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Fiscal Policy and Debt

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When you apply for a loan to buy a car, you undoubtedly will go through a credit check and receive a credit rating, which is a number that estimates the probability of you paying back the loan. The government is also given a credit rating for the loans it takes out. This rating, like yours, estimates the probability of the government paying back its loans.

On August 5, 2011, Standard and Poor’s (S&P), a credit rating agency, did something it had never done in its history: lower the debt rating of the United States government from a perfect AAA rating to a slightly less than perfect AA+ rating. Although an AA+ rating is still excellent, this change was significant, because it suggested for the first time that the United States government is not immune from all and any hardships in paying its debts.

Why did the United States government lose its perfect debt rating? One reason was its extensive use of fiscal policy in the aftermath of the 2007–2009 recession. Fiscal policy is the use of government revenue collection (mainly taxation) and spending to influence the economy. When the government taxes something, individuals and businesses have less money to spend. Therefore, taxes put the brakes on various economic activities. However, in terms of spending, think of what it means to local employment if the government decides to improve the roads and bridges in a city. By their very nature, taxation and spending affect the economy.

In extraordinary times, governments use fiscal policy to influence the macroeconomy with the express purpose of smoothing fluctuations in the business cycle. During the 2007–2009 recession, nearly $800 billion in additional government spending was added in an attempt to pull the economy out of its doldrums. If people would not spend, government would spend in their place. Spending was used to spur the economy when citizens were too scared to spend themselves. In inflationary times, government uses fiscal policy to pull money out of people’s hands in an attempt to cool down spending and inflation.

Fiscal policy influences aggregate demand and aggregate supply in many ways. However, fiscal policy that is used to stimulate the economy is often accompanied by persistent budget deficits and debt. Why and to what end? This chapter will examine these issues and focus on the problem of financing deficits by accruing debt.

Most Americans are accustomed to dealing with debt. Individuals might have a home mortgage, car loan, student loan, or credit card balances, while businesses often take out loans for capital purchases and other expenses to run their operations. Most debt is managed by making periodic payments toward the balance and interest. However, when debt becomes too high to be controlled, individuals and companies face financial distress and are sometimes forced to declare bankruptcy.

As we will see, it is no surprise that governments also deal with debt. In recent years, deficits and the national debt have dominated economic headlines. The national debt grows when the government spends more than the tax revenues it collects. In 2015, the U.S. government collected about $3.25 trillion in taxes, but spent about $3.69 trillion. The difference of $440 billion represented the federal deficit that was added to the national debt.

Unlike individuals and small companies, a government has a much larger arsenal of tools to prevent it from going bankrupt, including the power to tax and the ever-powerful ability to “print” money. But even those tools can sometimes be rendered useless, causing a government to rack up sizeable debt and increasing the burden of managing the debt. Further, when a government does default on its debt, havoc in markets throughout the world may result.

In this chapter, we analyze the tools government uses to implement fiscal policy and study their effects on aggregate demand and aggregate supply, which affects income and output. We then analyze whether the amount of the federal debt is a problem, and if so, what the government can do about it. This chapter will give you a good sense of the scope of fiscal policy and the tradeoffs between relying on public debt and balancing taxes and spending.