Worth: Mankiw Economics 5e CHAPTER FIFTEEN Government Debt Blessed are the young, for they shall inherit the national debt Herbert hoover When a government spends more than it collects in taxes, it borrows from the private sector to finance the budget deficit. The accumulation of past borrowin 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 be- lieved thata national debt, if it is not excessive, will be to us a national blessing, whereas James Madison argued that "a public debt is a public curse "Indeed, the location of the nations 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 Although attention to the government debt has waxed and waned over the years, it was especially intense during the last two decades of the twentieth cen- tury. Beginning in the early 1980s, the U.S. federal government began running large budget deficits--in part because of increased spending and in part because of reduced taxes. As a result, the government debt expressed as a percentage of GDP roughly doubled from 26 percent in 1980 to 50 percent in 1995. By the late 1990s. the b deficit had come under control and had even turned into a budget surplus. Policymakers then turned to the question of how rapidly the debt should be paid off. The large increase in government debt from 1980 to 1995 is without prece- dent in U.S. history. Government debt most often rises in periods of war or de- pression, but the United States experienced neither during this time. Not surprisingly, the episode sparked a renewed interest among economists and poli cymakers in the economic effects of government debt. Some view the large bud- get deficits of the 1980s and 1990s as the worst mistake of economic policy since the Great Depression, whereas others think that the deficits matter very little. This chapter considers various facets of this debate. We begin by looking at the numbers. Section 15-1 examines the size of the S. government debt, comparing it to the debt of other countries and to the debt that the United States has had during its own past. It also takes a brief look at what the future may hold. Section 15-2 discusses why measuring changes in 405 User LUxpI: Job EFFo1431: 6264_ch15: Pg 405: 26545#/eps at 1004g Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 405:26545#/eps at 100% *26545* Wed, Feb 20, 2002 3:28 PM When a government spends more than it collects in taxes, it borrows from the private sector to finance the budget deficit.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,” whereas 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. Although attention to the government debt has waxed and waned over the years, it was especially intense during the last two decades of the twentieth century. Beginning in the early 1980s, the U.S. federal government began running large budget deficits—in part because of increased spending and in part because of reduced taxes. As a result, the government debt expressed as a percentage of GDP roughly doubled from 26 percent in 1980 to 50 percent in 1995. By the late 1990s, the budget deficit had come under control and had even turned into a budget surplus. Policymakers then turned to the question of how rapidly the debt should be paid off. The large increase in government debt from 1980 to 1995 is without precedent in U.S. history. Government debt most often rises in periods of war or depression, but the United States experienced neither during this time. Not surprisingly, the episode sparked a renewed interest among economists and policymakers in the economic effects of government debt. Some view the large budget deficits of the 1980s and 1990s as the worst mistake of economic policy since the Great Depression, whereas others think that the deficits matter very little. This chapter considers various facets of this debate. We begin by looking at the numbers. Section 15-1 examines the size of the U.S. government debt, comparing it to the debt of other countries and to the debt that the United States has had during its own past. It also takes a brief look at what the future may hold. Section 15-2 discusses why measuring changes in | 405 Government Debt 15 CHAPTER Blessed are the young, for they shall inherit the national debt. — Herbert Hoover FIFTEEN
Worth: Mankiw Economics 5e 406 PART V Microeconomic Policy Debates government indebtedness is not as straightforward as it might seem. Indeed,some conomists argue that traditional measures are so misleading that they should be We then look at how government debt affects the economy. Section 15-3 de scribes the traditional view of government debt, according to which go vernmen borrowing reduces national saving and crowds out capital accumulation. This view is held by most economists and has been implicit in the discussion of fisca olicy throughout this book. Section 15-4 discusses an alternative view, called Ricardian equivalence, which is held by a small but influential minority of econo- mists. According to the Ricardian view, government debt does not influence na tional 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 15-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should try to always balance its the effects of government debt on monetary policy, the political process, dlass budget and, if not, when a budget deficit or surplus is desirable. It also examine role of a country in the world economy. 75-1 The Size of the Government Debt Let's begin by putting the government debt in perspective. In 2001, the debt of the U.S. federal government was $3.2 trillion. If we divide this number by 276 million, the number of people in the United States, we find that each per- son's share of the government debt was about $11, 600. Obviously, this is not a trivial number--few people sneeze at $11, 600. Yet if we compare this debt to able 15-1 How Indebted Are the World's Governments? Count Government Debt as Government Debt as a Percentage of GDP a Percentage of GDP Japan 119 Ireland Belgium Finland Canada Sweden Greece Denmark United States 0066s Austria Netherlands Australia orway rtuga Source: OECD Economic Outlook. Figures are based on estimates of gross government debt and GDP for 2001 User LUKBI: Job EFFo1431: 6264_ch15: Pg 406: 28036#/eps at 100sl Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 406:28036#/eps at 100% *28036* Wed, Feb 20, 2002 3:28 PM government indebtedness is not as straightforward as it might seem. Indeed, some economists argue that traditional measures are so misleading that they should be completely ignored. We then look at how government debt affects the economy. Section 15-3 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 15-4 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 15-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should try to always 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 the role of a country in the world economy. 15-1 The Size of the Government Debt Let’s begin by putting the government debt in perspective. In 2001, the debt of the U.S. federal government was $3.2 trillion. If we divide this number by 276 million, the number of people in the United States, we find that each person’s share of the government debt was about $11,600. Obviously, this is not a trivial number—few people sneeze at $11,600.Yet if we compare this debt to 406 | PART V Microeconomic Policy Debates Country Government Debt as Country Government Debt as a Percentage of GDP a Percentage of GDP Japan 119 Ireland 54 Italy 108 Spain 53 Belgium 105 Finland 51 Canada 101 Sweden 49 Greece 100 Germany 46 Denmark 67 Austria 40 United Kingdom 64 Netherlands 27 United States 62 Australia 26 France 58 Norway 24 Portugal 55 Source: OECD Economic Outlook. Figures are based on estimates of gross government debt and GDP for 2001. How Indebted Are the World’s Governments? table 15-1
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 407 the roughly $1 million a typical person will earn over his or her working life, the government debt does not look like the catastrophe it is sometimes made be One way to judge the size of a government's debt is to compare it to the amount of debt other countries have accumulated. Table 15-1 shows the amount of government debt for 19 major countries expressed as a percentage of each ountry's GDP On the top of the list are the heavily indebted countries of Japan and Italy, which have accumulated a debt that exceeds annual GDP. At the bot tom are Norway and Australia, which have accumulated relatively small debts The United States is in the middle of the pack. By international standards, the U.S. government is neither especially profligate nor especially frugal. Over the course of U.S. history, the indebtedness of the federal government has varied substantially. Figure 15-1 shows the ratio of the federal debt to GDP since 1791. The government debt, relative to the size of the economy, varies from close to zero in the 1830s to a maximum of 107 percent of GDP in 1945 Historically, the primary cause of increases in the government debt is war. The debt-GDP ratio rises sharply during major wars and falls slowly during Peacetime. Many economists think that this historical pattern is the appropriate figure 15-1 Debt-GDP 0 Civi World War/ 179118111831185118711891191119311951197119912001 The Ratio of Government Debt to GDP Since 1790 The U.S. federal government debt held by the public, relative to the size of the U.S. economy, rises sharply during wars and declines slowly during peacetime. The exception is the period since 1980, when the debt-GDP ratio rose without the occurrence of a major military conflict. Source: U.S.Department of Treasury, U.S. Department of Commerce, and T.S. Berry, "Production and Population Since 1789, "Bostwick Paper No. 6, Richmond, 198 User LUKBI: Job EFFo1431: 6264_ch15: Pg 407: 28037#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 407:28037#/eps at 100% *28037* Wed, Feb 20, 2002 3:28 PM the roughly $1 million a typical person will earn over his or her working life, the government debt does not look like the catastrophe it is sometimes made out to be. One way to judge the size of a government’s debt is to compare it to the amount of debt other countries have accumulated.Table 15-1 shows the amount of government debt for 19 major countries expressed as a percentage of each country’s GDP. On the top of the list are the heavily indebted countries of Japan and Italy, which have accumulated a debt that exceeds annual GDP. At the bottom are Norway and Australia, which have accumulated relatively small debts. The United States is in the middle of the pack. By international standards, the U.S. government is neither especially profligate nor especially frugal. Over the course of U.S. history, the indebtedness of the federal government has varied substantially. Figure 15-1 shows the ratio of the federal debt to GDP since 1791.The government debt, relative to the size of the economy, varies from close to zero in the 1830s to a maximum of 107 percent of GDP in 1945. Historically, the primary cause of increases in the government debt is war. The debt–GDP ratio rises sharply during major wars and falls slowly during peacetime. Many economists think that this historical pattern is the appropriate CHAPTER 15 Government Debt | 407 figure 15-1 Year Debt–GDP ratio Revolutionary War Civil War World War I World War II 1.2 1 0.8 0.6 0.4 0.2 0 1791 1811 1831 1851 1871 1891 1911 1931 1951 1971 1991 2001 The Ratio of Government Debt to GDP Since 1790 The U.S. federal government debt held by the public, relative to the size of the U.S. economy, rises sharply during wars and declines slowly during peacetime. The exception is the period since 1980, when the debt–GDP ratio rose without the occurrence of a major military conflict. Source: U.S. Department of Treasury, U.S. Department of Commerce, and T.S. Berry, “Production and Population Since 1789,” Bostwick Paper No. 6, Richmond, 1988
Worth: Mankiw Economics 5e 408 PART V Microeconomic Policy Debates way to run fiscal policy. As we discuss more fully later in this chapter, deficit financing of wars appears optimal for reasons of both tax smoothing and gen- erational equity. One instance of a large increase in government debt in peacetime occurred during the 1980s and early 1990s, when the federal gov- ernment ran substantial budget deficits. Many economists have criticized this increase in government debt as imposing a burden on future generations without justification During the middle of the 1990s, the U.S. federal government started to get its budget deficit under control. A combination of tax hikes, spending cuts, and rapid economic growth caused the ratio of debt to gdp to stabilize and then de- cline. Recent experience has tempted some observers to that exploding government debt is a thing of the past. But as the next case study suggests, the st may be CASE STUDY The Fiscal Future: Good News and bad News What does the future hold for fiscal policymakers? Economic forecasting is far from precise, and it is easy to be cynical about economic predictions. But good policy cannot be made if policymakers only look backwards. As a result, econo- mists in the Congressional Budget Office(CBO) and other government agen cies are always trying to look ahead to see what problems and opportunities are likely to dev When George W Bush moved into the White House in 2001, the fiscal pic- ure facing the U.S. government was mixed. In particular, it depended on how far one looked ahead Over a ten- or twenty-year horizon, the picture looked good. The U.S. federal government was running a large budget surplus. As a percentage of GDP, the projected surplus for 2001 was the largest since 1948. Moreover, the surplus was expected to grow even larger over time. The surplus was large enough so that, without any policy changes, the government debt would be paid off by 2008 9 These surpluses arose from various sources. The elder George Bush had signed ax increase in 1990, and Bill Clinton had signed another in 1993. Because of these tax hikes, federal tax revenue as a percentage of GDP reached its highest level since World War II. Then, in the late 1990s, productivity accelerated, most comes led to rising tax revenue, which on technology. The high growth in in- likely because of advances in informatic pushed the federal governments budget from deficit to surplus a debate arose over how to respond to the budget surplus. The go vernment ould use the large projected surpluses to repay debt, increase spending, cut taxes, or some combination of these. The new Republican president George W Bush advocated a tax cut of $1.6 trillion over 10 years, which was about one-fourth of the projected surpluses. Democrats in Congress argued for a smaller tax cut and greater government spending. The end result was a compromise bill that cut taxes by a bit less than Bush had advocated User LUKBI: Job EFFo1431: 6264_ch15: Pg 408: 28038#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 408:28038#/eps at 100% *28038* Wed, Feb 20, 2002 3:28 PM way to run fiscal policy. As we discuss more fully later in this chapter, deficit financing of wars appears optimal for reasons of both tax smoothing and generational equity. One instance of a large increase in government debt in peacetime occurred during the 1980s and early 1990s, when the federal government ran substantial budget deficits. Many economists have criticized this increase in government debt as imposing a burden on future generations without justification. During the middle of the 1990s, the U.S. federal government started to get its budget deficit under control. A combination of tax hikes, spending cuts, and rapid economic growth caused the ratio of debt to GDP to stabilize and then decline. Recent experience has tempted some observers to think that exploding government debt is a thing of the past. But as the next case study suggests, the worst may be yet to come. 408 | PART V Microeconomic Policy Debates CASE STUDY The Fiscal Future: Good News and Bad News What does the future hold for fiscal policymakers? Economic forecasting is far from precise, and it is easy to be cynical about economic predictions. But good policy cannot be made if policymakers only look backwards.As a result, economists in the Congressional Budget Office (CBO) and other government agencies are always trying to look ahead to see what problems and opportunities are likely to develop. When George W. Bush moved into the White House in 2001, the fiscal picture facing the U.S. government was mixed. In particular, it depended on how far one looked ahead. Over a ten- or twenty-year horizon, the picture looked good.The U.S. federal government was running a large budget surplus. As a percentage of GDP, the projected surplus for 2001 was the largest since 1948. Moreover, the surplus was expected to grow even larger over time.The surplus was large enough so that, without any policy changes, the government debt would be paid off by 2008. These surpluses arose from various sources.The elder George Bush had signed a tax increase in 1990, and Bill Clinton had signed another in 1993. Because of these tax hikes, federal tax revenue as a percentage of GDP reached its highest level since World War II.Then, in the late 1990s, productivity accelerated, most likely because of advances in information technology. The high growth in incomes led to rising tax revenue, which pushed the federal government’s budget from deficit to surplus. A debate arose over how to respond to the budget surplus.The government could use the large projected surpluses to repay debt, increase spending, cut taxes, or some combination of these.The new Republican president George W. Bush advocated a tax cut of $1.6 trillion over 10 years, which was about one-fourth of the projected surpluses. Democrats in Congress argued for a smaller tax cut and greater government spending.The end result was a compromise bill that cut taxes by a bit less than Bush had advocated
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 409 While the 10-year horizon looked rosy, the longer-term fiscal picture was more roublesome. The problem was demographic. Advances in medical technology have been increasing life expectancy, while improvements in birth-control techniques and changing social norms have reduced the number of children people have. Be- cause of these developments, the elderly are becoming a larger share of the popula- tion. In 1990, there were 21 elderly for every 100 people of working age(ages 20 to 64); this figure is projected to rise to 36 by the year 2030. Such a demographic change has profound implications for fiscal policy. About one-third of the budget of the U.S. federal government is devoted to pensions and health care for the el- derly. As more people become eligible for these "entitlements, as they are some- times called, government spending automatically rises over time, pushing the budget toward deficit. The magnitude of these budgetary pressures was documented in a CBO re- port released in October 2000. According to the CBO, if no changes in fiscal policy are enacted, the government debt as a percentage of gDP will start rising around 2030 and reach historic highs around 2060. At that point, the govern- ment's budget will spiral out of control Of course, all economic forecasts need to be greeted with a bit of skepticism especially those that try to look ahead half a century. Shocks to the economy can alter the government's revenue and spending. In fact, only months after moving into the White House, George W. Bush saw the fiscal picture start to change First the economic slowdown in 2001 reduced tax revenue. Then. the terrorist attacks in September 2001 induced an increase in government spending. Both developments reduced the projected near-term government surpluses. As this book was going to press, there was great uncertainty about future government spending and the rate of technological advance--two key determinants of the fiscal situation Yet one thing is clear: the elderly are making up a larger share of the popula tion, and this fact will shape the fiscal challenges in the decades ahead. 75-2 Problems in Measurement The government budget deficit equals government spending minus government revenue, which in turn equals the amount of new debt the government needs to issue to finance its operations. This definition may sound simple enough, but in fact debates over fiscal policy sometimes arise over how the budget deficit should be measured. Some economists believe that the deficit as currently measured is not a good indicator of the stance of fiscal policy. That is, they believe that the budget deficit does not accurately gauge either the impact of fiscal policy on todays economy or the burden being placed on future generations of taxpayers. In this section we discuss four problems with the usual measure of the budget deficit. I Congressional Budget Office, The Long- Tem Budget Outlook, October 2000 User LUKBI: Job EFFo1431: 6264_ch15: Pg 409: 28039#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 409:28039#/eps at 100% *28039* Wed, Feb 20, 2002 3:28 PM 15-2 Problems in Measurement The government budget deficit equals government spending minus government revenue, which in turn equals the amount of new debt the government needs to issue to finance its operations.This definition may sound simple enough, but in fact debates over fiscal policy sometimes arise over how the budget deficit should be measured. Some economists believe that the deficit as currently measured is not a good indicator of the stance of fiscal policy.That is, they believe that the budget deficit does not accurately gauge either the impact of fiscal policy on today’s economy or the burden being placed on future generations of taxpayers.In this section we discuss four problems with the usual measure of the budget deficit. CHAPTER 15 Government Debt | 409 While the 10-year horizon looked rosy, the longer-term fiscal picture was more troublesome.The problem was demographic.Advances in medical technology have been increasing life expectancy, while improvements in birth-control techniques and changing social norms have reduced the number of children people have. Because of these developments,the elderly are becoming a larger share of the population. In 1990, there were 21 elderly for every 100 people of working age (ages 20 to 64); this figure is projected to rise to 36 by the year 2030. Such a demographic change has profound implications for fiscal policy.About one-third of the budget of the U.S. federal government is devoted to pensions and health care for the elderly.As more people become eligible for these “entitlements,” as they are sometimes called, government spending automatically rises over time, pushing the budget toward deficit. The magnitude of these budgetary pressures was documented in a CBO report released in October 2000. According to the CBO, if no changes in fiscal policy are enacted, the government debt as a percentage of GDP will start rising around 2030 and reach historic highs around 2060. At that point, the government’s budget will spiral out of control.1 Of course, all economic forecasts need to be greeted with a bit of skepticism, especially those that try to look ahead half a century. Shocks to the economy can alter the government’s revenue and spending. In fact, only months after moving into the White House, George W. Bush saw the fiscal picture start to change. First, the economic slowdown in 2001 reduced tax revenue.Then, the terrorist attacks in September 2001 induced an increase in government spending. Both developments reduced the projected near-term government surpluses. As this book was going to press, there was great uncertainty about future government spending and the rate of technological advance—two key determinants of the fiscal situation. Yet one thing is clear: the elderly are making up a larger share of the population, and this fact will shape the fiscal challenges in the decades ahead. 1 Congressional Budget Office, The Long-Term Budget Outlook, October 2000
Worth: Mankiw Economics 5e 410 PART V Microeconomic Policy Debates Measurement problem 1: Inflation The least controversial of the measurement issues is the correction for infation Almost all economists agree that the government's indebtedness should be mea- sured in real terms. not in nominal terms. The measured deficit should equal the hange in the government's real debt, not the change in its nominal debt The budget deficit as commonly measured, however, does not correct for in- fation. To see how large an error this induces, consider the following example Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced In this case, the nominal debt must be rising at the △D/D=丌 where T is the inflation rate and D is the stock of government debt. This implies The government would look at the change in the nominal debt AD and would report a budget deficit of TD. Hence, most economists believe that the reported budget deficit is overstated by the amount TD We can make the same argument in another way. The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate t the budget deficit is overstated by TD This correction for inflation can be large, especially when inflation is high and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the pub- lic (excluding the Federal Reserve)was $495 billion. The deficit was therefore ted by 丌D=0.086×$495 billion =$43 billion Corrected for inflation, the reported budget deficit of $28 billion turns into a budget surplus of $15 billion! In other words, even though nominal government debt was rising, real government debt was falling Measurement Problem 2: Capital Assets Many economists believe that an accurate assessment of the government's budget deficit requires accounting for the governments assets as well as its liabilities. In particular, when measuring the government's overall indebtedness, we should subtract government assets from government debt. Therefore, the budget deficit should be measured as the change in debt minus the change in assets User LUKBI: Job EFFo1431: 6264_ch15: Pg 410: 28040#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 410:28040#/eps at 100% *28040* Wed, Feb 20, 2002 3:28 PM Measurement Problem 1: Inflation The least controversial of the measurement issues is the correction for inflation. Almost all economists agree that the government’s indebtedness should be measured in real terms, not in nominal terms.The measured deficit should equal the change in the government’s real debt, not the change in its nominal debt. The budget deficit as commonly measured, however, does not correct for in- flation.To see how large an error this induces, consider the following example. Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced. In this case, the nominal debt must be rising at the rate of inflation.That is, DD/D = p , where p is the inflation rate and D is the stock of government debt.This implies DD = p D. The government would look at the change in the nominal debt DD and would report a budget deficit of p D. Hence, most economists believe that the reported budget deficit is overstated by the amount p D. We can make the same argument in another way.The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate p , the budget deficit is overstated by p D. This correction for inflation can be large, especially when inflation is high, and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the public (excluding the Federal Reserve) was $495 billion.The deficit was therefore overstated by p D = 0.086 × $495 billion = $43 billion. Corrected for inflation, the reported budget deficit of $28 billion turns into a budget surplus of $15 billion! In other words, even though nominal government debt was rising, real government debt was falling. Measurement Problem 2: Capital Assets Many economists believe that an accurate assessment of the government’s budget deficit requires accounting for the government’s assets as well as its liabilities. In particular, when measuring the government’s overall indebtedness, we should subtract government assets from government debt.Therefore, the budget deficit should be measured as the change in debt minus the change in assets. 410 | PART V Microeconomic Policy Debates
Worth: Mankiw Ecol CHAPTER I5 Government Debt 411 Certainly, individuals and firms treat assets and liabilities symmetrically. When person borrows to buy a house, we do not say that he is running a budget deficit. Instead, we offset the increase in assets(the house)against the increase in debt(the mortgage)and record no change in net wealth. Perhaps we should treat the governments finances the same we a budget procedure that accounts for assets as well as liabilities is called capi- tal budgeting, because it takes into account changes in capital. For example, suppose that the government sells one of its office buildings or some of its land and uses the proceeds to reduce the government debt. Under current budget procedures, the reported deficit would be lower Under capital budgeting, the revenue received from the sale would not lower the deficit because the reduc tion in debt would be offset by a reduction in assets. Similarly, under capital bud- geting, government borrowing to finance the purchase of a capital good would not raise the deficit The major difficulty with capital budgeting is that it is hard to decide which ditures should count as capital expenditures. For example, should the interstate highway system be counted as an asset of the government? If so, what is its value? What about the stockpile of nuclear weapons? Should spending on education be treated as expenditure on human capital? These diffi- cult questions must be answered if the government is to adopt a capital budget Economists and policymakers disagree about whether the federal government should use capital budgeting.(Many state governments already use it. )Oppo- nents of capital budgeting argue that, although the system is superior in principle to the current system, it is too difficult to implement in practice. Proponents of capita budgeting argue that even an imperfect treatment of capital assets wor be better than ignoring them altogether Measurement Problem 3: Uncounted liabilities Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities. For example, consider the pen- sions of government workers. These workers provide labor services to the govern- ment today, but part of their compensation is deferred to the future. In essence, these workers are providing a loan to the government. Their future pension bene- fits represent a government liability not very different from government debt. Yet this liability is not included as part of the government debt, and the accumulation timates, this implicit liability is almost as large as the official government debt es- of this liability is not included as part of the budget deficit. According to some Similarly, consider the Social Security system. In some ways, the system is like a pension plan. People pay some of their income into the system when young and expect to receive benefits when old. Perhaps accumulated future Social Security benefits should be included in the government's liabilities Estimates suggest that the government's future Social Security liabilities(less future Social Security taxes) are more than three times the government debt as officially measured. One might argue that Social Security liabilities are different from government debt because the government can change the laws determining Social Securit User LUKBI: Job EFFo1431: 6264_ch15: Pg 411: 28041#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 411:28041#/eps at 100% *28041* Wed, Feb 20, 2002 3:28 PM Certainly, individuals and firms treat assets and liabilities symmetrically.When a person borrows to buy a house, we do not say that he is running a budget deficit. Instead, we offset the increase in assets (the house) against the increase in debt (the mortgage) and record no change in net wealth. Perhaps we should treat the government’s finances the same way. A budget procedure that accounts for assets as well as liabilities is called capital budgeting, because it takes into account changes in capital. For example, suppose that the government sells one of its office buildings or some of its land and uses the proceeds to reduce the government debt. Under current budget procedures, the reported deficit would be lower. Under capital budgeting, the revenue received from the sale would not lower the deficit, because the reduction in debt would be offset by a reduction in assets. Similarly, under capital budgeting, government borrowing to finance the purchase of a capital good would not raise the deficit. The major difficulty with capital budgeting is that it is hard to decide which government expenditures should count as capital expenditures. For example, should the interstate highway system be counted as an asset of the government? If so, what is its value? What about the stockpile of nuclear weapons? Should spending on education be treated as expenditure on human capital? These diffi- cult questions must be answered if the government is to adopt a capital budget. Economists and policymakers disagree about whether the federal government should use capital budgeting. (Many state governments already use it.) Opponents of capital budgeting argue that, although the system is superior in principle to the current system, it is too difficult to implement in practice. Proponents of capital budgeting argue that even an imperfect treatment of capital assets would be better than ignoring them altogether. Measurement Problem 3: Uncounted Liabilities Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities. For example, consider the pensions of government workers.These workers provide labor services to the government today, but part of their compensation is deferred to the future. In essence, these workers are providing a loan to the government.Their future pension bene- fits represent a government liability not very different from government debt.Yet this liability is not included as part of the government debt, and the accumulation of this liability is not included as part of the budget deficit.According to some estimates, this implicit liability is almost as large as the official government debt. Similarly, consider the Social Security system. In some ways, the system is like a pension plan. People pay some of their income into the system when young and expect to receive benefits when old. Perhaps accumulated future Social Security benefits should be included in the government’s liabilities. Estimates suggest that the government’s future Social Security liabilities (less future Social Security taxes) are more than three times the government debt as officially measured. One might argue that Social Security liabilities are different from government debt because the government can change the laws determining Social Security CHAPTER 15 Government Debt | 411
Worth: Mankiw Economics 5e 412 PART V Microeconomic Policy Debates benefits. Yet, in principle, the government could always choose not to repay all of its debt: the government honors its debt only because it chooses to do so. Promises to pay the holders of government debt may not be fundamentally dif ferent from promises to pay the future recipients of Social Security A particularly difficult form of government liability to measure is the contingent liability-the liability that is due only if a specified event occurs. For example, the government guarantees many forms of private credit, such as student loans, mortgages for low-and moderate-income families, and deposits in banks and savings-and-loan institutions. If the borrower repays the loan, the government pays nothing; if the borrower defaults, the government makes the repayment. When the government provides this guarantee, it undertakes a liability contin gent on the borrowers default. Yet this contingent liability is not reflected in the budget deficit, in part because it is not clear what dollar value to attach to it. Measurement Problem 4: The Business Cycle Many changes in the government's budget deficit occur automatically in re- sponse to a fluctuating economy. For example, when the economy goes into a cession, incomes fall, so people pay less in personal income taxes. Profits fall,so corporations pay less in corporate income taxes. More people become eligible for government assistance, such as welfare and unemployment insurance, so gov ernment spending rises. Even without any change in the laws governing taxation and spending, the budget deficit increases These automatic changes in the deficit are not errors in measurement, becaus the government truly borrows more when a recession depresses tax revenue and boosts government spending. But these changes do make it more difficult to use the deficit to monitor changes in fiscal policy. That is, the deficit can rise or fall either because the government has changed policy or because the economy has changed direction. For some purposes, it would be good to know which is occurring To solve this problem, the government calculates a cyclically adjusted bud get deficit(sometimes called the full-employment budget deficit). The cyclically ad- justed deficit is based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and em- ployment. The cyclically adjusted deficit is a useful measure because it reflects policy changes but not the current stage of the business cycle umming Up Economists differ in the importance they place on these measurement problems Some believe that the problems are so severe that the measured budget deficit is almost meaningless. Most take these measurement problems seriously but still view the measured budget deficit as a useful indicator of fiscal policy The undisputed lesson is that to evaluate fully what fiscal po do mists and policymakers must look at more than only the measured budget deficit. And, in fact, they do. The budget documents prepared annually by the Office of Management and Budget contain much detailed information about the govern- ment's finances, including data on capital expenditures and credit programs User LUKBI: Job EFFo1431: 6264_ch15: Pg 412: 28042#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 412:28042#/eps at 100% *28042* Wed, Feb 20, 2002 3:28 PM benefits.Yet, in principle, the government could always choose not to repay all of its debt: the government honors its debt only because it chooses to do so. Promises to pay the holders of government debt may not be fundamentally different from promises to pay the future recipients of Social Security. A particularly difficult form of government liability to measure is the contingent liability—the liability that is due only if a specified event occurs. For example, the government guarantees many forms of private credit, such as student loans, mortgages for low- and moderate-income families, and deposits in banks and savings-and-loan institutions. If the borrower repays the loan, the government pays nothing; if the borrower defaults, the government makes the repayment. When the government provides this guarantee, it undertakes a liability contingent on the borrower’s default.Yet this contingent liability is not reflected in the budget deficit, in part because it is not clear what dollar value to attach to it. Measurement Problem 4: The Business Cycle Many changes in the government’s budget deficit occur automatically in response to a fluctuating economy. For example, when the economy goes into a recession, incomes fall, so people pay less in personal income taxes. Profits fall, so corporations pay less in corporate income taxes. More people become eligible for government assistance, such as welfare and unemployment insurance, so government spending rises. Even without any change in the laws governing taxation and spending, the budget deficit increases. These automatic changes in the deficit are not errors in measurement, because the government truly borrows more when a recession depresses tax revenue and boosts government spending.But these changes do make it more difficult to use the deficit to monitor changes in fiscal policy.That is, the deficit can rise or fall either because the government has changed policy or because the economy has changed direction. For some purposes, it would be good to know which is occurring. To solve this problem, the government calculates a cyclically adjusted budget deficit (sometimes called the full-employment budget deficit).The cyclically adjusted deficit is based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and employment. The cyclically adjusted deficit is a useful measure because it reflects policy changes but not the current stage of the business cycle. Summing Up Economists differ in the importance they place on these measurement problems. Some believe that the problems are so severe that the measured budget deficit is almost meaningless. Most take these measurement problems seriously but still view the measured budget deficit as a useful indicator of fiscal policy. The undisputed lesson is that to evaluate fully what fiscal policy is doing, economists and policymakers must look at more than only the measured budget deficit. And, in fact, they do.The budget documents prepared annually by the Office of Management and Budget contain much detailed information about the government’s finances, including data on capital expenditures and credit programs. 412 | PART V Microeconomic Policy Debates
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 413 No economic statistic is perfect. Whenever we see a number reported in the media, we need to know what it is measuring and what it is leaving out. This is especially true for data on government debt and budget deficits CASE STUDY Generational Accounting One harsh critic of current measures of the budget deficit is economist Laurence Kotlikoff Kotlikoff argues that the budget deficit is like the fabled emperor who wore no clothes: everyone should plainly see the problem, but no one is willing to admit to it. He writes, " On the conceptual level, the budget deficit is intellec tually bankrupt. On the practical level, there are so many official deficits that"bal- anced budget has lost any true meaning "He sees an"urgent need to switch from an outdated, misleading, and fundamentally noneconomic measure of fiscal li ely the budget deficit, to generational Generational accounting, Kotlikoff's new way to gauge the influence of fiscal policy, is based on the idea that a persons economic well-being depends on his or her lifetime income. (This idea is founded on Modigliani's life-cycle theory of consumer behavior, which we examine in Chapter 16.)When evaluating fiscal policy, therefore, we should not be concerned with taxes or spending in any sin- gle year. Instead, we should look at the taxes paid, and transfers received, by peo- ple over their entire lives. Generational accounts measure the impact of fiscal policy on the lifetime incomes of different generations Generational accounts tell a very different story than the budget deficit about the history of U.S. fiscal policy. In the early 1980s, the U.S. government cut taxes, beginning a long period of large budget deficits. Most commentators claim that older generations benefited at the expense of younger generations during this period, because the young inherited the government debt. Kotlikoff agrees that hese tax cuts raised the burden on the young, but he claims that this standard analysis ignores the impact of many other policy changes. His generational ac- counts show that the young were hit even harder during the 1950s, 1960s, and 1970s. During these years, the government raised Social Security benefits for the elderly and financed the higher spending by taxing the working-age population This policy redistributed income away from the young, even though it did not ffect the budget deficit. During the 1980s, Social Security reforms reversed this trend, benefiting younger generations. Despite Kotlikoff's advocacy, generational accounting is not likely to replace the budget deficit. This alternative system also has flaws. For example, to calculate the total tax burden on different generations, one needs to make assumptions about future policy, which are open to dispute. Nonetheless, generational ac- ounting offers a useful perspective in the debate over fiscal policy 2 Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend New York: The Free Press, 1992). For an appraisal of the book, see David M. Cutler, Book Review, National Tax Journal 56(March 1993): 61-67. See also the symposium on generational accounting in the winter 1994 issue of the Journal of Economic Perspectives. User LUKBI: Job EFFo1431: 6264_ch15: Pg 413: 28043#/eps at 100sl I Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 413:28043#/eps at 100% *28043* Wed, Feb 20, 2002 3:28 PM No economic statistic is perfect.Whenever we see a number reported in the media, we need to know what it is measuring and what it is leaving out.This is especially true for data on government debt and budget deficits. CHAPTER 15 Government Debt | 413 CASE STUDY Generational Accounting One harsh critic of current measures of the budget deficit is economist Laurence Kotlikoff. Kotlikoff argues that the budget deficit is like the fabled emperor who wore no clothes: everyone should plainly see the problem, but no one is willing to admit to it. He writes,“On the conceptual level, the budget deficit is intellectually bankrupt. On the practical level, there are so many official deficits that ‘balanced budget’ has lost any true meaning.” He sees an “urgent need to switch from an outdated, misleading, and fundamentally noneconomic measure of fiscal policy, namely the budget deficit, to generational accounting.” Generational accounting, Kotlikoff’s new way to gauge the influence of fiscal policy, is based on the idea that a person’s economic well-being depends on his or her lifetime income. (This idea is founded on Modigliani’s life-cycle theory of consumer behavior, which we examine in Chapter 16.) When evaluating fiscal policy, therefore, we should not be concerned with taxes or spending in any single year. Instead, we should look at the taxes paid, and transfers received, by people over their entire lives. Generational accounts measure the impact of fiscal policy on the lifetime incomes of different generations. Generational accounts tell a very different story than the budget deficit about the history of U.S. fiscal policy. In the early 1980s, the U.S. government cut taxes, beginning a long period of large budget deficits. Most commentators claim that older generations benefited at the expense of younger generations during this period, because the young inherited the government debt. Kotlikoff agrees that these tax cuts raised the burden on the young, but he claims that this standard analysis ignores the impact of many other policy changes. His generational accounts show that the young were hit even harder during the 1950s, 1960s, and 1970s. During these years, the government raised Social Security benefits for the elderly and financed the higher spending by taxing the working-age population. This policy redistributed income away from the young, even though it did not affect the budget deficit. During the 1980s, Social Security reforms reversed this trend, benefiting younger generations. Despite Kotlikoff’s advocacy, generational accounting is not likely to replace the budget deficit.This alternative system also has flaws. For example, to calculate the total tax burden on different generations, one needs to make assumptions about future policy, which are open to dispute. Nonetheless, generational accounting offers a useful perspective in the debate over fiscal policy.2 2 Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend (New York:The Free Press, 1992). For an appraisal of the book, see David M. Cutler, Book Review, National Tax Journal 56 (March 1993): 61–67. See also the symposium on generational accounting in the Winter 1994 issue of the Journal of Economic Perspectives
Worth: Mankiw Economics 5e 414 PART V Microeconomic Policy Debates 75-3 The Traditional View of Government Debt Imagine that you are an economist working for the Congressional Budget Office (CBO). You receive a letter from the chair of the Senate Budget Committee Dear CBo Economist. Congress is about to consider the president's request to cut all taxes by 20 per- cent. Before deciding whether to endorse the request, my committee would like your analysis. We see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country? Sincerely, Committee chair Before responding to the senator, you open your favorite economics textbook- this one, of course-to see what the models predict for such a change in fiscal cy o ana the long-run effects of this policy change, you turn to the els in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 7 shows that lower investment eventu- ally leads to a lower steady-state capital stock and a lower level of output. Be cause we concluded in Chapter 8 that the U.S. economy has less capital than in the golden Rule steady state(the steady state with maximium consump- tion), the fall in steady-state capital means lower consumption and reduced economic well-being To analyze the short-run effects of the policy change, you turn to the IS-LM model in Chapters 10 and 11. This model shows that a tax cut stimulates con- sumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemploy put,and the higher aggregate demand results in a higher price leve tate of out- ment. Over time, as prices adjust, the economy returns to the natural To see how international trade affects your analysis, you turn to the open- economy models in Chapters 5 and 12. The model in Chapter 5 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit. Although the inflow of capital from abroad lessens the effect of the fiscal-policy change on U.S. capital accumulation, the United States becomes indebted to foreign countries. The fiscal-policy change also causes the dollar to appreciate, which makes foreign goods cheaper in the United States and domestic goods more expensive abroad. The Mundell-Fleming model in Chapter 12 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on Itput and employment User LUKBI: Job EFFo1431: 6264_ch15: Pg 414: 28044#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 414:28044#/eps at 100% *28044* Wed, Feb 20, 2002 3:28 PM 15-3 The Traditional View of Government Debt Imagine that you are an economist working for the Congressional Budget Office (CBO).You receive a letter from the chair of the Senate Budget Committee: Dear CBO Economist: Congress is about to consider the president’s request to cut all taxes by 20 percent. Before deciding whether to endorse the request, my committee would like your analysis.We see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country? Sincerely, Committee Chair Before responding to the senator, you open your favorite economics textbook— this one, of course—to see what the models predict for such a change in fiscal policy. To analyze the long-run effects of this policy change, you turn to the models in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 7 shows that lower investment eventually leads to a lower steady-state capital stock and a lower level of output. Because we concluded in Chapter 8 that the U.S. economy has less capital than in the Golden Rule steady state (the steady state with maximium consumption), the fall in steady-state capital means lower consumption and reduced economic well-being. To analyze the short-run effects of the policy change, you turn to the IS–LM model in Chapters 10 and 11.This model shows that a tax cut stimulates consumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemployment. Over time, as prices adjust, the economy returns to the natural rate of output, and the higher aggregate demand results in a higher price level. To see how international trade affects your analysis, you turn to the openeconomy models in Chapters 5 and 12. The model in Chapter 5 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit.Although the inflow of capital from abroad lessens the effect of the fiscal-policy change on U.S. capital accumulation, the United States becomes indebted to foreign countries. The fiscal-policy change also causes the dollar to appreciate, which makes foreign goods cheaper in the United States and domestic goods more expensive abroad.The Mundell–Fleming model in Chapter 12 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on output and employment. 414 | PART V Microeconomic Policy Debates
