Budget_Balance_National_Debt_Secular_Stagnation_and_Investment.ipynb

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    "# 14. Budget Balance, National Debt, Secular Stagnation, and Investment\n",
    "\n",
    "**QUESTIONS**\n",
    "\n",
    "1. What is the best measure of the government's budget balance for analyzing short-run stabilization policy? For analyzing the effect of changes in the national debt on long-run growth?\n",
    "2. What is the typical pattern that the U.S. national debt follows over time?\n",
    "3. How has experience in the past generation deviated from this traditional pattern of debt behavior?\n",
    "4. Why should we worry about a rising national debt? Why shouldn't we worry too much?\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "**government deficit**: The difference between government spending and the government's revenue when the first is larger than the second.\n",
    "\n",
    "**national debt**: The sum total of all past deficits less all past surpluses the government has run.\n",
    "\n",
    "**government surplus**: The difference between the government's spending and the government's revenues when the second is larger than the first.\n",
    "\n",
    "**full employment cyclically adjusted deficit**: An estimate of what the budget deficit would be if national product were at potential output. This measure removes shifts in d due to the operation of the economy's automatic stabilizers.\n",
    "\n",
    "**cash budget balance**: A way of measuring the government's budget balance called \"cash\" because it does not take account of changes in the value of government- owned assets or of the future liabilities owed by the government.\n",
    "\n",
    "**generational accounting**: A way of looking at the government's tax and spending plans that attempts to set out the total lifetime impact of government policy on an individual's resources and obligations.\n",
    "\n",
    "**equilibrium debt-to-GDP ratio**: The constant ratio of government debt to GDP when both real government debt and real GDP are growing at the same rate.\n",
    "\n",
    "**voter myopia**: The theory that voters react to the immediate economic situation, rather than to what happened in the further past or what is likely to happen in the future.\n",
    "\n",
    "**policy mix**: The combination of monetary and fiscal policies being followed by a country's government and central bank.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "A government spending more than it collects in taxes must borrow the difference to finance its spending. The amount borrowed this year is this year’s government deficit. A government borrows by selling its citizens and foreigners bonds: promises that the government will repay the principal it borrows with interest. These accumulated promises to pay make up the national debt. In a year when government spending is less than tax collections, the difference is the government surplus. The national debt shrinks by the amount of the surplus.\n",
    "\n",
    "Call the debt D and the deficit d (and recognize that a surplus is a negative value of d). Then the relationship between the debt and the deficit is simple:\n",
    "\n",
    ">$ {\\Delta} D = d $\n",
    "\n",
    "The change in the debt from year to year AD is equal to the deficit d. Economists are interested in the debt and the deficit for two reasons. First, the deficit is a convenient and often handy—though sometimes treacherous—measure of fiscal policy’s role in stabilization policy. It is an index of how government spending and tax plans affect the position of the IS curve. The central bank will in general adjust its stance to try to offset the effects of the deficit on planned expenditure so that deficits do not upset the monetary policy reaction function\n",
    "(MPRF).\n",
    "\n",
    "Second, the debt and deficit are closely connected with national saving and investment. A rising debt—a deficit—tends to depress capital formation. It lowers the economy’s long-run balanced-growth path and reduces the balanced-growth GDP per worker. Moreover, a high national debt means that taxes in the future will be higher to pay higher interest charges. Such higher taxes are likely to further discourage economic activity and reduce economic welfare.\n",
    "\n",
    "What to do about the national debt is one of the current flashpoints of American politics. The United States ran its national debt up by an enormous amount during the high-deficit Reagan and Bush 41—the 41st president (George H. W. Bush)—administrations from 1981 to 1992. This pattern of large deficits and rapidly growing debt was restored beginning in 2001 under the Bush 43—the 43rd president (George W. Bush)—administration: This self-generated problem is one of the biggest economic problems that will confront the United States in the second half of this decade.\n",
    "\n",
    "One of the main questions facing American voters and politicians now is: What (if anything) should be done to deal with the large future rise in the debt that is currently being forecast? Should the government accept large deficits? Should it try to stabilize the government debt-to-GDP ratio, and if so at what level? Should the government aim for large surpluses in order to push the debt down to its late-1970s level (or even lower) share of GDP? At the moment this issue hangs in the balance.\n",
    "\n",
    "\n",
    "&nbsp;"
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    "## 14.1 The Budget Deficit and Stabilization Policy\n",
    "\n",
    "### 14.1.1 The Budget Deficit\n",
    "\n",
    "An increase in government purchases increases planned expenditure. It shifts the IS curve out and to the right, increasing the level of real GDP for each possible value of the interest rate. The increase in government purchases shifts the MPRF in and to the left, decreasing the unemployment rate at each level of inflation.\n",
    "\n",
    "A decrease in government tax collections also increases planned expenditure. If the decrease in tax collections is due to a drop in income, we simply move along an IS curve. But if a change in tax policy made tax collections fall, this change also shifts the IS curve out and the MPRF in: Unless the Federal Reserve changes the rule it uses to set interest rates, it will find that the fiscal stimulus is making unem- ployment lower than it expected and desired given the current rate of inflation.\n",
    "\n",
    "The government’s budget deficit is equal to purchases minus net taxes. Must we bother with two measures of fiscal policy — purchases and net taxes—when we can just keep track of their difference? No. Our drive for simplification is the reason for focusing on the government’s budget balance as a measure of fiscal policy.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.1.2 The Cyclically-Adjusted Budget Deficit\n",
    "\n",
    "But it turns out that the right measure of budget balance is not the governments actual deficit (or surplus). Instead, the right measure of fiscal policy is the full-employment or cyclically adjusted deficit (or surplus): what the government’s budget balance would be if the economy were at full employment.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "**An Increase in the Full-Employment Deficit Shifts the IS Curve Outward and the MPRF Inward**: An increase in government purchases or a decrease in net taxes when employment is held at full employment shifts the IS curve to the right and shifts the MPRF to the left. To keep track of the impact of government tax and spending policy on the position of the IS curve, we need to look at the difference between the two when the economy is at full employment—the full-employment government deficit (or surplus).\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "However, one tax cut—the Bush tax cut of 2001—did, largely by accident, take effect right at the moment that consumer confidence was depressed by the destruction of the World Trade Center. According to Morgan Stanley’s economic analysis staff, the tax cut enacted in 2001 boosted household disposable income in the first quarter of 2002 by an amount equal to approximately $100 billion a year, well over 1 percent of GDP This boost to household disposable income was very welcome and kept the recession of 2001 from being longer and deeper than would otherwise have been the case.\n",
    "\n",
    "\n",
    "What of the standard argument that fiscal policy—tax cuts and spending increases—should not be used to manage the business cycle? This argument hinges on the belief that the Federal Reserve (1) is more competent than the Congress and the president, (2) is more efficient than the Congress and the president, and (3) has sufficient room to maneuver to stabilize the economy near full employment. Although the quality of the Federal Reserve staff analysis certainly is higher than that of the Congress, and although the long and variable “inside” lags associated with legislation make discretionary fiscal policy erratic, nevertheless, by the end of 2001 the Federal Reserve found that it had cut interest rates almost as far as they could go: The short-term federal funds interest rate was down to 1.75 percent per year, and in its internal discussions the Federal Reserve was beginning to worry that with “short-term interest rates . . . already . . . very low,” if “the economy were to deteriorate substantially ... it might be impossible to ease monetary policy sufficiently through the usual interest rate process” to keep the economy near full employment. In this context, the extra boost to planned expenditure provided by the arrival of the stimulative effects of the Bush 2001 tax cut was very welcome.\n",
    "\n",
    "In 2003 an even stronger argument could be made for using fiscal policy to try to stimulate demand. The U.S. recovery had stalled in late 2002, and the Federal Reserve had run out of room to lower short-term interest rates further without risking damage to the ability of important financial institutions to survive. A further boost to demand at that time would have been very welcome as well. Unfortunately, the tax cut proposed and passed by the Bush administration was one that channeled most of the tax relief to those with relatively low marginal propensities to consume, and the effec­ tiveness of the 2003 tax reduction as a short-run stabilization policy is questionable.\n",
    "\n",
    "Does fiscal policy therefore have a stable place as an important stabilization policy tool? This seems unlikely. Recall that the beneficial effects of the 2001 Bush tax cut came about as a result of an unexpected and lucky chance. It is still the case that — as long as full employment does not require that the Federal Reserve push short-term safe nominal interest rates below zero — monetary policy is a faster acting and more flexible stabilization policy tool than discretionary fiscal policy. And situations like those of 2003, when the Federal Reserve found itself in the position of having already reduced interest rates almost as far as they could go, are very unusual.\n",
    "\n",
    "However, in a low-inflation world like that in which we live today, the fact that the Federal Reserve cannot push short-term safe nominal interest rates below zero places limits on the effectiveness of monetary policy as well.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.1.2.1 The Bush Tax Cut of 2001: Economic Policy\n",
    "\n",
    "It is extremely rare in the United States that a tax cut legislated by the Congress and signed by the president takes effect at the right moment to offset a recession. Most tax cuts that have their origin in a desire to fight a recession do not take effect until long after the need has passed. The most recent such example is the so-called stimulus package proposed in the aftermath of the September 11, 2001, terrorist attacks on the World Trade Center and the Pentagon. Squabbling between the houses of Congress and between the Congress and the president kept it from being enacted until the consensus of economists and the Federal Reserve was that the recession of 2001 had already ended.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.1.3 Measuring the Budget Balance\n",
    "\n",
    "Unfortunately, the government budget bottom line reported in the newspapers is not the full-employment budget balance. It is either the “unified cash” balance or the balance excluding Social Security. \n",
    "\n",
    "The first of these bottom lines is the difference between the money that the government actually spends in a year and the money that it takes in. This balance is called “unified” because it unifies all of the government’s accounts and trust funds (including Social Security). This balance is called “cash” because it does not take account of either changes in the value of government-owned assets or the future liabilities owed by the government: It is just cash in minus cash out. The second of these bottom lines is equal to the unified cash balance minus the revenues and plus the expenditures of the Social Security program. It takes the Social Security system “off budget.”\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.1.4 Budget Balance and IS Curve Shifts\n",
    "\n",
    "Why is the full-employment budget balance a better index than either of the more frequently mentioned cash budget balance measures? Consider a situation in which the government does not change either its purchases or its tax rates, and so there is no change in government fiscal policy. But suppose that monetary policy tightens: Real interest rates are raised, and so the economy moves up and to the left along a stable IS curve (see Figure 14.2). As the economy moves along the IS curve, real GDP falls and tax collections fall too. The government’s cash deficit increases, even though there has been no change in government policy to shift the IS curve. The full-employment budget balance, however, remains constant. The fact that the cash budget balance changes as the economy moves along a constant IS curve means that it is not a good indicator of how the government’s fiscal policy is affecting the location of the IS curve: The full-employment budget balance is better.\n",
    "\n",
    "To turn the cash balance into the full-employment balance, we must adjust the budget deficit (or surplus) for the automatic reaction of taxes and spending to the business cycle, as is done in Figure 14.3. When unemployment is high, taxes are low and social welfare spending high. The budget balance swings toward deficit. When unemployment is low, taxes are high and the budget balance swings toward surplus.\n",
    "\n",
    "The standard budget deficit you see reported in the newspapers is not even a good measure of the effect of taxing and spending on the position of the IS curve. And the cyclically adjusted budget deficit is itself far from being a perfect measure of the effect of taxing and spending on the position of the IS curve. An increase in government purchases $ {\\Delta}G $ shifts the IS Curve out to the right by an amount $ {\\mu}{\\Delta}G $. An increase in the tax rate $ {\\Delta}t $ shifts the IS Curve in to the left by an amount $ {\\mu}{c_y}Y{\\Delta}t $. The combination of the two shifts the deficit by:\n",
    " \n",
    ">$ {\\Delta}d = {\\Delta}G - Y{\\Delta}t $\n",
    "\n",
    "and shifts the IS Curve by:\n",
    "\n",
    ">$ {\\Delta}Y = {\\mu}{\\Delta}G - {\\mu}{c_y}Y{\\Delta}t $\n",
    "\n",
    "If one divides the shift in the IS Curve by $ {\\mu} $, one gets not $ {\\Delta}d $ but rather:\n",
    "\n",
    ">$ \\frac{{\\Delta}Y}{\\mu} = {\\Delta}G - {c_y}Y{\\Delta}t =\\left(\\frac{{\\Delta}G - {c_y}Y{\\Delta}t}{{\\Delta}G - Y{\\Delta}t}\\right){\\Delta}d $\n",
    "\n",
    "because a change in tax revenue $ Y{\\Delta}t $ shifts the IS Curve in by less than a change in governent purchases $ {\\Delta} $ shifts the IS Curve out. Why? Because not all of a tax cut is spent on consumption goods and services. A fraction $ (1-c_y) $ is saved. And that savings keeps tax cuts from having as great a stimulative effect as a government purchases increase.\n",
    "\n",
    "This matters...\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**The Full-Employment and the Cash Budget Deficits**: The difference between the actual cash budget balance and the full- employment balance can be substantial when the economy is either suffering from a recession as in the early 1990s or undergoing an uplifting boom as in the late 1990s.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.1.5 RECAP: The Budget Deficit and the IS Curve\n",
    "\n",
    "The cyclically adjusted budget deficit is a good measure of the impact of the government’s taxing and spending on aggregate demand. When the cyclically adjusted budget deficit rises, the IS curve shifts right as government policy becomes more stimulative. When the cyclically adjusted budget deficit falls, the IS curve shifts left as government policy becomes more contractionary.\n",
    "\n",
    "&nbsp;"
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    "## 14.2 Measuring the Debt and the Deficit\n",
    "\n",
    "In addition to cyclical adjustment, we should consider making three other adjustments to the reported cash budget balance.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.2.1 The Debt and Inflation\n",
    "\n",
    "One adjustment economists make is to correct the officially reported cash budget balance for the effects of inflation. A portion of the debt interest paid out by the government to its bondholders merely compensates them for inflation’s erosion of the value of their principal. A good measure of the deficit should be a measure of whether the government is spending more in the way of resources than it is taking in: a measure of the change in the real debt that the government owes. At the end of the year the debt principal plus this inflation component of debt interest are together equal—in their power to purchase useful goods and services—to what the debt principal was at the start of the year. So the real interest that the government has paid on its debt is not equal to the nominal interest rate times the debt, iD, but to the real interest rate times debt, rD. The difference between the nominal and the real interest rate is the expected rate of inflation, which we’ll assume here equals the inflation rate π. Hence the real deficit is related to the cash deficit by\n",
    "\n",
    ">$ d^R = d^c - {\\pi}D $\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "Almost everyone who analyzes economic and budget policy prefers to work with\n",
    "these inflation-adjusted measures of the deficit and debt.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**The Cash Balance and the Inflation-Adjusted Budget Balance**: Large differences between officially reported and economically relevant measures of budget balance emerge as more adjustments are made. Adjusted for both the state of the business cycle and inflation, the federal budget was in rough balance or even in surplus (save for the peak of the Vietnam War) until the 1980s.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.2.2 Public Investment\n",
    "\n",
    "Yet another adjustment corrects for an asymmetry between the treatment of private and public assets. Private spending on long-lived capital goods is called “investment.” A business with total sales of $100 million, costs of goods sold of $90 million, and $20 million spending on enlarging its capital stock reports a profit of $10 million — not a deficit of $10 million. Standard and sensible accounting treatment of long-lived valuable assets in the private sector is definitely not to count their entire cost as a charge at the time of initial purchase, but instead to spread the cost out — a process called “amortization” — over the useful life of the asset. The government should do its accounting the same way, like a business, and amortize rather than expense its spending on long-lived assets.\n",
    "\n",
    "Calls for reforming the federal government budget to use capital budgeting are heard periodically. But few people use numbers based on capital budgeting. The principal reason that capital budgeting is resisted is political. Which government expenditures are capital expenditures? Aircraft carriers and nuclear weapons? The interstate highway system? Improvements to trails in the national parks? Head Start expenditures — money spent on educating poor children? (After all, this is an investment in their future.)\n",
    "\n",
    "From a political point of view, a dividing line between government investment and government consumption expenditures is unlikely to stand for long when subjected to pressure from Congress eager to justify expenditures by calling them “investments,” and possessing the legal power to direct estimating agencies like the Congressional Budget Office and the Office of Management and Budget to do so. Thus critics regard capital budgeting as simply too difficult to implement in a helpful way. Supporters, however, point out that not doing capital budgeting at all is, in a sense, worse than even the least helpful implementation.\n",
    "\n",
    "The fact that the numbers usually reported do not correct for public investment should be kept in mind: The reported numbers tend to overestimate the real value of the outstanding national debt and overstate the magnitude of the current deficit.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.2.3 Debt Capacity\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.2.4 Future Government Liabilities and Generational Accounting\n",
    "\n",
    "All of the issues surrounding capital budgeting appear again whenever the long- run future of the government’s budget is considered. Back when Brad worked at the Treasury Department, some 10,000 a year was set aside for him in his Treasury pension account. It is as if his income had been 10,000 a year higher, and he had invested that extra 10,000 in U.S. government bonds. Bonds issued by the government appear on the books as part of the government’s debt. But pension fund liabilities that the government owes to former workers do not.\n",
    "\n",
    "Thus in a sense the right way to count the government’s debt is to look not just at the bonds that it has issued but at all of the promises to pay money in the future that it has made. Indeed, a large chunk of the government’s expenditures — those by the Medicare and Social Security trust funds, for example — are presented to the public in just this way. The Social Security deficit reported by the trustees of the Social Security system every spring is not the difference between Social Security taxes paid in and Social Security benefits paid out, but is instead the long-run, 75-year balance between the estimated value of the commitments to pay benefits that the Social Security system has made and will make and the estimated value of the taxes that will be paid into the Social Security trust funds.\n",
    "\n",
    "But the Social Security trustees’ report covers just one program — albeit a big program. And great confusion is created by the fact that the Social Security system’s expenditures and revenues are also included within the unified budget balance.\n",
    "\n",
    "Wouldn’t it be better to bring all of taxation and spending within a long-run system like that currently used by Social Security?\n",
    "\n",
    "Economists Laurence Kotlikoff and Alan Auerbach say an emphatic yes. They pro­ pose that instead of the year-by-year budget balances, the U.S. government shift to a system of “generational accounting.” Generational accounting would examine the lifetime impact of taxes and spending programs on individuals born in specific years and provide a final balance that could be used for long-term planning. Auerbach and Kotlikoff clearly have a strong case. Yet few analysts of the budget use their genera­ tional accounting measures, and at the moment these issues are not often dealt with in macroeconomics classes, but are reserved for public finance classes.\n",
    "\n",
    "Generational accounting is thus not part of the present state of macroeconomics, but it should become part of its future, for the issues involved are the biggest ones facing the domestic American government today. For example, in the fall of 2004 Brookings Institution economists William Gale and Peter Orszag projected that current U.S. government policies would produce cash deficits averaging 3.5 percent of GDP over the next decade as shown in Figure 14.5. Compared to a balanced budget, they argued, such deficits would reduce annual GDP a decade from now by 1 to 2 percent — that is, 1,500 to 3,000 per household. And that, they said, was the “good part of the story.” The bad part lay further in the future in the liabilities the government was assuming through its big social-insurance programs: Medicare, Medicaid, and Social Security. Over the next 75 years, as Figure 14.6 on page 424 shows, the nation’s fiscal gap would amount to about 7 percent of GDP. At some point taxes must be raised substantially or benefits paid to Social Security, Medicaid, and Medicare recipients need to be cut well below currently projected levels. The fact that budget accounting does not include generational accounting reduces politicians’ incentives to try to tackle these problems today.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Budget Deficit Projections over the Next 10 Years**: The Bush administration, newly reelected in 2004, is committed to (1) making permanent the 2001 and 2003 tax cuts, (2) extending the standard list of other expiring tax preferences, and (3) keeping the Alternative Minimum Tax (AMT) from becoming the effective tax system. These commitments mean that the deficit is unlikely to decline as a share of the economy.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Projected Entitlement Costs as a Percentage of GDP**: As America's population ages and medical care costs continue to rise, the costs of federal \"entitlement\" programs are projected to rise enormously. From today's level of 8.5 percent of GDP, the three big programs — Medicare, Medicaid, and Social Security — are projected under current law to rise to 23 percent of GDP by 2080.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.2.5 RECAP: Measuring the Debt and Deficit\n",
    "\n",
    "Measuring the debt in an economically relevant way requires — in addition to a cyclical adjustment-- three further\"adjustments to the reported cash government budget balance. Adjusting for inflation’s effect on debt interest produces the real deficit. Adjusting for public spending on investment goods — a political hot potafx) — is capital budgeting. Adjusting for taxes we are strapping our kids and grandkids with — an even hotter political potato — is generational accounting. In practice, the reported government deficit includes none of these adjustments.\n",
    "\n",
    "&nbsp;"
   ]
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    "## 14.3 Analyzing the Debt and Deficit: Sustainability\n",
    "\n",
    "The first question to ask about a government that is running a persistent deficit is: “Can it go on?” Is it possible for the government to continue running its current deficit indefinitely, or must policy change — possibly for the better, but also quite possibly for the worse?\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.3.1.  The Equilibrium Debt-to-GDP Ratio\n",
    "\n",
    "The variable to look at to assess whether the government’s current fiscal policy is sustainable is the time path of the ratio of the government’s total debt to GDP, or the debt-to-GDP ratio, D/Y. Fiscal policy is sustainable if the debt-to-GDP ratio is heading for a constant value; that is, a balanced growth equilibrium.\n",
    "As in Chapters 4 and 5, we can analyze the debt-to-GDP ratio D/Y by looking to see if it heads for some constant equilibrium value. At that value, both the numerator D (the debt) and the denominator Y (GDP) will be growing at the same proportional rate — there will be balanced growth of debt and GDP. We know that real GDP grows in the long run at a proportional annual rate n + g, where n is the annual growth rate of the labor force and g is the annual growth rate of the efficiency of labor.\n",
    "\n",
    "What is the proportional growth rate of the debt, D? Adding time subscripts to keep things clear, the real debt next year will be equal to:\n",
    "\n",
    ">$ D_{t+1} = (1 - {pi}_t)D_t + d_t $\n",
    "\n",
    "The real value of the debt shrinks by a proportional amount π as inflation erodes away the real value of the debt principal owed by the government, and grows by an amount equal to the officially reported cash deficit d. As the economy grows, tax revenues grow roughly in proportion to real GDP and spending grows in proportion to real GDP too. So it makes sense to focus not on the deficit itself but on the deficit as a share of GDP, d/Y.\n",
    "\n",
    "Then the proportional growth rate of the debt is:\n",
    "\n",
    ">$ \\frac{D_{t+1} - D_t}{D_t} = -\\pi + \\left(\\frac{d}{Y}\\right)\\left(\\frac{Y}{D}\\right) $\n",
    "\n",
    "The debt-to-GDP ratio will be stable when these two proportional growth rates — of GDP and of the debt — are equal to each other:\n",
    "\n",
    ">$ n + g = -\\pi + \\left(\\frac{d}{Y}\\right)\\left(\\frac{Y}{D}\\right) $\n",
    "\n",
    "which happens when:\n",
    "\n",
    ">$ \\frac{D}{Y} = \\frac{\\frac{d}{Y}}{n+g+\\pi} $\n",
    "\n",
    "This is the level toward which the debt-to-GDP ratio will head; Box 14.2 provides an example of how to calculate this long-run value of the debt-to-GDP ratio. This is the level consistent with a constant cash-balance deficit of d/Y percent of GDP in an economy with long-run inflation rate π and with long-run real GDP growth rate n + g.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.3.1.1 The Equilibrium Debt-to-GDP Ratio: An Examp;e\n",
    "\n",
    "Suppose that the economy is running a constant budget deficit of 4 percent of GDP year after year. Suppose further that the growth rate of the labor force is 2 percent per year, the growth rate of output per worker is 1 percent per year, and the inflation rate is 5 percent per year. What then will be this economy’s equilibrium ratio of government debt to GDP?\n",
    "\n",
    "To determine the answer, simply plug the parameter values into the formula:\n",
    "\n",
    ">$ \\frac{D}{Y} = \\frac{\\frac{d}{Y}}{n+g+\\pi} $\n",
    "\n",
    "The equilibrium debt-to-GDP ratio will be 1/2. If the current debt-to-GDP ratio is less than 1/2, the debt-to-GDP ratio will grow. If the current debt-to-GDP ratio is greater than 1/2, the debt-to-GDP ratio will fall.\n",
    "\n",
    "Notice a similarity to the analysis of the equilibrium capital-output ratio way back in Chapter 4? The mathematical tools and models are the same, even though the phenomena in the world to which they apply are very different. Such recycling of a formal model in a different context is yet another trick economists use\n",
    "to try to keep their discipline and their models simple.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.3.2  Is the Equilibrium Debt-to-GDP Ratio Possible?\n",
    "\n",
    "Why then do economists talk about deficit levels as being “unsustainable”? For any deficit as a share of GDP (d/Y), the debt-to-GDP ratio heads for its well-defined value (d/Y)/(n + g + π). The reason is that this calculation is at most half the story. The ratio of the debt to GDP that the government wants to issue heads for a stable value, yes. But are there enough investors in the world willing to hold that amount of debt? The higher the debt-to-GDP ratio, the riskier an investment financiers judge the debt of a country to be, and the less willing they are to buy and hold that debt.\n",
    "\n",
    "A higher debt-to-GDP ratio makes investment in the debt issued by a government more risky for two reasons. First, revolutions — or other, more peaceful changes of government — happen. One of the things a new government must decide is whether it is going to honor the debt issued by previous governments. \n",
    "\n",
    "Are these debts the commitments of the nation, which, as an honorable entity, honors its commitments? \n",
    "\n",
    "Or are these debts the reckless mistakes made by and obligations of a gang of thugs, unrepresentative of the nation, to whom investors should have known better than to lend money for the thugs to steal? \n",
    "\n",
    "The holders of a government’s debt anxiously await every new government’s decision on this issue. The higher the debt-to-GDP ratio, the greater the temptation for a new government to repudiate debt issued by its predecessor, hence the riskier it is to buy and hold a portion of that country’s national debt.\n",
    "\n",
    "Second, a government can control the real size of the debt it owes by controlling the rate of inflation. The (nominal) interest rate to be paid on government debt is fixed by the terms of the bond issued. The real interest rate paid on the debt is equal to the nominal interest rate minus the rate of inflation — and the government controls the rate of inflation.\n",
    "\n",
    "Thus a government that seeks to redistribute wealth away from its bondholders to its taxpayers can do so by increasing the rate of inflation. The more inflation, the less the government’s debt is worth and the lower the real taxes that have to be imposed to pay off the interest and principal on the debt. Whether a government is likely to increase the rate of inflation depends on the costs and benefits — and raising the rate of inflation does have significant political costs. But the higher the debt-to-GDP ratio, the greater the benefits to taxpayers of a sudden burst of inflation. When the debt-to-GDP ratio is equal to 2, a sudden 10 percent rise in the price level reduces the real wealth of the government’s creditors and increases  the real wealth of taxpayers by an amount equal to 20 percent of a year’s GDP. By contrast, when the debt-to-GDP ratio is equal to 0.2, the same rise in the price level redistributes wealth equal to only 2 percent of a year’s GDP.\n",
    "\n",
    "Thus the government’s potential creditors must calculate that the greater the debt-to-GDP ratio, the greater the benefits to the government of inflation as a way of writing down the value of its debt. The higher the debt-to-GDP ratio, the more likely the government is to resort to inflation. Thus the higher the debt-to-GDP ratio, the riskier it is to invest in a government’s debt.\n",
    "\n",
    "A deficit is sustainable only if the associated debt-to-GDP ratio is low enough that investors judge the debt safe enough to be willing to hold it. Think of each government as having a debt capacity — a maximum debt-to-GDP ratio at which investors are willing to hold the debt issued at reasonable interest rates. If this debt capacity is exceeded, then the interest rates that the government must pay on its debt spike upward. The government is faced with a much larger deficit than planned (as a result of higher interest costs). Either the government must raise taxes, or it must resort to high inflation or hyperinflation to write the real value of the debt down.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.3.2.1 The U.S. Debt-to-GDP Ratio\n",
    "\n",
    "The United States ended the Revolutionary War with what was then thought of as a considerable national debt given the limited taxing capacity of late-eighteenth-century governments. The first secretary of the treasury, Alexander Hamilton, pressed hard and won congressional approval for the federal government to assume and pay the debts the individual states had incurred to fight the Revolutionary War. \n",
    "\n",
    "Hamilton believed that this assumption of the debt would make it easier for the federal government to borrow in the future. Moreover, he believed that if the government owed people money, there would be a strong interest group in favor of the continuation of the United States of America: Bondholders would like to be paid.\n",
    "By the presidency of Andrew Jackson, however, virtually the entire debt run up first in the Revolutionary War and then in the War of 1812 had been repaid (see Figure 14.7). The Union debt run up during the Civil War was also repaid within a few decades. \n",
    "\n",
    "But then in quick succession came World War I, the Great Depression, and World War II, which together drove the U.S. national debt up to more than a year’s GDP. Thereafter the growth of the economy, inflation, and more-or- less balanced budgets saw the debt fall relative to GDP until the coming of the 1980s with the Reagan tax cut and the resulting deficits and rapid increase in the debt once again.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.3.3 The Primary Deficit\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.3.4 The U.S. Deficit in Historical Perspective\n",
    "\n",
    "The U.S. national debt today, however, is below the level at which economists begin to watch the debt with anxious concern. There were fears during the 1980s that the United States had put itself on a course for national disaster through a mounting national debt. These fears have been renewed as the surpluses of the late 1990s have been replaced by the return of large deficits. But the United States is still far from the edge of the precipice.\n",
    "\n",
    "The typical pattern the United States has followed is one of sharp spikes in the debt-to-GDP ratio during wartime, followed by paying off the national debt as a share of GDP during peacetime. Why governments usually run up large debts during wartime is easily explained. Their survival, and perhaps the survival of their nation and their civilization, is at stake. So during major wars, governments use all the tools they have to gain control of resources for their fleets, armies, and air forces. And one of those tools is a substantial dose of government borrowing.\n",
    "\n",
    "The great peaks in U.S. government debt as a share of total domestic product all came after the three major wars in which the United States was engaged: the Civil War, World War I, and World War II. The minor peaks were mostly wartime peaks too: the initial level of debt as the federal government took over responsibility for state borrowing during the Revolutionary War, the uptick during the War of 1812, and a tiny uptick during the Spanish-American War at the end of the nineteenth century. (See Box 14.3 on page 428 for some details.)\n",
    "\n",
    "There have been only three upward movements in the debt as a share of GDP not connected to wars: the rise in the national debt during the Great Depression of the 1930s, the rise in the national debt during the Reagan and Bush 41 presidencies of the 1980s, and the rise during the Bush 43 presidency (see Figure 14.8).\n",
    "\n",
    "The reason that during peacetime the size of the government debt as a share of GDP typically falls is also straightforward. Economic growth raises real GDP and inflation provides an additional boost to nominal GDP. As long as the government’s tax and spending programs are not grossly out of whack, in peacetime government debt tends to fall as a share of GDP. Before 1930 the government’s tax and spending pro­ grams could not get out of whack in peacetime: There was barely any peacetime federal government. Since 1930, however, the peacetime federal government has increased its share of the economy. Thus to see the emergence of substantial peacetime government budget deficits and a rising national debt-to-GDP ratio first in the 1980s and then again in the 2000s was a great surprise.\n",
    "\n",
    "Partly because of higher spending on defense and other programs in the 1980s, partly because of substantial tax cuts, and partly because the productivity slowdown led real GDP growth to be smaller than previous forecasts, the Reagan presidency set in motion a series of deficits that ended by nearly doubling the burden of the federal government debt as a share of GDP. The rise in the debt was brought to an end by two factors:\n",
    "\n",
    "* President Clinton, his economic advisers, and the Democratic members of Congress who made deficit reduction the highest priority of his administration in 1993.\n",
    "* A healthy dose of good macroeconomic luck.\n",
    "\n",
    "A fair but rough assignment of credit would give 60 percent to those who planned the deficit-reduction program, and 40 percent to sheer dumb good luck.\n",
    "\n",
    "However, the early 2000s saw a return of the U.S. budget deficit to levels like those of the Reagan and first Bush administrations. It was the deficit-reduction program of the 1990s that appears to have been the anomaly. The big deficits of the 1980s and 2000s appear to have become the rule.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**U.S. Debt-to-GDP Ratio since the Revolutionary War**\n",
    "\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Federal Revenues and Expenditures as Shares of GDP**: Since the Civil War U.S. government expenditures have significantly outrun revenues on five occasions: World War I, World War II, the Great Depression, the Reagan/Bush 41 deficits of the 1980s, and the Bush 43 deficit.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.3.4 RECAP: Analyzing the Debt and Deficit: Sustainability\n",
    "\n",
    "The first question to ask about a deficit is: is it sustainable? Will continuing on the current path produce some sort of crisis?\n",
    "\n",
    "&nbsp;"
   ]
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    "## 14.4 Analyzing the Debt and Deficits: Effects\n",
    "\n",
    "Even if a given deficit as a share of GDP is sustainable, it still may have three types of significant effects on the economy. It may affect the political equilibrium that determines the government’s tax and spending levels. It may, if the central bank allows it, affect the level of real GDP in the short run. And it will (except in very special cases) affect the level of real GDP in the long run.\n",
    "\n",
    "How important is the near doubling of the debt as a share of GDP that took place in the last quarter century, and the further doubling that we can look forward to under current policies over the next generation? One view, held by a majority of economists, is that such large government deficits have three sets of effects. First, they have uncertain but probably destructive effects on the formulation of government spending and tax plans. Second, they have the potential to have expansionary effects on the economy in the short run. Third, they have contractionary effects on the economy in the long run by reducing investment and capital formation, and putting the economy on a less prosperous long-run balanced-growth path. The most important effect is probably the third. How big? The rule of thumb set out by economists Gregory Mankiw and Douglas Elmendorf is that 1 of extra debt reduces long-run real GDP by about seven cents.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.4.1 Short-Run Economic Effects of Deficits\n",
    "\n",
    "#### 14.4.1.1 Aggregate Demand\n",
    "\n",
    "In the short run, the income-expenditure diagram of Chapter 9 tells us that a deficit produced by a tax cut stimulates consumer spending and thus indirectly increases planned expenditure. A deficit produced instead by an increase in government pur­ chases directly increases planned expenditure. Either way, the deficit shifts the IS curve out and to the right: Any given interest rate is associated with a higher equilib­ rium value of production and employment.\n",
    "\n",
    "If the money stock is unchanged — if the LM curve of Chapter 11 does not shift — then output and employment rise in response to the tax cut. A deficit is expansionary in the short run.\n",
    "If monetary policy is set by the Taylor rule of Chapter 12, the MPRF shifts in and to the left. Unless expectations are rational — which they likely are not — unemployment falls and inflation rises. Again, a deficit is expansionary in the short run.\n",
    "\n",
    "Of course, the belief that deficits are expansionary — that they increase pro­ duction and employment — in the short run hinges not only on how we form our expectations but also on the Federal Reserve’s response to the rise in the deficit. If the Federal Reserve does not want inflation to rise at all — if its is very large — it will respond to the rightward expansionary shift in the IS curve by tightening monetary policy and' raising interest rates, neutralizing at least part of the expan­ sionary effect of the deficit. The MPRF will then be very flat. \n",
    "\n",
    "Because the decision­ making and policy implementation cycle for monetary policy is significantly shorter than the decision-making and policy implementation cycle for discretionary fiscal policy, the central bank can keep legislative actions to change the deficit from affecting the level of production and unemployment. The question is whether it will. The answer is, most of the time, yes. The central bank is trying its best to guide the economy along a narrow path without excess unemployment and without accelerating inflation. It has made its best guess as to what level of planned expenditure leads us along that path. In all likelihood its senior officials are unin­ terested in seeing the economy pushed away from that path by the fiscal policy decisions of legislators.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.4.1.2 International Effects of Deficits\n",
    "\n",
    "An increase in the government’s budget deficit also leads to an increase in the trade deficit. The outward shift in the IS curve and inward shift of the MPRF push up interest rates. Higher interest rates mean an appreciated dollar — a lower value of the exchange rate and of foreign currency — and therefore net exports fall. Up to now we have implicitly assumed that the composition of planned expenditure has no effect on the productivity of industry. Businesses have been implicitly assumed to be equally happy and equally productive whether they are producing consumption goods, investment goods for domestic use, goods and services that the government will purchase, or goods for the export market. Yet this is unlikely to be true. Recall from your microeconomics courses that the point of international trade is to trade goods that your economy is especially productive at making for goods that your economy is relatively unproductive at making.\n",
    "\n",
    "As large deficits that increase interest rates lower the value of the exchange rate, export industries — likely to be highly productive — shrink as exports shrink. This presumably reduces total productivity. Nobody, however, has a very sound estimate of how large these effects might be.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.4.1.3 Safe-Asset Shortage\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.4.2 Long-Run Economic Effects of Deficits\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 14.4.2.1 The Business-Cycle Long Run\n",
    "\n",
    "##### 14.4.2.1 Crowding Out\n",
    "\n",
    "Higher full-employment deficits lead to low investment. In the flexible-price context the analysis of persistent deficits is straightforward. Such deficits reduce government saving. Flow-of-funds equilibrium thus requires higher real interest rates and lower levels of investment spending and net exports.\n",
    "\n",
    "Even in a sticky-price context it may well be that higher deficits reduce investment and net exports. The central bank can, and probably will, change monetary policy to neutralize at least part of the effect of the higher deficit on real GDP. The central bank chose its baseline monetary policy in order to try to strike the optimum balance between the risk of higher-than-necessary unemployment and the risk of rising inflation. The central bank does not want this balance disturbed by shifts in the IS curve, so it is highly likely to use monetary policy to offset at least partially the effect of the deficit-driven shift in the IS curve on the level of real GDP and employment. The IS curve shifts out, but interest rates rise, leaving investment lowered. \n",
    "\n",
    "Will the central bank raise interest rates high enough to create a dollar-for-dollar swap between government purchases on one hand and investment plus gross exports on the other? In the business cycle long run, it will. But in the short run it may or may not. \n",
    "\n",
    "If the central bank’s responsiveness to a rise in inflation — the central bank’s rn — is infinitely large, then it will fully offset the increase in government purchases. Or if the central bank shifts its interest rate rule in order to keep the location of the MPRF unchanged in spite of the fiscal stimulus, then again it will fully offset the increase. In other cases, in the short run, the central bank will allow some of the increase in government purchases to boost the economy.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Higher Full-Employment Deficits Reduce Investment**: In the long run, higher budget deficits are not expansionary. Instead, increased interest rates reduce investment spending and lower the economy's balanced-growth path of real GDP per worker.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "##### 14.4.2.1 Debt Service, Taxation, and Real GDP\n",
    "\n",
    "But there are still more long-term effects. A higher deficit means a higher debt, which means that the government owes more in the way of interest payments to bondholders. Over time — even if the level of the deficit is kept constant — the increase in interest payments will require tax increases. And these tax increases will discourage entrepreneurship and economic activity. In addition to the reduction in output per worker resulting from the lower capital-output ratio, there will be an additional reduction in output per worker: The increased taxes needed to finance the interest owed on the national debt will have negative supply-side effects on production.\n",
    "\n",
    "The interaction of macroeconomic policy, tax policy, incentives for production, and the level of real GDP deserves more space. No discussion of fiscal policy could be complete without noting, for example, a possible drawback of the progressive tax rates that create strong fiscal automatic stabilizers. The higher the marginal tax rate, the greater the danger that at the margin taxes will discourage economic activity — leading either to hordes of lawyers wasting social time executing negative-sum tax-avoidance strategies, to a shift away from aggressive entrepreneurship toward more cautious, less growth-promoting activities taxed at lower rates, or to a depreciated exchange rate (and thus less power to purchase imports) as capital flows across national borders to jurisdictions that have lower tax rates at the margin.\n",
    "\n",
    "Thinking through these issues is complicated. Are government expenditures on infrastructure, basic research, and other public goods themselves productive? Do they raise total output by more than the increased tax rates threaten to reduce it? And what is the government’s objective? After all, maximizing measured total output is the same thing as maximizing social welfare only if externalities are absent, and only if the distribution of total wealth corresponds to the weight individuals have in the social welfare function — with the tastes and desires of the rich being given more weight.\n",
    "\n",
    "These topics are traditionally reserved for public finance courses, and are not covered in macroeconomics courses. But no one should think that an analysis of fiscal policy can start and end with the effects of discretionary fiscal policy and automatic stabilizers on the business cycle and the effects of persistent deficits on national saving. There is much more to be thought about.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.4.2.2 The Growth-Model Long-Run\n",
    "\n",
    "Higher full-employment deficits lead to low investment. Higher deficits lower government saving. In any run long enough for the full-employment flexible-price model of Chapter 7 to be relevant, large full-employment deficits lead to lower total saving, higher real interest rates, and lower investment spending.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 14.4.3 Political-Economic Effects of Deficits\n",
    "\n",
    "One thread of political economic analysis holds that deficits have destructive political consequences: The possibility of financing government spending through borrowing makes the government less effective at advancing the public welfare. Electoral politics suffers from a form of institutional voter myopia: The benefits from higher government spending now are clear and visible to voters, and the costs of the higher taxes later that will be needed to finance the debt built up via deficit spending are distant, fuzzy, and excessively discounted. Moreover, the unborn and underage do not vote: Many of those who will be obligated to pay taxes to make interest payments on tomorrow’s national debt do not vote today. The principle of “no taxation without representation” would seem to call for no long-term national debt — or, rather, for a national debt that is not larger than the government’s capital stock.\n",
    "\n",
    "Thus economists like Nobel Prize-winner James Buchanan have argued for a stringent balanced-budget rule. In Buchanan’s view, only if political dialogue must simultaneously confront both the benefits of spending and the pain of the taxes needed to finance that spending can we expect a democratic political system to adequately and effectively weigh the costs and benefits of proposed programs.\n",
    "\n",
    "Since the start of the 1980s, another argument has appeared: an argument for deficits created by tax cuts. The political system, its proponents argue, delivers steadily rising government spending unless it is placed under immediate and dire pressure to reduce the deficit. Therefore the only way to avoid an ever-growing inefficient government share of GDP is to run a constant deficit that politicians feel impelled to try to reduce. And should they ever succeed, the appropriate response is to pass another tax cut to create a new deficit. Only by starving the beast Leviathan that is government can it be kept from indefinite expansion.\n",
    "\n",
    "The U.S. experience of the past quarter century tends to support James Buchanan’s position, and to count against the alternative position. Few today are satisfied with the decisions about government spending and tax policy made in the 1980s and 1990s. Moreover, the deficits of the 1980s and of today do not seem to have put downward pressure on federal spending. Program spending fell, but total spending rose because of the hike in interest payments created by the series of deficits in the 1980s. Because interest payments are part of government spending, modern deficits appear to put not downward but upward pressure on the size of government.\n",
    "\n",
    "&nbsp;"
   ]
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    "### 14.4.4 RECAP Analyzing the Debt and the Deficit: Effects\n",
    "\n",
    "A high government budget deficit has three types of significant effects on the economy First, it will tend to swell the absolute size of the government in relation to GDP. Myopic voters will see the benefits of spending increases and not count the costs of future tax increases to finance them. Higher national debt levels increase interest payments, and the government must eventually raise taxes to make these interest payments. A high government budget deficit may — if the central bank allows it — raise real GDP and lower unemploy­ ment in the short run. A high government budget deficit will in the long run slow economic growth and lower real GDP below what it would otherwise have been.\n",
    "\n",
    "&nbsp;"
   ]
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    "Chapter Summary\n",
    "\n",
    "1. The United States is usually a moderate-debt country. The level of the national debt with which U.S. politicians and voters are comfortable is not terribly large. Only immediately after major wars does the U.S. na­ tional debt reach a high value relative to real GDP.\n",
    "2. The last quarter century, however, saw steep rises in the national debt — unprecedented rises in peacetime — interrupted by only a few brief and temporary years of budget surpluses at the end of the 1990s.\n",
    "3. Nevertheless, the U.S. national debt is still significantly below the level at which economists begin seriously worrying about the consequences of the debt for the health of the economy.\n",
    "4. From the standpoint of analyzing stabilization policy, the best measure of the government’s stance is the full- employment deficit. The full-emplovment deficit is not\n",
    "a bad measure of the net effect of government policy on the location of the IS curve and the MPRF\n",
    "5. From the standpoint of analyzing the effect of changes in the national debt on long-run growth, the debt and deficit need to be adjusted for inflation and government investment. A third adjustment — for outstanding gov­ ernment liabilities — has been proposed and has some attractive features, but it is not usually used.\n",
    "6. Persistent deficits — a rising national debt — threaten to diminish national saving, reduce the level of output per worker along the economy’s balanced-growth path,\n",
    "and retard econom ic growth.\n",
    "7. Past deficits — which produce a high ratio of current debt to GDP — threaten to reduce national prosperity because the higher taxes required to service the national debt act as a drag on economic activity.\n",
    "\n",
    "&nbsp;"
   ]
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    "## <font color=\"880000\">Catch Our Breath</font>\n",
    "\n",
    "<img src=\"https://tinyurl.com/20181029a-delong\" width=\"300\" style=\"float:right\" />\n",
    "\n",
    "* Ask me two questions…\n",
    "* Make two comments…\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "* Further reading…\n",
    "\n",
    "<br clear=\"all\" />\n",
    "\n",
    "----\n",
    "\n",
    "Lecture Support: <>    \n",
    "Keynote: <>\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "----"
   ]
  }
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