1

Views of American leaders on the national debt

“A national debt, if it is not excessive, will be to us a national blessing.” [Alexander Hamilton, 1781]

“It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F. D. Roosevelt]

“There are myths also about our public debt. Borrowing can lead to over-extension and collapse – but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.”

[John F. Kennedy, Yale Commencement Address, 1962]

“It is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now.” [B. Obama, 2010]

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Five Genuine Concerns about Government Debt

1. Impact on growth of potential output- Higher deficit and debt leads to lower saving and capital stock- Leads to lower potential output (we will review the savings

experiment)

2. Efficiency impacts of higher debt:- Higher debt means higher interest payments- These require higher taxes, and this has a “dead-weight loss”

3. In open economy, some of debt will be held abroad- To extent that have net foreign borrowing (trade deficit), this

requires net exports to pay.- If debt is in foreign currency, can lead to financial crisis, higher

interest rates, higher deficits, and a death spiral of confidence, and eventual default

4. Higher debt forces higher taxes or crowds out other critical spending

The overall federal budget

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16

18

20

22

24

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1960 1970 1980 1990 2000 2010

Revenues/GDP

Spending/GDP

Deficit

Current projections of debt/GDP

“Extended Alternative” = continuation of certain policies (war, Bush era tax cuts, Medicare, etc.).

“Extended Baseline” = cliff

Long-term projection of debt/GDP

5CBO, The Long-Term Budget Outlook, June 2010

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What are the sources of the spending growth?

CBO, The Long-Term Budget Outlook, June 2010/

0

2

4

6

8

10

12

14

2010 2015 2020 2025 2030 2035 2040

Projected federal spending as % of GDP

Social SecurityHealthEverything else

Debt bathtub

Debt (beginning of year)

Spending

Revenues

Debt (end of year) = Debt (beginning) + deficit

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Debt algebraBasic identity:

Debt (end of t) = Debt (beginning of t) + Deficit (t)Stable system when debt-GDP ratio is constant.

Define debt-GDP ratio = βPrimary surplus = PS = taxes – noninterest spending.Given U.S. parameters, stable β when PS = 0.

Assume = nominal GDP growth. Then, equation for change in debt is:

/

Then debt-GDP ( = D/ Y) ratio is constant when

/ / 0 / / [ / ] ( )

Algebra of stable debt -GDP ratio.

g

D t iD PS

t D t D g iD PS D g i g

/

Historically for the U.S., i g, so a stable financial situation implies that

the primary deficit must be zero 0).

PS D

PS

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1981 1986 1991 1996 2001 2006 2011 2016 2021

Cliff fiscal policy

Extended baseline (currentlaw)

Actual

Primary surplus ratio

Clinton-erasurpluses

Recession and stimulus package

CBOForecast

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Case 1. Closed classical economy

• Fundamental difference between spending on I and spending on C:

- Borrowing for spending on productive I does not lower long-run C- Growth lowered from borrowing for government or private C

• Two problems from domestic debt (or closed economy debt)- Internal debt requires taxation to service and leads to inefficiency- Debt crowds out capital and reduces the growth/level of potential

output

The marginal dead weight loss of debt/taxes

P(1+τ1)

P

P(1+τ2)

X0X1X2

= incremental DWL of higher taxes

~ increase revenues

DWL

Empirical estimates: 20 – 40 cents of DWL per $ of taxes from higher tax rates

Taxes and debt for a purely internal debt

Assume that we “owe the debt to ourselves”- Many identical people- All get benefits and pay taxes to service debt- Suppose that we have program which provides $1 in PV

of C; and finances it by $1 of debt.

Classical case:- Suppose no change in path of output. - Higher interest payments with present value of $1.- Taxes cause efficiency losses with a dead-weight loss

(DWL).- If marginal DWL on taxes is 30%, then have cost of

$0.30.- Net value of government program is minus $0.30.

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Debt in neoclassical growth model

National investment = national saving = private saving + government

savingNS = PS + GSIf PS unchanged, then higher deficit leads to lower saving and investment.Then follow through standard Solow neoclassical growth model, with lower s.

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k

y = f(k)

(n+δ)k

y**

(I/Y)*

k**

Impact of Deficits on Economy

k*

y*

i = s1f(k)

i = s2f(k)

time

ln K, ln GD

ln K

ln GD

ln GD’

ln K’

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time

ln Y, ln C

ln Y

ln (C+G)’

ln Y’

Note that govt spending firstraises (C+G), but then lowers (C+G)’

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ln (C+G)

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Case 2. Impact of government debt in an open economy (assuming borrowing

in own currency)• In open economy:

K + NFA = Wealth = Private wealth – Government Debt

W/L = v = (K + NFA)/L = k +nfa, where nfa=NFA/L• For small open economy, the marginal investment is

abroad!– With r = rw, no change in domestic capital stock!– Therefore, no effect on GDP, but has effect on income

from abroad– Will show up in national income (NNP) not in GDP! (Most macro models get this wrong.)

• Large open economy like US:– Somewhere in between small open and closed.– I.e., some decrease in domestic I and some in decrease

net foreign assets• But results on changes in W and C are same in

open as closed economy.

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k, v

y = f(k*)+f’(k*)(w-k) = f(k*)+rw(w-k)

(n+δ)k

v*

Solow model for open economy with net foreign borrowing

k*

i = sy

nfa*

y=NNP/L;v = per capita wealthv= k + nfa;

Show how:↓s → ↓v → ↓nfa but no change k → ↓y

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The fiscal cliff

Everything goes poof on December 31, 2012.

Tax cuts expire, doctors don’t get paid, unemployed lose insurance, military and government programs slashed, rich get big tax increase.

The actual details…

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Fiscal Cliff Calendar year

[billions of dollars at annual rate] 2013

Bush era tax cuts 295 High income and estate 66 "Middle class" 229

Payroll tax 127 Other expiring provisions 87 Taxes included in the Affordable Care Act 24 Other misc taxes 105 TOTAL, Revenues 637

Changes in Specified Spending Policies

Budget Control Act 87 Unemployment insurance 35 Medicare "doc fix" 15 Other 35 TOTAL, Expenditures 171

Total Change in Deficit 808 As % of GDP 4.9%

Source: CBO, May 2012

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Fiscal Cliff Calendar year

[billions of dollars at annual rate] 2013

Bush era tax cuts 295 High income and estate 66 "Middle class" 229

Payroll tax 127 Other expiring provisions 87 Taxes included in the Affordable Care Act 24 Other misc taxes 105 TOTAL, Revenues 637

Changes in Specified Spending Policies

Budget Control Act 87 Unemployment insurance 35 Medicare "doc fix" 15 Other 35 TOTAL, Expenditures 171

Total Change in Deficit 808 As % of GDP 4.9%

Source: CBO, May 2012

= contentious.

Game of chicken and the cliff

R’s concede R’s hang tough

D’s concede • No recession.• Everyone one

looks good. • Politically

neutral.

• No recession.• Obama loses face

early in second term.

• Repubs get overconfident.

D’s hang tough • No recession. • Repubs lose

face. • Dems get

overconfident.

• Deep recession.• Everyone looks

equally bad politically.

***

*** Nash equilibrium if prisoners’ dilemma zero-sum structure.