percent of Federal debt. Finally, foreigners own 28.9 percent of the debt —this is the U.S. external debt. Figure 15.6 Ownership of Gross Federal Debt, 2019 Source: Treasury Department, 2021, Tables OFS-1; Distribution of Federal Securities by Class of Investors and Type of Issues, Table OFS-2; Estimated Ownership of US Treasury Securities and Table. In 2021, Japan and China together owned more than 30 percent of the external U.S. debt (Figure 15.7), a reflection of the large trade surpluses that the two countries have had with the United States for several decades. As we saw in Chapter 13, when China and Japan export more to the United States than they import from us, they acquire a surplus of U.S. dollars, which they then use to buy U.S. federal debt. Why do they choose to hold U.S. government debt? For the same reason that domestic investors, state and local governments, and the Social Security trust fund trustees do: U.S. Federal debt is widely perceived as returning risk-free income. Eleven countries—the United Kingdom, Ireland, Luxembourg, Switzerland, the Cayman Islands, Brazil, Taiwan, France, Hong Kong, Belgium, and India—accounted for over 40 percent of the U.S. external debt. Other countries collectively owned 27.4 percent of the U.S. external debt as of 2021. Although in absolute terms the U.S. debt is by far the highest in the world, it is a very different story if we look at total debt in relation to GDP. Japan’s ratio of debt to GDP has risen since its economic slowdown started in the 1990s and is currently 256 percent of GDP (Figure 15.8). Nevertheless, Japanese bonds are still bought and traded on the secondary market, which may be a testament to the widespread belief in the stability of the Japanese economy. This is in contrast to Greece, which has had to raise interest rates on its bonds substantially to attract continued investors. Like Japan, Greece has a high debt to GDP ratio (237 percent) but is clearly considered less credit worthy. Figure 15.7 Foreign Holders of Gross Federal Debt, 2021 Source: Treasury Department, 2021, Major Foreign Holders of Treasury Securities. Figure 15.8 Debt-GDP Ratios, an International Comparison, 2000–2020 Including state and local debt, the U.S. debt to GDP ratio more than doubled from 72 percent in 2000 to over 161 percent in 2020, impelled by tax cuts, the financial crisis, and the more recent global pandemic. Still, the U.S. situation continues to resemble Japan’s, in that growing indebtedness has not noticeably altered investor confidence, allowing the U.S. bond yields to remain relatively low. 4.2 The Twin Deficits As we have seen, the term “deficit” can refer either to a government’s finances or to a country’s trade balance. The fact that the two types of deficits are closely linked adds to the not infrequent confusion between the terms. Indeed, our debt to other countries as measured in terms of their ownership of our bonds is related both to our budget and trade deficits. Yet as we can see from Figure 15.9, the trend lines do not always move together. Up until the early to mid-1970s, the trade balance in the United States was around 1 percent of GDP, a relatively insubstantial amount, and frequently changed from surplus to deficit and vice-versa. The federal budget, on the other hand, was consistently in deficit (with a brief exception in 1969), though mostly at less than 2 percent of GDP. Starting in the mid-1970s, however, both the federal budget and the trade balance turned sharply more negative. The United States has failed to run a trade surplus (i.e., exports greater than imports) since then, and its trade deficit has not been below 2 percent of GDP since 1998, reaching almost 6 percent in 2005 and 2006. The federal budget balance has been even more volatile over this forty-year period, swinging from a surplus of more than 2 percent of GDP in the year 2000 (one of only four years since 1969 that the budget was in surplus) to a deficit of almost 15 percent most recently, in 2020. Figure 15.9 United States Twin Deficits as Percent of GDP, 1960–2020 Sources: CBO and U.S. Census Bureau. As discussed in Chapter 13, if a country has positive net exports, it means that it will have a surplus of funds (foreign exchange) to lend to other countries. If, in contrast, a country has negative net exports, it typically must borrow from foreigners, essentially to pay for the difference. If the government budget is in deficit, as also discussed in Chapter 13, this tends to create or increase a trade deficit, unless it is financed by a surplus of domestic savings—which has generally not been the case for the United States. Thus, while the two deficits do not move together in lockstep, the twin deficits hypothesis states that they should usually broadly move in the same direction. twin deficits hypothesis: the belief in a causal link between a country’s budget balance and its trade balance. 4.3 The Balanced Budget Debate If balancing the budget were legally required, the United States could not have accumulated a national debt. Hoping to avoid uncontrolled debt dependence, many in the past have advocated legislation, or even an amendment to the Constitution, requiring that the budget be balanced. While this idea sounds attractive to many people, the economic consequences would be severe. Most states have a balanced budget requirement that forces them to cut services and government employees during a recession. The federal government often provides aid to allow states to minimize cost cutting, in an attempt to prevent the economy from weakening further. States have no other recourse because, unlike the federal government, they are unable to create additional funds. In large part, this explains why, as discussed in Chapter 9, states (as well as municipalities) often practice “procyclical” instead of countercyclical policy, which tends to worsen rather than counteract recessions. A balanced budget amendment would effectively make the federal government little different from the states. Proponents argue that such a law would prevent the federal government from imprudently running deficits, potentially causing inflation, in good economic times. But there is a very serious downside, in that such an amendment would make the federal government powerless to use countercyclical policy to fight recessions. In 1985, Congress passed the Balanced Budget and Emergency Deficit Control Act, more popularly known as the Gramm-Rudman-Hollings act (named after the senators who sponsored it). It required that a limit be set on the annual deficit and that the limit be reduced until a balanced budget was achieved in 1991. While less stringent than a constitutional requirement, the deficit ceiling was nevertheless strict. Not meeting it would require spending to be reduced automatically to the point where the deficit was no higher than the prescribed limit for that year. This proved too much for Congress, and even for the Supreme Court, which found the automatic reduction provision unconstitutional. deficit ceiling: a congressionally mandated limit on the size of the federal budget deficit Congress frequently has contentious debates over raising the debt ceiling. (This is different from a deficit ceiling. According to rules set by Congress, a vote of Congress is required to increase the debt beyond a set amount, called the debt ceiling.) As the debt approaches the mandated ceiling, the country confronts the prospect of not being able to borrow fresh funds to pay bonds that are coming due for payment. The risk of such a default would be a decline in the perceived creditworthiness of the United States. As noted earlier, in 2011 Standard and Poor’s lowered the grade of U.S. Treasury bonds from AAA to AA+ as a result of a debt ceiling crisis, the first time in history that this had happened. debt ceiling: a congressionally mandated limit on the size of the gross federal debt Following heated and partisan negotiations, Congress and the President struck a deal in 2011, allowing the debt ceiling to be raised (by about a trillion dollars). Since then, debt ceiling deadlines have become an issue every few years. The debt ceiling was suspended three times during the Trump presidency, and recently increased under Biden. In October of 2021, Congress increased the debt ceiling by $480 billion, only to increase it by another $2.5 trillion in December of the same year. The periodic focus on the debt ceiling is in many ways misleading. If Congress and the President want to avoid increasing the debt, they would have to agree on a balanced budget, in which case the debt ceiling would no longer be an issue. But that is a lot easier said than done. A balanced budget would either require drastic cutbacks in popular programs such as Social Security, or significant tax increases. In the long run, of course, it is important to keep debt levels under control, but it is a mistake to presume that the federal government should maintain zero debt. The ability to use deficits at appropriate times to generate a fiscal stimulus is what sets the federal government apart from the states and cities and possibly protects a weak economy from sinking deeper. An alternative approach to balanced budgets is the principle of functional finance, which requires that national governments do their utmost to ensure that aggregate demand remain at a reasonable level, ideally achieving full employment. The assumption behind this principle is that the healthy economic growth that resulted would ensure that the government could sustainably finance its debt with greater tax revenue. A similar argument that it is more important to focus on current employment than debt levels is put forward by advocates of the Modern Monetary Theory (MMT) school, as discussed in Chapter 11. This point of view is in direct conflict with the perspective of deficit “hawks,” who would maintain absolute limits on deficit and debt levels. functional finance: the idea that a sovereign government should finance current needs and provide for adequate aggregate demand to maintain employment levels Who are the hawks? Even this is not a simple question; while Republicans are traditionally regarded as the party of fiscal “prudence,” in recent years both Republicans and Democrats have found themselves on either side of the controversy. But there are major differences even among those not so concerned about deficits. Keynesians like economist Paul Krugman have long believed that the government should be spending more in such areas as infrastructure investment; most Republican members of Congress, in contrast, believe that the government should be taxing less. From the standpoint of fiscal balance, the two approaches are equivalent. But from an equity standpoint they are very different. Federal government spending tends to benefit the broad population, while major tax cuts, including the Reagan tax cuts of the 1980s and the Bush tax cuts of the 2000s, have disproportionately benefitted the well- off. As noted in Chapter 14, tax cuts that primarily benefit upper-income groups have contributed to the recent intensification of inequality in the United States. Discussion Questions 1. Should there be a balanced budget amendment to the Constitution? What problems might such an amendment create? 2. What is the difference between the budget deficit and the trade deficit? Are they related? How? 5 Deficit Projections and Potential Policy Responses 5.1 Deficit Projections The U.S. annual federal deficit declined from a peak of 10 percent of GDP in 2009 to 2.4 percent of GDP in fiscal 2015 (Figure 15.10). It then increased again, shooting up to nearly 15 percent of GDP in response to the global pandemic. The Congressional Budget Office (CBO), which provides non-partisan economic analysis for Congress, expects the deficit to remain in double digits for 2021, and projects that the deficit will then drop sharply and remain at 3 to 5 percent of GDP for the remainder of the decade. 1 This is greater than the annual average of about 3.3 percent over the past fifty years, implying a continual increase in overall Federal debt. 2 Figure 15.10 Annual Deficit as a Percent of GDP, Actual and Projected 1962–2031 Source: Congressional Budget Office, 2021. Note: Data from 2020 to 2031 are projected. The Federal debt held by the public is accordingly projected to increase slightly from about 100 percent of GDP in 2020 to about 106 percent by 2031 (Figure 15.11). But the longer-term outlook is more severe (see Figure 15.12). According to a CBO analysis conducted one year into the COVID-19 pandemic, “Federal debt held by the public will reach double the size of the economy, rising from 79 percent of GDP at the end of 2019 and 100 percent of GDP at the end of Fiscal Year FY 2020 to 202 percent of GDP by 2051. Projected debt in 2051 will be over 4.5 times the 50-year average of 44 percent of GDP and will be on track to double the previous record of 106 percent of GDP a few years later.” Figure 15.11 Federal Debt Held by the Public as a Percent of GDP, Actual and Projected 1962–2031 Source: Congressional Budget Office, 2021. Note: Data from 2020 to 2031 are projected. Figure 15.12 Federal Debt Held by the Public a Percent of GDP, Long-Term Projection 2000–2051 Source: Congressional Budget Office, 2021. Note: Data from 2020 to 2050 are projected. In addition to insufficient revenue—a problem aggravated by Trump’s 2017 tax cuts (Box 15.1)—there are other factors contributing to the projections that deficits will remain at relatively high levels, causing a significant increase in total debt over time. First are the demographic pressures of an aging population. According to estimates from the US Census, 21 percent of the country’s population will be 65 or older by 2030—compared to 17 percent today—after which the elderly population will only continue growing until at least 2060. What this means is that a smaller share of the US population will be working to support a greater share of retirees, putting further strain on government finances. Box 15.1 Trump’s Most Enduring Legacy? The Trump tax cuts of 2017 have left a legacy of insufficient revenue that will seriously affect budgetary management for decades. “The growth in the annual deficit under Trump ranks as the third-biggest increase, relative to the size of the economy, of any US presidential administration, according to a calculation by Eugene Steuerle, cofounder of the Urban-Brookings Tax Policy Center. And unlike George W. Bush and Abraham Lincoln, who oversaw the larger relative increases in deficits, Trump did not launch two foreign conflicts or have to pay for a civil war.” 3 Federal finances under Trump had already deteriorated before the pandemic, as revenues fell as a percent of GDP following the tax cuts. Major spending increases in response to the pandemic then caused both the deficit and the debt to soar. “After he took office, Trump predicted that economic growth created by the 2017 tax cut, would help eliminate the budget deficit and let the United States begin to pay down its debt. On July 27, 2018, he told Fox News’s Sean Hannity, ‘We have $21 trillion in debt. When [the 2017 tax cut] really kicks in, we’ll start paying off that debt like it’s water.’ That’s not how it played out. Trump’s tax cuts, especially the sharp reduction in the corporate tax rate to 21 percent from 35 percent, took a big bite out of federal revenue.” “The actual amount of revenue collected in FY2018 was significantly lower than the Congressional Budget Office’s (CBO) projection of FY2018 revenue made in January 2017—before the tax cuts were signed into law in December 2017. The shortfall was $275 billion, or 7.6% of revenues that were expected before the tax cuts took place." 4 “As of Dec. 31, 2020, the national debt had jumped to $27.75 trillion, up 39 percent from $19.95 trillion when Trump was sworn in . . . about $23,500 in new federal debt for every person in the country.”5 “Analyses have also shown that the overall effects have largely benefited corporations and wealthy Americans more than middle-class and low-wage workers. The corporate tax cuts, in particular, failed to translate to the promised wage and economic growth.” 6 Second, US health care costs are projected to continue increasing. According to the Centers for Medicare and Medicaid services, national health care spending is expected to grow at an average annual rate of 5.4 percent, significantly faster than projected GDP growth. The two factors are closely related and suggest that a focus on health care should be an important component of any significant long-term budgetary reforms in the United States. Social Security and Medicare taxes and outlays are, as we have seen, considered “off budget.” In other words, Social Security taxes are dedicated to finance Social Security benefits, not military or social expenditures. One might, therefore, justifiably question whether old-age or healthrelated taxes and spending should be affected by the debate over the deficit. The reality is, unfortunately, more complex. Since, as noted earlier, one of the many federal government creditors (i.e., buyers of Treasury bonds) is the Social Security trust fund itself, many of the hundreds of billions of dollars held in the fund are invested in government debt. Social Security recipients are therefore, in part, paid from the income as federal debt held by the Social Security system comes due. This reinforces concerns about future sustainability of the deficit. As the number of retirees grows relative to the working age population (which contributes Social Security taxes), full payment of Social Security benefits will require an additional contribution from the Federal budget, increasing the size of the deficit. If nothing changed, the government could eventually face a choice between paying Social Security beneficiaries or other creditors (see Box 15.2). Box 15.2 How Can the U.S. Salvage Social Security? In a 2016 report to Congress, the Social Security Board of Trustees projected that the [Social Security] program’s funds will be depleted by 2034, after which only 79 percent of what was promised to American retirees will be paid out. The “crisis” of Social Security isn’t that it’s going bankrupt or that there won’t be any benefits paid out after 2034. It’s that the system may not be able to pay all of what retirees put in and were promised—an issue that, according to many polls, is very important to many Americans both young and elderly. What can be done to put Social Security on a sounder basis before 2034? A number of possible solutions have been proposed: • Raising the payroll tax by about 2 percent, which would be enough to make Social Security solvent for the next 75 years. 7 • Raising or eliminating the cap on the Social Security payroll tax. The Social Security tax only applies to income earned below a certain threshold—$147,000 in 2022. It is thus regressive, taking a higher proportion of income from lower-income taxpayers. Eliminating the cap would make the tax less regressive by requiring more affluent taxpayers to contribute more. • Raising the retirement age, which would reduce the amount of benefits paid out over the lifetime of recipients. • Indexing benefits to inflation using techniques such as the chained CPI (discussed in Chapter 4) that yield a smaller annual increase in benefits. There really are only two basic answers to the Social Security problem: increase revenue or reduce benefits. Any potential solution will thus run into political opposition from those who would pay higher taxes or receive lower benefits. To be politically feasible, any potential compromise needs to be perceived as fair as well as effective in preserving income security for everyone in the system. Measures such as raising the retirement age would disproportionately harm lower-income individuals, as they rely more heavily on Social Security benefits, and would therefore be likely to encounter significant political opposition. Rejecting the idea of reducing benefits, Senator Elizabeth Warren has proposed an across-the board increase in Social Security benefits and in Supplementary Security income for people with disabilities. She proposes to pay for this with a substantial increase in contributions from upper-income taxpayers: “a new 14.8 percent payroll tax on individuals who earn more than $250,000 a year, to be split by workers and their employers, and a 14.8 percent tax on investment income that would apply to the top 2 percent of earners.” 8 This would convert the Social Security tax from a regressive tax (with lower income people paying a higher proportion of income in tax) to a progressive tax (with higher income people paying a higher proportion). The issues of meeting growing needs and of diminishing tax revenues are linked. Assuming that the CBO projections on deficit increases are correct, lower tax receipts will aggravate problems such as the adequate funding of Social Security and health costs. Advocates of the 2017 tax cuts argued that the positive effect of the tax cuts on the economy would, over the long term, bring in higher revenues—essentially the “supply-side” argument discussed earlier. But the overall effect of the cuts has been shown to be higher, not lower, deficits. In addition, it is broadly assumed that the historically low interest rates of the past decade are unsustainable. When rates do go up, a significant increase in interest payments on the federal debt is likely. Although the lending rate was only around 1 percent in 2020, the Federal budget could eventually be hit with an annual interest charge several times what it currently pays. Such an event would make an already difficult debt problem that much more difficult to handle. 5.2 Future Policy Choices Given these foreseeable issues with debt and deficits, the principle that the United States requires long-term budgetary reform is widely accepted. The basic math dictates that the choices are limited to revenue (i.e., tax) increases, spending cuts, or—most realistically—some combination of the two. The controversial issues concern which taxes should be increased (and for whom), and which expenditures should be cut. The recent patterns of Federal spending and revenues give some indications of what the options for the future may be. After generally declining in the two decades following 1980, Federal spending increased from 17.7 percent of GDP in 2000 to 31.2 percent in 2020. The spike in Federal spending in 2020 was pandemic-induced (the ratio was 21 percent in 2019), and the CBO expects the number to taper into the 21-23 percent range for the remainder of the decade. But this is still significantly higher than projected revenues, which are not expected to exceed about 18 percent of GDP. 9 New challenges that will unquestionably be costly to address include climate change, future pandemics, and supporting an aging population. The United States will need to confront these challenges while trying to reduce—or at least stabilize—its debt as a percent of GDP. Therefore, as controversial as they are, revenue (i.e., tax) increases will likely be essential. Experience has taught us that tax cuts are counterproductive because they fail to promote sufficient growth to increase overall tax revenues. But we also know that tax increases have the potential to dampen economic activity. The main difficulty, then, will be to address the country’s upcoming challenges while achieving fiscal stability. Possible policies to consider can be summarized as follows: • Increase revenues through growth-promoting policies. Of course, the type of growth matters. As noted in Chapter 9, responding to climate change is likely to require major “green” infrastructure changes, with the potential to create many new jobs. To lower deficits, this job creation must generate sufficient tax revenue to pay for them in the long term. • Eliminating government subsidies for fossil-fuel and chemical-intensive industries would generate revenue, but there may be a case for moving these subsidies to sectors relying on renewable energy and environmentally efficient approaches. This would be effective climate policy, but might mean no net revenue increase. • Tax reform, such as lowering rates for middle-class earners, while closing loopholes that allow the wealthy to avoid taxes and repealing tax cuts for upper-income individuals and large corporations. • Instituting a general wealth tax as a reliable means of generating revenue. Another possibility is to introduce a tax on financially speculative transactions—such as futures and derivatives trading—as an indirect means of encouraging economically-productive investment, while raising revenue. • Increase revenue through environmentally oriented taxes such as taxes on carbon emissions or (Federal) consumption taxes. These would require rebates or dividends for lower-income taxpayers in order to avoid a regressive impact (since the poor on average spend a greater percentage of their income). • Reduce “mandatory” spending on programs such as Social Security, Medicare, Medicaid, and the Affordable Care Act. Cuts to these programs are likely to increase inequity, but spending reductions could be achieved through holding down health care costs, which has already been achieved to some extent in Medicare and through Affordable Care Act provisions. • Increase efficiency of spending in health care and other areas, seeking more “bang for the buck” including state/Federal and public/private collaboration initiatives. This is especially critical in anticipation of future pandemics and other health crises that experts predict. • To the extent that any of these policies can be successful in reducing deficits and long-term growth of the debt, interest costs will also be reduced. While there is broad agreement that some combination of these policies will be needed to avoid a long-term increase in debt, the question of which policies to implement will remain controversial. 5.3 Debt and Deficits in Context The debate over debts and deficits should be placed in a larger macroeconomic context as well as a social and environmental context. Given the strong negative impacts of wide inequalities on the social and economic health of a society, it makes sense that major federal policies, regarding both spending and taxing, should emphasize reducing inequality. Addressing environmental concerns and improving infrastructure are also important priorities. Our review of the history of debt and deficits indicates that neither is inherently bad for the economy, and that deficits in times of recession are often essential to helping the economy recover. But some degree of balance is required. Deficits must be limited as a percent of GDP, and long-term increases in the debt burden should be avoided. Some combination of the policies we have discussed can promote both a healthy economy and a manageable debt. Gaining sufficient political support for such polices will represent a major challenge, but perhaps not an insurmountable one since some aspects, such as greater tax equity and job-creating investment, may prove politically popular. Discussion Questions 1. Do you think that we can reduce deficits while also avoiding an increase in tax rates? Why would political leaders consider tax hikes? Should everyone experience the same increase? 2. Are there tax policies that can reduce the deficit while also addressing social and environmental problems? Review Questions 1. What is the difference between the national debt and a deficit? 2. What years were debt/GDP levels the highest in the United States? What years were the lowest? 3. What was the role of the national debt in the early period of U.S. history? What was Hamilton’s vision for the U.S national debt? 4. How did the national debt picture change with the New Deal and World War II? 5. What factors contributed to the federal surplus during the Clinton administration, and why did it turn into a deficit in the following Bush administration? 6. Summarize some of the potential problems with government debt. 7. What does it mean to monetize the debt? 8. How do European policies of austerity differ from U.S. policies reading debt and deficits? 9. What do we mean by ’twin deficits’? How are the two types of deficits related? 10. What are the pros and cons of a balanced budget amendment? Exercises 1. Go to Federal Reserve Economic Database (http://research.stlouisfed.org/fred2/) and look in categories/national accounts for recent data on the U.S. national debt as a percent of GDP and recent figures on budget deficits. What does this tell you about recent trends? Compare the period 1990–2007 to more recent years. Do the figures indicate that we may be returning to a more “normal” situation regarding debt and deficits? 2. Search the internet and locate relatively recent debt/GDP data for European countries. Construct a table of Eurozone members and their debt/GDP ratios based on your search. Review the convergence criteria for participation in the Eurozone presented in the chapter. Don’t forget to document your source(s)! What did you discover in this exercise? Explain your answer. 3. The chapter identifies and explains several reasons why it is inappropriate to compare the government debt to the debt of a private citizen. Which of these explanations are consistent with the presentation in the chapter? a. Governments have the ability to “roll over” their debt more or less endlessly. b. Governments cannot default on their debt obligations. c. A significant portion of the government debt is owed to U.S. citizens. d. The U.S. government pays interest on its debt in dollars that it prints. e. Government debt is always used to finance investment. 4. The chapter identifies and explains several reasons why we are likely to observe relatively high deficits in the U.S. even as the economy stabilizes. Which of these explanations is consistent with the chapter’s presentation? a. Health care costs are expected to continue to increase. b. Young adults are having too many children and that creates demographic pressures. c. Federal subsidies of health care are expected to grow. d. The rising costs of higher education will contribute to deficits. e. Interest payments on the debt will likely increase in the future. 5. The chapter is very clear that it’s dangerous to assume that, “government debt is never a concern.” Which of the following are reasons articulated in the chapter for why debt can be a concern? a. Foreign holders of U.S. debt may decide to sell their bonds. b. A larger share of future budgets must be devoted to interest payments. c. It is always unwise for governments to get into debt d. Interest payments to high income individuals could exacerbate income inequality. e. Deficit spending during a recession will only make the economic downturn worse. 6. Match each concept in Column A with a definition or example in Column B. Column A Column B a. Debt 1. The portion of the gross federal debt that is owed to individuals or groups within the country b. Deficit 2. A congressionally mandated limit on the size of the federal debt c. Gross federal debt 3. The portion of the gross federal debt that is owed to foreign individuals or groups d. Debt held by the public 4. A stock variable that represents the accumulation of deficits over many years e. Internal debt 5. The gross federal debt minus the debt owed to other government accounts such as Social Security and Medicare f. External debt 6. A policy of deficit cutting that reduces public expenditures and/ or raises taxes to balance the budget g. Monetizing the debt 7. A flow variable that measures the excess of spending over revenue collections Column A Column B h. Debt ceiling 8. The requirements that EU countries must satisfy as a condition for participating in the Eurozone i. Austerity 9. The purchase of new debt from the Treasury Department by the Federal Reserve j. Convergence criteria 10. Total amount owed by the federal government to all claimants, including foreigners, the public in the United States, and other government accounts