POLITICS, DEFICITS, AND DEBT

Deficit and Debt

The Definition of Debt and Assets

• Debt is accumulated deficits minus accumulated surpluses.

• Deficits and surpluses are flow concepts.

• Debt is a stock concept.

Debt Management

• The U.S. Treasury must sell new bonds when running a deficit and refinance previously issued bonds as they come due.

The Need to Judge Debt Relative to Assets

• Debt needs to be judged relative to assets.

• Debt is a summary measure of a nation’s financial situation.

• As a summary measure, debt has even more problems than deficit.

The Need to Judge Debt Relative to Assets

• Debt by itself is only half the picture.

• The other half is assets.

The Need to Judge Debt Relative to Assets

• For a nation, assets include:

– Its skilled work force.– Natural resources.– Its housing stock.– Holdings of foreign assets.

– The buildings and land it owns.– A portion of the assets of the people in the

country, since government gets a portion of all earnings of those assets in tax revenue.

The Need to Judge Debt Relative to Assets

• For a government, assets include:

• If the assets are valued at more than their costs, then the deficit is making the society better off.

The Need to Judge Debt Relative to Assets

• When the government runs a deficit, it might be spending on projects that increase its assets.

• These assets earn money in the future for the business.

The Need to Judge Debt Relative to Assets

• When businesses spend on projects that increase its assets, such expenditures are included in a capital budget.

• Determining what is an investment in government is extraordinarily difficult.

The Need to Judge Debt Relative to Assets

• Government does not have a capital budget.

• Thus, government avoids trying to measure the capitalizing aspects of spending.

The Need to Judge Debt Relative to Assets

• Most government goods earn no income, they are supplied free to individuals and are paid for by taxes.

Arbitrariness in Defining Debt and Assets

• Defining debt and assets can be arbitrary.

• As was the case with income, revenues, and deficits, there is no perfect answer as to how assets and debt should be valued.

Arbitrariness in Defining Debt and Assets

• Even after assets are taken into account, you still have to be careful when deciding whether or not to be concerned about debt.

• The government holds about 44 percent of its own debt, most of it in the Social Security trust fund.

Arbitrariness in Defining Debt and Assets

• Much of the government debt is internal to the government.

Difference Between Individual and Government Debt***

• Government debt is different from an individual’s debt for three reasons:– Government debt is ongoing – it does not

die.– Government can print money to pay off its

debt – individuals can’t. – 82 percent of government debt is internal

debt – debt owed to other government agencies or to its citizens.

Arbitrariness in Defining Debt and Assets

Federal Reserve (9%)

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Foreign individuals and firms (25%)

U.S. individuals and firms (24%)

U.S. government agencies (42%)

Ownership of Debt

Federal agencies

17%Social Security 13%Federal Reserve 9%

State and localgovernments 8%

Public Sector

Foreigners

Foreigners 20%

Private Sector

Individuals6%Banks,

corporations,insurance

companies,etc, 8%

Difference Between Individual and Government Debt***

• Paying interest on the internal debt involves a redistribution among citizens of the country.

• It does not not involves a net reduction in income of the average citizen.

• External debt – government debt owed to individuals in foreign countries.

Difference Between Individual and Government Debt**

• External debt is more like an individual’s debt.

Government Deficits and Debt: the Historical Record

• The government has run almost continual deficits from World War II until now, except for a few years in the late 1990s.

• Deficits as a percentage of GDP did not rise significantly in the 1970s and 1980s.

• Debt relative to GDP has not been continuously increasing.

• Deficits and debt relative to GDP provide a measure of a country’s ability to pay off a deficit and service its debt.

A String of Deficits

1970 1994 1996 1998 2000 200219721974 19761978 1980 198219841986 198819901992

Budget Surpluses

Budget Deficits

10%

0

-10

-20

-301900 1920 1940 1960 1980 2000

Budget Deficits as a Percentage of GDP

Always in Debt

• 1835-36: Debt Free! – The U.S. was completely out of debt by 1835.

• The Mexican-American War (1846-48) caused a four-fold increase in the debt

Debt as a Percentage of GDP

100%

75

50

25

01800 1920 1940 1960 1980 20001820 1840 1860 1880 1900

The Debt Burden*

• Most of the decrease in the debt-to-GDP ratio occurred through growth of GDP.

• Real growth in the U.S. has averaged about 2.5 to 3.5 percent per year.

• This means that U.S. debt can grow between 2.5 to 3.5 percent a year without increasing debt/GDP ratio.

The Debt Burden

• Most of the decrease in the U.S. debt-to-GDP ratio occurred through growth in GDP.

• When GDP grows, the government can reasonably handle more debt.

U.S. Debt Compared to Foreign Countries’ Debt

Interest Rates and Debt Burden

• The interest rate determines annual debt service.

• The annual debt service is the interest rate on debt times the total debt.

Interest Rates and Debt Burden

• Interest payments on the debt is government revenue that cannot be spent on defense or welfare.

• That is what people mean when they say a deficit is burdening future generations.*

Interest Rates and Debt Burden

• The U.S. can actually afford more debt since U.S. government securities are considered the safest in the world.

Nominal and Real Surpluses and Deficits

• Inflation reduces the value of the debt.

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• That reduction is taken into account when the real deficit is calculated.

Nominal and Real Surpluses and Deficits

• A nominal deficit is determined by looking at the difference between expenditures and receipts.

• A real deficit is the nominal deficit adjusted for inflation.

Nominal and Real Surpluses and Deficits

• The real deficit is calculated by adjusting the nominal deficit for inflation.

Real deficit = Nominal deficit – (Inflation x Total debt)

Nominal and Real Surpluses and Deficits

• The lowering of the real deficit by inflation is not costless to the government.

• Persistent inflation gets built into expectations and causes higher interest rates.