Government Debt and Budget Deficits

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Blessed are the young, for they shall inherit the national debt.

—Herbert Hoover

I think we ought to just go ahead and make “zillion” a real number. “Gazillion,” too. A zillion could be ten million trillions, and a gazillion could be a trillion zillions. It seems to me it’s time to do this.

—George Carlin

When a government spends more than it collects in taxes, it has a budget deficit, which it finances by borrowing from the private sector or from foreign governments. The accumulation of past borrowing is the government debt.

Debate about the appropriate amount of government debt in the United States is as old as the country itself. Alexander Hamilton believed that “a national debt, if it is not excessive, will be to us a national blessing,” while James Madison argued that “a public debt is a public curse.” Indeed, the location of the nation’s capital was chosen as part of a deal in which the federal government assumed the Revolutionary War debts of the states: because the northern states had larger outstanding debts, the capital was located in the South.

The debate over government debt has been particularly fervent in recent years. In the aftermath of the financial crisis of 2008–2009, the U.S. government ran very large budget deficits. These deficits were in part due to automatic stabilizers: tax revenue falls and government spending on programs like unemployment insurance rises when the economy goes into recession. In addition, various discretionary changes in fiscal policy aimed at stimulating the economy further increased the deficit. In 2009, the deficit was 9.8 percent of GDP, the largest budget shortfall since World War II. As the economy improved, the deficit shrank to 3.7 percent of GDP in 2014. But many analysts feared that the deficit would rise in the years ahead, because the large baby boom generation would soon retire and become eligible for various government benefits such as Social Security and Medicare.

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This chapter considers various aspects of the debate over the economic effects of government debt. We begin by looking at the numbers. Section 19-1 examines the size of the U.S. government debt, comparing it to the historical and international record. It also takes a brief look at what the future may hold. Section 19-2 discusses why measuring changes in government indebtedness is not as straightforward as it might seem.

We then look at how government debt affects the economy. Section 19-3 describes the traditional view of government debt, according to which government borrowing reduces national saving and crowds out capital accumulation. This view is held by most economists and has been implicit in the discussion of fiscal policy throughout this book. Section 19-4 discusses an alternative view, called Ricardian equivalence, which is held by a small but influential minority of economists. According to the Ricardian view, government debt does not influence national saving and capital accumulation. As we will see, the debate between the traditional and Ricardian views of government debt arises from disagreements over how consumers respond to the government’s debt policy.

Section 19-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should always try to balance its budget and, if not, when a budget deficit or surplus is desirable. It also examines the effects of government debt on monetary policy, the political process, and a nation’s role in the world economy.

Although this chapter provides the foundation for understanding the effects of government debt and budget deficits, the story will not be completed until the next chapter. There we will examine the financial system more broadly, including the causes of financial crises. As we will see, excessive government debt can be at the center of such crises—a lesson that several European nations have recently been learning, all too painfully.