1.3 Module 68: Budget Deficits and Public Debt

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Headlines about the government’s budget tend to focus on just one point: whether the government is running a surplus or a deficit and, in either case, how big. People usually think of surpluses as good: when the federal government ran a record surplus in 2000, many people regarded it as a cause for celebration. Conversely, people usually think of deficits as bad: the record deficits run by the U.S. federal government from 2009–2012 were a cause of concern for many people.

The Budget Balance

How do surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? To answer those questions, let’s look at the causes and consequences of surpluses and deficits.

The Budget Balance as a Measure of Fiscal Policy

What do we mean by surpluses and deficits? The budget balance, which we defined earlier, is the difference between the government’s revenue, in the form of tax revenue, and its spending, both on goods and services and on government transfers, in a given year. That is, the budget balance—savings by government—is defined by Equation 68-1 (which is the same as Equation 20-7):

     (32-1) S_Government = T − G − TR

where T is the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers. A budget surplus is a positive budget balance and a budget deficit is a negative budget balance.

Other things equal, expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Conversely, contractionary fiscal policies—reduced government purchases of goods and services, lower government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

You might think this means that changes in the budget balance can be used to measure fiscal policy. In fact, economists often do just that: they use changes in the budget balance as a “quick-and-dirty” way to assess whether current fiscal policy is expansionary or contractionary. But they always keep in mind two reasons this quick-and-dirty approach is sometimes misleading:

1. Two different changes in fiscal policy that have equal-sized effects on the budget balance may have quite unequal effects on the economy. As we have already seen, changes in government purchases of goods and services have a larger effect on real GDP than equal-sized changes in taxes and government transfers.
2. Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.

To understand the second point, we need to examine the effects of the business cycle on the budget.

The Business Cycle and the Cyclically Adjusted Budget Balance

Historically there has been a strong relationship between the federal government’s budget balance and the business cycle. The budget tends to move into deficit when the economy experiences a recession, but deficits tend to get smaller or even turn into surpluses when the economy is expanding. Figure 68-1 shows the federal budget deficit as a percentage of GDP from 1970 to 2013. Shaded areas indicate recessions; unshaded areas indicate expansions. As you can see, the federal budget deficit increased around the time of each recession and usually declined during expansions. In fact, in the late stages of the long expansion from 1991 to 2000, the deficit actually became negative—the budget deficit became a budget surplus.

The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions.

Sources: Bureau of Economic Analysis; National Bureau of Economic Research.

The relationship between the business cycle and the budget balance is even clearer if we compare the budget deficit as a percentage of GDP with the unemployment rate, as we do in Figure 68-2. The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls.

There is a close relationship between the budget balance and the business cycle: a recession moves the budget balance toward deficit, but an expansion moves it toward surplus. Here, the unemployment rate serves as an indicator of the business cycle, and we should expect to see a higher unemployment rate associated with a higher budget deficit. This is confirmed by the figure: the budget deficit as a percentage of GDP moves closely in tandem with the unemployment rate.

Source: Federal Reserve Bank of St. Louis.

Is this relationship between the business cycle and the budget balance evidence that policy makers engage in discretionary fiscal policy, using expansionary fiscal policy during recessions and contractionary fiscal policy during expansions? Not necessarily. To a large extent the relationship in Figure 68-2 reflects automatic stabilizers at work. As we learned in the discussion of automatic stabilizers, government tax revenue tends to rise and some government transfers, like unemployment benefit payments, tend to fall when the economy expands. Conversely, government tax revenue tends to fall and some government transfers tend to rise when the economy contracts. So the budget balance tends to move toward surplus during expansions and toward deficit during recessions even without any deliberate action on the part of policy makers.

In assessing budget policy, it’s often useful to separate movements in the budget balance due to the business cycle from movements due to discretionary fiscal policy changes. The former are affected by automatic stabilizers and the latter by deliberate changes in government purchases, government transfers, or taxes.

It’s important to realize that business-cycle effects on the budget balance are temporary: both recessionary gaps (in which real GDP is below potential output) and inflationary gaps (in which real GDP is above potential output) tend to be eliminated in the long run. Removing their effects on the budget balance sheds light on whether the government’s taxing and spending policies are sustainable in the long run. In other words, do the government’s tax policies yield enough revenue to fund its spending in the long run? This is a fundamentally more important question than whether the government runs a budget surplus or deficit in the current year.

To separate the effect of the business cycle from the effects of other factors, many governments produce an estimate of what the budget balance would be if there were neither a recessionary nor an inflationary gap. The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated.

Figure 68-3 shows the actual budget deficit and the Congressional Budget Office estimate of the cyclically adjusted budget deficit, both as a percentage of GDP, from 1970 to 2013. As you can see, the cyclically adjusted budget deficit doesn’t fluctuate as much as the actual budget deficit. In particular, large actual deficits, such as those of 1975, 1983, and 2009, are usually caused in part by a depressed economy.

The cyclically adjusted budget deficit is an estimate of what the budget deficit would be if the economy was at potential output. It fluctuates less than the actual budget deficit because years of large budget deficits also tend to be years when the economy has a large recessionary gap.

Sources: Congressional Budget Office; Bureau of Economic Analysis.

Should the Budget Be Balanced?

Persistent budget deficits can cause problems for both the government and the economy. Yet politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes. As a result, there are occasional attempts by policy makers to force fiscal discipline by introducing legislation—even a constitutional amendment—forbidding the government from running budget deficits. This is usually stated as a requirement that the budget be “balanced”—that revenues at least equal spending each fiscal year. Would it be a good idea to require a balanced budget annually?

Most economists don’t think so. They believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. They don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.

As we’ve learned, the tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments generated by a downturn in the economy push the budget toward deficit. If constrained by a balanced-budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession.

Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary. As the following Economics in Action explains, Europe has had a lot of trouble reconciling rules to enforce fiscal responsibility with the challenges of short-run fiscal policy.

!world_eia!EUROPE’S SEARCH FOR A FISCAL RULE

In 1999 a group of European nations took a momentous step when they adopted a common currency, the euro, to replace their various national currencies, such as the French franc, the German mark, and the Italian lira. Along with the introduction of the euro came the creation of the European Central Bank, which sets monetary policy for the whole region.

As part of the agreement creating the new currency, governments of member countries signed on to the European “stability pact,” requiring each government to keep its budget deficit—its actual deficit, not a cyclically adjusted number—below 3% of the country’s GDP or face fines.

The pact was intended to prevent irresponsible deficit spending arising from political pressure that might eventually undermine the new currency. The stability pact, however, had a serious downside: in principle, it would force countries to slash spending and/or raise taxes whenever an economic downturn pushed their deficits above the critical level. This would turn fiscal policy into a force that worsens recessions instead of fighting them.

As it turned out, the stability pact proved impossible to enforce: European nations, including France and even Germany, with its reputation for fiscal probity, simply ignored the rule during the 2001 recession and its aftermath.

In 2011 the Europeans tried again, this time against the background of a severe debt crisis. In the wake of the 2008 financial crisis, Greece, Ireland, Portugal, Spain, and Italy lost the confidence of investors worried about their ability and/or willingness to repay all their debt—and the efforts of these nations to reduce their deficits seemed likely to push Europe back into recession.

Although several European nations have adopted a common currency—the euro—many of them have struggled to establish effective fiscal policy.

Image source photography/Veer

Yet a return to the old stability pact didn’t seem to make sense. Among other things, the stability pact’s rule on the size of budget deficits would not have done much to prevent the crisis—in 2007 all of the problem debtors except Greece were running deficits under 3% of GDP. Ireland and Spain were actually running surpluses.

So the agreement reached in December 2011 was framed in terms of the “structural” budget balance, more or less corresponding to the cyclically adjusted budget balance as we defined it in the text. According to the new rule, the structural budget balance of each country should be very nearly zero, with deficits not to exceed 0.5% of GDP. This seemed like a much better rule than the old stability pact.

Yet big problems remained. One was a question about the reliability of the estimates of the structural budget balances. Also, the new rule seemed to ban the use of discretionary fiscal policy, under any circumstances. Was this wise?

Before patting themselves on the back over the superiority of their own fiscal rules, Americans should note that the United States has its own version of the original, flawed European stability pact. The federal government’s budget acts as an automatic stabilizer, but 49 of the 50 states are required by their state constitutions to balance their budgets every year. When recession struck in 2008, most states were forced to—guess what?—slash spending and raise taxes, exactly the wrong thing from a macroeconomic point of view.

Long-Run Implications of Fiscal Policy

The severe economic downturn that followed Greece’s debt crisis continued into 2014.

Slavoljub Pantelic/Shutterstock

In 2009 the government of Greece ran into a financial wall. Like most other governments in Europe (and the U.S. government, too), the Greek government was running a large budget deficit, which meant that it needed to keep borrowing more funds, both to cover its expenses and to pay off existing loans as they came due. But governments, like companies or individuals, can only borrow if lenders believe there’s a good chance they are willing or able to repay their debts. By 2009 most investors, having lost confidence in Greece’s financial future, were no longer willing to lend to the Greek government. Those few who were willing to lend demanded very high interest rates to compensate them for the risk of loss.

Figure 68-4 compares interest rates on 10-year bonds issued by the governments of Greece and Germany. At the beginning of 2007, Greece could borrow at almost the same rate as Germany, widely considered a very safe borrower. By the end of 2013, however, Greece had to pay an interest rate around 10 times the rate Germany paid.

As late as 2008, the government of Greece could borrow at interest rates only slightly higher than those facing Germany, widely considered a very safe borrower. But in early 2009, as it became clear that both Greek debt and Greek deficits were larger than previously reported, investors lost confidence, sending Greek borrowing costs sky-high.

Source: European Central Bank.

Why was Greece having these problems? Largely because investors had become deeply worried about the level of its debt (in part because it became clear that the Greek government had been using creative accounting to hide just how much debt it had already taken on). Government debt is, after all, a promise to make future payments to lenders. By 2009 it seemed likely that the Greek government had already promised more than it could possibly deliver.

The result was that Greece found itself unable to borrow more from private lenders; it received emergency loans from other European nations and the International Monetary Fund, but these loans came with the requirement that the Greek government make severe spending cuts, which wreaked havoc with its economy, imposed severe economic hardship on Greeks, and led to massive social unrest.

No discussion of fiscal policy is complete if it doesn’t take into account the long-run implications of government budget surpluses and deficits, especially for government debt. We now turn to those long-run implications.

Deficits, Surpluses, and Debt

When a family spends more than it earns over the course of a year, it has to raise the extra funds either by selling assets or by borrowing. And if a family borrows year after year, it will eventually end up with a lot of debt.

The same is true for governments. With a few exceptions, governments don’t raise large sums by selling assets such as national parkland. Instead, when a government spends more than the tax revenue it receives—when it runs a budget deficit—it almost always borrows the extra funds. And governments that run persistent budget deficits end up with substantial debts.

To interpret the numbers that follow, you need to know a slightly peculiar feature of federal government accounting. For historical reasons, the U.S. government does not keep books by calendar years. Instead, budget totals are kept by fiscal years, which run from October 1 to September 30 and are labeled by the calendar year in which they end. For example, fiscal 2010 began on October 1, 2009, and ended on September 30, 2010.

At the end of fiscal 2013, the U.S. federal government had total debt equal to $16.7 trillion. However, part of that debt represented special accounting rules specifying that the federal government as a whole owes funds to certain government programs, especially Social Security. We’ll explain those rules shortly. For now, however, let’s focus on public debt: government debt held by individuals and institutions outside the government. At the end of fiscal 2013, the federal government’s public debt was “only” $12.0 trillion, or 71% of GDP. If we include the debts of state and local governments, total public debt at the end of fiscal 2013 was larger than it was at the end of fiscal 2012 because the federal government ran a budget deficit during fiscal 2013. A government that runs persistent budget deficits will experience a rising level of public debt. Why is this a problem?

Problems Posed by Rising Government Debt

There are two reasons to be concerned when a government runs persistent budget deficits. We described the first reason in an earlier module: when the economy is at full employment and the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may crowd out private investment spending, increasing interest rates and reducing the economy’s long-run rate of growth.

But there’s a second reason: today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. The impact of current deficits on future budgets is straightforward. Like individuals, governments must pay their bills, including interest payments on their accumulated debt. When a government is deeply in debt, those interest payments can be substantial. In fiscal 2013, the U.S. federal government paid 1.3% of GDP—$221 billion—in interest on its debt. The more heavily indebted government of Italy paid interest of 5.3% of its GDP in 2013.

Colin Anderson/Brand X Pictures/Getty Images

Other things equal, a government paying large sums in interest must raise more revenue from taxes or spend less than it would otherwise be able to afford—or it must borrow even more to cover the gap. And a government that borrows to pay interest on its outstanding debt pushes itself even deeper into debt. This process can eventually push a government to the point where lenders question its ability to repay. Like a consumer who has maxed out his or her credit cards, it will find that lenders are unwilling to lend any more funds. The result can be that the government defaults on its debt—it stops paying what it owes. Default is often followed by deep financial and economic turmoil.

Americans aren’t used to the idea of government default, but such things do happen. In the 1990s Argentina, a relatively high-income developing country, was widely praised for its economic policies—and it was able to borrow large sums from foreign lenders. By 2001, however, Argentina’s interest payments were spiraling out of control, and the country stopped paying the sums that were due. In the end, it reached a settlement with most of its lenders under which it paid less than a third of the amount originally due. By late 2011 investors were placing a fairly high probability on an Argentine-type default by Greece, Ireland, and Portugal—and were seriously worried about Italy and Spain. Each one was forced to pay high interest rates on its debt by nervous lenders, raising the risk of default.

Default creates havoc in a country’s financial markets and badly shakes public confidence in the government and the economy. Argentina’s debt default was accompanied by a crisis in the country’s banking system and a very severe recession.

And even if a highly indebted government avoids default, a heavy debt burden typically forces it to slash spending or raise taxes, politically unpopular measures that can also damage the economy. In some cases, “austerity” measures intended to reassure lenders that the government can indeed pay end up depressing the economy so much that lender confidence continues to fall, a situation faced to varying degrees by Greece, Ireland, Portugal, Spain, and Italy at the end of 2013.

Some may ask, why can’t a government that has trouble borrowing just print money to pay its bills? Yes, it can if it has its own currency (which the troubled European nations don’t). But printing money to pay the government’s bills can lead to another problem: inflation. Governments do not want to find themselves in a position where the choice is between defaulting on their debts and inflating those debts away by printing money.

Concerns about the long-run effects of deficits need not rule out the use of expansionary fiscal policy to stimulate the economy when it is depressed. However, these concerns do mean that governments should try to offset budget deficits in bad years with budget surpluses in good years. In other words, governments should run a budget that is approximately balanced over time. Have they actually done so?

Deficits and Debt in Practice

Figure 68-5 shows how the U.S. federal government’s budget deficit and its debt evolved from 1940 to 2013. Panel (a) shows the federal deficit as a percentage of GDP. As you can see, the federal government ran huge deficits during World War II. It briefly ran surpluses after the war, but it has normally run deficits ever since, especially after 1980. This seems inconsistent with the advice that governments should offset deficits in bad times with surpluses in good times.

Panel (a) shows the U.S. federal budget deficit as a percentage of GDP from 1940 to 2013. The U.S. government ran huge deficits during World War II and has run smaller deficits, or a surplus, ever since. Panel (b) shows the U.S. debt–GDP ratio. Comparing panels (a) and (b), you can see that in many years the debt–GDP ratio has declined in spite of government deficits. This seeming paradox reflects the fact that the debt–GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. The rising debt–GDP ratio in recent years can be attributed to the aftermath of the 2008 financial crisis when deficits were much larger than average and growth in GDP was well below average.

Source: Office of Management and Budget.

However, panel (b) of Figure 68-5 shows that for most of the period these persistent deficits didn’t lead to runaway debt. To assess the ability of governments to pay their debt, we use the debt–GDP ratio, the government’s debt as a percentage of GDP. We use this measure, rather than simply looking at the size of the debt, because GDP, which measures the size of the economy as a whole, is a good indicator of the potential taxes the government can collect. If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government’s potential tax revenue.

What we see from panel (b) is that although the federal debt grew in almost every year, the debt–GDP ratio fell for 30 years after the end of World War II. This shows that the debt–GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt.

Still, a government that runs persistent large deficits will have a rising debt–GDP ratio when debt grows faster than GDP. In the aftermath of the financial crisis of 2008, the U.S. government began running deficits much larger than anything seen since World War II, and the debt–GDP ratio began rising sharply. Similar surges in the debt–GDP ratio could be seen in a number of other countries in 2008.

Economists and policy makers agreed that this was not a sustainable trend, that governments would need to get their spending and revenues back in line. But when to bring spending in line with revenue was a source of great disagreement. Some argued for fiscal tightening right away; others argued that this tightening should be postponed until the major economies had recovered from their slump.

Implicit Liabilities

Looking at Figure 68-5, you might be tempted to conclude that until the 2008 crisis struck, the U.S. federal budget was in fairly decent shape: the return to budget deficits after 2001 caused the debt–GDP ratio to rise a bit, but that ratio was still low compared with both historical experience and some other wealthy countries. In fact, however, experts on long-run budget issues view the situation of the United States (and other countries such as Japan and Italy) with alarm. The reason is the problem of implicit liabilities. Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.

The largest implicit liabilities of the U.S. government arise from two transfer programs that principally benefit older Americans: Social Security and Medicare. The third-largest implicit liability, Medicaid, benefits low-income families. In each of these cases, the government has promised to provide transfer payments to future as well as current beneficiaries. So these programs represent a future debt that must be honored, even though the debt does not currently show up in the usual statistics. Together, these three programs currently account for almost 40% of federal spending.

The implicit liabilities created by these transfer programs worry fiscal experts. Figure 68-6 shows why. It shows actual spending on Social Security and on Medicare, Medicaid, and CHIP (a program that provides health care coverage to uninsured children) as percentages of GDP from 2000 to 2013, together with Congressional Budget Office projections of spending through 2085. According to these projections, spending on Social Security will rise substantially over the next few decades and spending on the three health care programs will soar. Why?

This figure shows Congressional Budget Office projections of spending on social insurance programs as a share of GDP. Partly as a result of an aging population, but mainly because of rising health care costs, these programs are expected to become much more expensive over time, posing problems for the federal budget.

Source: Congressional Budget Office.

In the case of Social Security, the answer is demography. Social Security is a “pay-as-you-go” system: current workers pay payroll taxes that fund the benefits of current retirees. So the ratio of the number of retirees drawing benefits to the number of workers paying into Social Security has a major impact on the system’s finances.

There was a huge surge in the U.S. birth rate between 1946 and 1964, commonly called the “baby boom.” Most baby boomers are currently of working age—which means they are paying taxes, not collecting benefits. But some are starting to retire, and as more of them do so, they will stop earning taxable income and start collecting benefits. As a result, the ratio of retirees receiving benefits to workers paying into the Social Security system will rise.

In 2013 there were 35 retirees receiving benefits for every 100 workers paying into the system. By 2030, according to the Social Security Administration, that number will rise to 46; by 2050, it will rise to 48; and by 2080, that number will be 51. So as baby boomers move into retirement, benefit payments will continue to rise relative to the size of the economy.

The aging of the baby boomers, by itself, poses only a moderately sized long-run fiscal problem. The projected rise in Medicare and Medicaid spending is a much more serious concern. The main story behind projections of higher Medicare and Medicaid spending is the long-run tendency of health care spending to rise faster than overall spending, both for government-funded and for privately funded health care.

To some extent, the implicit liabilities of the U.S. government are already reflected in debt statistics. We mentioned earlier that the government had a total debt of $16.7 trillion at the end of fiscal 2013 but that only $12.0 trillion of that total was owed to the public. The main explanation for that discrepancy is that both Social Security and part of Medicare (the hospital insurance program) are supported by dedicated taxes: their expenses are paid out of special taxes on wages. At times, these dedicated taxes yield more revenue than is needed to pay current benefits.

In particular, since the mid-1980s the Social Security system has been taking in more revenue than it currently needs in order to prepare for the retirement of the baby boomers. This surplus in the Social Security system has been used to accumulate a Social Security trust fund, which was $2.7 trillion at the end of fiscal 2013.

The money in the trust fund is held in the form of U.S. government bonds, which are included in the $16.7 trillion in total debt. You could say that there’s something funny about counting bonds in the Social Security trust fund as part of government debt. After all, these bonds are owed by one part of the government (the government outside the Social Security system) to another part of the government (the Social Security system itself). But the debt corresponds to a real, if implicit, liability: promises by the government to pay future retirement benefits.

So many economists argue that the gross debt of $16.7 trillion, the sum of public debt and government debt held by Social Security and other trust funds, is a more accurate indication of the government’s fiscal health than the smaller amount owed to the public alone.

Module 68 Review

Check Your Understanding

Suppose the economy is in a slump and the current public debt is quite large. Explain the trade-off of short-run versus long-run objectives that policy makers face when deciding whether or not to engage in fiscal policy.

PITFALLS: DEFICITS AND DEBT DO DIFFER

DEFICITS AND DEBT DO DIFFER

What Is the difference between deficit and debt? Confusing deficit and debt is a common mistake—it happens all the time in news reports, for example.

A DEFICIT IS THE DIFFERENCE BETWEEN THE AMOUNT OF MONEY A GOVERNMENT SPENDS AND THE AMOUNT IT RECEIVES IN TAXES OVER A GIVEN PERIOD — USUALLY, THOUGH NOT ALWAYS, A YEAR. A DEBT IS THE SUM OF MONEY A GOVERNMENT OWES AT A PARTICULAR POINT IN TIME. Deficit numbers always come with a statement about the time period to which they apply, as in “the U.S. budget deficit in fiscal 2013 was $683 billion.” Debt numbers usually come with a specific date, as in “U.S. public debt at the end of fiscal 2013 was $17 trillion.”

Although deficits and debt are linked, because government debt grows when governments run deficits, they aren’t the same thing, and they can even tell different stories. For example, Italy, which found itself in debt trouble in 2011, had a fairly small deficit by historical standards, but it had very high debt, a legacy of past policies.

To learn more, see pages 333–334.