Government Imbalances: A Few Important Issues

Introduction: What are we talking about?

What's so bad about deficits and debt?  Many of you have credit card debt and some may have debt from car loans and home mortgages and are not too concerned this will bring about the end of the world, which is what you heard in the late 1980s and early 1990s in the US.  As we discuss the federal government's fiscal imbalances, it will be useful to keep in mind your own finances because there are some parallels between the two.  It is not, however, a perfect analogy because there are some differences that you need to recognize.  The three differences are:

1. The government has no life expectancy: When people die their estate is settled and all debts must be repaid.  This is not the case with a government that has no time limit and thus may never need to settle its debts.
2. The government can print money: To pay your debts you will need to earn money, but the government can print money to pay its bills as long as people will accept the money.  There are limits, though, and sometimes governments exceed those limits. The best recent example would be Yugoslavia where Slobadan Milosovic printed vast quantities of dinars to pay the government's bills.  The result was massive inflation - peaking at 331 million percent - and devaluation of the currency as no one would accept it as payment.
3. The government owes much of the debt to itself: Some of you probably own US savings bonds which means that you own a small piece of the government's debt. When the government pays interest on the debt it is simply transferring funds from those who pay taxes to those who collect interest on the government bonds they own.

In the remainder of this section we will examine three issues - How big are the deficits and debt? How did we end up with these deficits? and Why do we care about the deficits?  As you would expect these two issues have been hotly debated with the conservative / liberal divide very evident since this is to a large extent a debate over the proper scope of government. 

Deficits, Surpluses, and Debt: How much are we talking about and where did the come from?

Given these qualifiers concerning our approach, we can no turn our attention to the government's fiscal balance that changed dramatically during the 1990s.  At the outset of the decade the budget deficit was a major political issue in the presidential election of 1992 with the candidates proposing alternative plans for reducing the deficit, but by the 2000 election the budget surplus had become a major issue. 

As we start it is also important to note that the budget deficit is a federal phenomenon since state and local government's have consistently run surpluses that averaged about 2-3 percent of GDP [Diagram 1].  When we talk about budget deficits we are talking about the federal government.

Diagram 1

A good place to start with our discussion of the federal budget imbalances would be a review of the historical track record.  In Diagram 2 we can see that massive deficits are a relatively new phenomenon, but that should be no surprise.   You will recall that prior to the Great Depression and the work of John Maynard Keynes in the 1930s, the dominant belief was the government should balance its budget. This was what prompted president Hoover to raise taxes and cut government spending as the economy slipped into the Depression.  After the Depression and WW II things were different as policymakers felt less constrained to balance the budget.  You may recall that President Kennedy, following the lead of his Keynesian advisors, pushed for tax cuts and budget deficits to honor his campaign promise to get the economy moving again.  It was the Reagan deficits, however, that changed everything and produced the largest deficits in US history - at least in the 20th century.  In WW II the federal deficit reached $50 billion, not even close to the nearly $300 billion in the early 1990s. This is what set off the "deficit alarms" in the mid 1980s and brought the budget deficit to the attention of policy makers and politicians, as well as the average citizen who was bombarded with gloom and doom stories of impending bankruptcy and impoverishment of the children.  

Diagram 2

But one of the things you know from your previous work is much happened between the 1900s and the 1990s - the US economy grew and prices rose - and a good analysis should account for this.  The rationale is that when the economy is larger there are more resources that can be tapped to pay a government's debts.  The same would be true with you.  If your debts doubled from $1,000 to $1,200, this may be cause for alarm if your income remained unchanged at $10,000 but there would be no cause for alarm if your income increased to $15,000.   Your ability to pay the cost of carrying the debt would be greater in the second situation, a fact captured in the lower debt/income ratio [.1 vs .08].

What if we take into account the fact the economy was much larger in the 1990s? Normalizing the deficit for the size of the economy (deficit/GDP) presents a very different picture of the history of budget deficits [Diagram 3].  What becomes clear is the Reagan deficits were much smaller than the deficits incurred during the first and second world wars when adjusted for the size of the economy.   In WW II the government borrowed nearly $50 billion, bout one quarter of the value of all goods and services produced that year, while in 1992 the $300 billion borrowed represented only 5 percent of the economy's production.  A similar pattern would emerge if you adjusted the deficit for price changes over that period of time.  The Reagan deficits, when using constant dollar figures, look far less imposing then the unadjusted data in the first diagram.  The US economy had lived through deficits that dwarfed the Reagan deficits, but this was the first time that these deficits occurred in peacetime. 

Diagram 3

Another feature of the budget deficit is their sensitivity to war and business cycles.  To finance wars governments generally run deficits financed by issuing government bonds - the savings bonds the Uncle Sam posters encouraged Americans to buy during WW II being a good example.  The US government ran HUGE deficits to finance WW I and WW II and a relatively small deficit to finance the Vietnam War.  You also can see a definite cyclical pattern as the deficit tends to rise during recessions.  In each of the post WW II recessions there was a budget deficit and during the Great Depression the federal government ran a deficit that reached 5% of GDP, something that we did not see again until the Reagan deficits in the mid 1980s.

This cyclical pattern in the deficit can be attributed in part to policy decisions such as Roosevelt's New Deal and Kennedy's tax cut, but for the most part it is a product of the automatic stabilizers that we discussed in the 1960s.  Many of the federal government's programs, both expenditures and receipts, are tied to the state of the economy. On the revenue side, a major source of government income comes from the income tax so as the economy falls into a recession, unemployment rising and income falling, you can expect to see a decline in government tax revenues.  Similarly, many of the transfer payments included in the Human Resource segment of the budget are tied to the economy's performance.  For example, as the economy expands unemployment will fall, and with it the government's expenditures on unemployment benefits.  Together these cyclical patterns in the government's finances tends to automatically stabilize the economy which helps explain why we saw greater stability in the economy, when measured either by GDP or unemployment, in the post WW II era.

Closely related to the budget deficit, what the government borrows in any year, is the national debt, what the government owes.   In 1939 the US government owed $41 billion, a number that grew to $4 trillion by 1998.  These numbers are once again distorted by the growth in the economy and inflation, so we will examine the debt/GDP ratio to get at a better measure of the deficit's size.  Once again WW II is very evident with a rapid build-up of debt - from 40% of the nation's production to over 100%.  This is somewhat similar to a student earning $10,000 a year who initially has a debt of $5,000 and then after a buying spree winds up with a debt of $20,000.  Following the war the government ran more deficits than surpluses so the federal debt continued to climb, but at a slower rate than the economy through the mid 1970s.  As a result the debt/GDP ratio continued to fall through the mid 1970s when the economy struggled through a severe case of stagflation.  After holding rather steady at less than 3% of GDP,  the debt began to rise in the 1980s - the direct result of the Reagan deficits.  It was this build-up in the deficits and debt that pushed the federal government finances onto the political agenda. 

Before moving on, let's look at how the fiscal imbalance of the US compares with that of some other industrialized nations.   Again turning to the public sector finances data provided by the OECD we find that the US is not alone.

General Government Deficits and Debt: Percentage of GDP

In the 1970-85 period the financial situation of most countries deteriorated with the general surpluses of 1970 evaporating by 1985. The turnaround was biggest in Germany where a small surplus of .2 percent of GDP ballooned into a deficit of 11.5 percent of GDP.  The impact of the widespread deficits can be seen in the increase in the debt/GDP ratios during this period.  In Canada and the US, the degree of government indebtedness increased by approximately 20 percent, far less than the 100 percent increases in Germany and Sweden and the 500 percent increase in Japan.  For the most part the excesses of the earlier period were reversed in the latter period.  Among the countries in this sample, only Germany, whose deficit had fallen sharply, and Japan, whose deficit increased about 900 percent as it poured on the spending to move it out of a decade long recession, had deficits in 1999.

Deficits and Debt: How much of a problem is it?

Budget deficits had always been a political issue.  You could see this in the statements of Hoover and Roosevelt in the 1930s, Kennedy and Eisenhower in the 1960s, Reagan and Mondale in the 1980s, and Clinton and Bush in the 1990s.  The deficits of the 1980s and 90s, however, brought the discussion to new heights and before beginning our work on this subject, you need recognize this is a very controversial issue and you will generally find three very different, oftentimes persuasive, perspectives.   On one pole we have those with conservative "roots" who see the deficit as a real evil undermining the American economic system.  On the other pole we have those from the liberal tradition who believe the furor surrounding the deficit is overblown and has directed our attention away from what really matters.  In between we have those who are concerned, but only with the long-term consequences.  You will also need to move effortlessly between the discussions of the budget deficit and the national debt.  The deficit is what the government borrows in a given year and the debt is what the government owes as a result of all of its previous deficits.  What you will find in the future is the debate over the surplus will focus on many of the issues in the historical deficit debate, and therefore even though the HUGE deficits appear behind us, it is useful to look briefly at the debate that raged over the need to balance the budget.  The debate has three dimensions that we will briefly examine - how big is it, what is its "burden" to society, and how do we fix it.

• How big is it? Anyone who knows even a little bit about accounting knows that you can "cook the books" which presents problems when we look at the federal finances - or more specifically when we look at only one number summarizing the hundreds of pages containing the thousands of transactions reflected in the budget.  A few of the issues that would fall under  "measurement" are:
  • There is no capital account in the federal budget - a $100,000 building built today designed to provide services for the next decade could be written off over ten years so that the expenses would be roughly $10,000 a year if there was a capital account.  The lack of a capital account means that the government writes off $100,000 in the year that the bills are paid which would generate a large deficit in that year.
  • The official budget figures "hide" a number of significant government obligations.  Most of you probably have federally insured bank accounts which means the government is on the hook for the money if the bank goes bust.  But there is no place on the government's books for this obligation which could be substantial.  We saw this with the Savings & Loan crisis in the late 1980s where the government bailed out the bankrupt institutions at a cost to taxpayers of over $200 billion. The same is true with your student loans and pension that the government insures.  There are enormous potential liabilities that do not show up in the budget.  And it gets worse since the government has considerable leverage as to how to classify revenues and expenses.  Again returning to the S&L crisis, the government did not report the expenses on its budget, but rather classified them as off-budget expenses.  What is did report were the additional fees that it began charging for insurance. The bottom line, the government incurred a $200 billion dollar expense and the reported budget deficit fell since the expenses were not reported and the additional revenues were.
  • An additional example of where the budget figures can be misleading would be the social security and pension systems.  The problem is that the systems are largely of the unfunded category which can create real problems in the future.   An unfunded system is one where there is no direct link between the contributions one makes and the payments one receives.  A funded pension would be one where the pension contributions would be put into a separate fund and this fund would provide the money to pay the benefits.  Social security contributions, however, have historically gone into the general fund and benefits have been paid from the fund - what could be called a pay-as-you-go system.  When you pay your F.I.C.A. taxes those funds are paying for the benefits being received by today's elderly.  This works as long as the population is young and growing, but it can cause real problems when the population is growing slowly and the number of retirees is growing, which is what is happening in most of the industrialized countries.  It is these demographic patterns that have prompted many to do the math on the number of people of working age who will be able to  support retirees by the time the baby boomers retire.
  • The cyclical nature of the deficit has prompted economists to create an artificial construct - the full-employment budget - which estimates the budget balance on the assumption that the economy was running at full employment.  Some argue the rule should be written so it is the full employment budget that is in balance.  Some argue the situation looks far less ominous when you offset the debt with the assets owned by the federal government. 
  • The federal deficit is only part of the picture. As we saw earlier, state & local areas have consistently run budget surpluses so that the government deficit was smaller than the federal deficit.  If the federal government eliminated its intergovernmental transfers to state and local governments then the federal deficit would disappear, but only to reappear at a reduced level at the state and local level.
  • Inflation needs to be acknowledged in the accounting.   The logic is straightforward as you can see in the simple example.  Assume you borrow $900 and agree to pay $1,000 back in one year.  The value of your debt is $1,000, but what would it be if you expected prices to double during that year.  You would pay $1,000, but it would have the buying power of $500 so should you count $1,000 or $500 as your debt? 

    Now let's use the logic to look at a simple example based on the government's finances.   We will assume that the government has a debt of $4,000 billion and is running a deficit of $100 billion when we exclude interest payments on the debt.  In the first scenario (column) we have nominal interest rates of 5% and inflation of 2%.  The nominal interest payment is $200 which brings the deficit to $300.  The real deficit is computed by adjusting the nominal (actual) debt by the expected inflation rate. With an inflation rate of 2%, the value of the debt is reduced by $80  which gives us a real deficit of $220 [$300 - .02*$4,000].   In the second column we examine what higher inflation does to the real deficit.  By further reducing the real value of the debt the real deficit has been reduced to $180 [$300 - .03*$4,000].

  Real vs. Nominal Deficit

  		2% Inflation rate	3% Inflation rate	3% Inflation rate
  Nominal debt	$4,000
  Nominal interest rate		0.05	0.05	.06
  Interest on debt		$200	$200	$240
  Non interest deficit		$100	$100	$100
  Nominal deficit		$300	$300	$340
  Reduced value of debt		-$80	-$120	-$120
  Real deficit		$220	-$180	$220

  What a way to eliminate the deficit - just produce a little bit of inflation.  The problem is the government's gain is someone else's loss.  Just as the debt the government owes is reduced in value, the bonds investors own have been reduced in value.  The inflation has redistributed money from investors to the government.  Fortunately for investors, there is a limit to this transfer and a way of eliminating any unexpected transfers of wealth.  The secret is in the adjustment of nominal interest rates to reflect higher inflation rates.  As we saw in an earlier discussion of interest rates, inflation will tend to be reflected in nominal interest rates.  In this case let us assume that the adjustment was perfect, that the 1% increase in inflation pushed interest rates 1% higher.  When you redo the calculations you find that the real deficit has returned to its original level.  The conclusion to be drawn here is the redistribution of income from investors to the government will occur only if interest rates are constrained by the government or if the inflation is unexpected.     

• What is the burden of the debt?  First, any assessment of the burden of the debt must begin with what the debt "bought."  For example, assume two friends of yours each take out $50,000 loans and they must pay 5% interest - an annual payment of $2,500.  The first friend uses the money to pay for a college education that will increase her earnings by $20,000 a year once she graduates.  The second friend uses it to take an extended vacation.  Clearly the impact of the debt would be different in the two case.  In the first, the additional income would more than compensate for the costs of carrying the debt, while in the second case there would be a real cost since the debt did not contribute to an increase in earnings. 

The same is true when we look at the federal debt.   There are very few people who have second thoughts about the enormous debt incurred in the two world wars in the twentieth century since they preserved the American way.  You would also probably find there would be general agreement that the government spending that produced the interstate highway system was a good investment in the nation's future, that it increased the productive capacity of the nation (GDP) more than enough to pay for the interest costs on the investment.  It does not take long, however, to reach spending projects people consider the equivalent of a vacation, spending that does not produce future income capacity that will allow for payment of the interest.   And, as we saw earlier, there is a bias in democracies toward deficit spending.  Imagine if you could take out a loan and you did not have to pay it back until sometime in the future.  In fact, assume that you could push the repayment onto the next generation so that you could actually escape the repayment.  This is the situation that the US finds itself in and it allows policymakers to avoid many tough decisions today and leave the problems to future policymakers.  If the future production capacity of the nation is not increased by the government's expenses that show up in the debt, then there will be a definite intergenerational transfer.  In a very real sense today's generation is leaving future generations with the bill for today's expenses.

In fact it can be worse than this.  Unless the economy is in a very serious recession or depression, the government's demand for funds to finance the debt will put upward pressure on interest rates.  This is the crowing-out phenomenon that we talked about in the 1930s.  As interest rates rise you will find businesses cutting back on their investment in new factories, offices, and machinery.  These investments would increase the productive capacity of the economy in the future, and therefore, to the extent investment spending is reduced today, future generations will live with older machines, offices, and factories which will leave them with a smaller capital base.  

And we are not done yet.  The upward pressure on interest rates will tend to "pull" money into the country as wealthy individuals try to earn the higher rate of return.  These investors will buy US securities and this will put upward pressure on the exchange rate.  The increase in the exchange rate, meanwhile, will make it more difficult for domestic producers to compete with foreign producers and thus you can expect to see a decline in the export industry that translates into lost jobs. 

But what if individuals, knowing today's budget deficits will need to be paid back, decide to increase their savings to allow them to pay the future taxes.  In this case the additional savings will free up the additional funds to finance the deficit, an idea called the Ricardian equivalence theorem.  In this case there would be no intergenerational transfer since today's generation would increase savings to pay for next generation's costs. Unfortunately, the track record does not support the propositions.

• How do we eliminate deficits?  While the deficit had long been an issue, it was not until the mid 1980s that any action was taken to reduce the deficit - at least some action on paper.  In 1986 Congress passed the Gramm-Rudman-Hollings Bill that set mandated targets for the deficit reduction so the budget would be balanced by 1991.  When the deficit remained stubbornly high, a new approach was taken with passage of the Budget Enforcement Act of 1990 which put caps on certain spending and established a pay-as-you-go standard - something comparable to an impact study.  All new programs needed to be budget neutral, with increased expenses had to be offset by spending cuts or tax increases.

  Unfortunately, as we saw earlier, much of government spending has a life of its own since two-thirds of federal spending is classified as nondiscretionary and therefore the legislation did not work.   This took it's toll on president George Bush who had to renege on his "read my lips: no new taxes" promise because of the large deficit and lost the 1992 election to Bill Clinton.  Clinton, after reversing himself on his campaign promise to "prime-the-pump" with a dose of Keynesian spending to move the economy out of the doldrums, set about the task of reigning in the deficit.  In 1993 the Omnibus Budget Reconciliation Act, which contained tax increases, primarily on the wealthy, and spending cuts, barely passed.  The budget deficits remained stubbornly high, though, and in 1995 the House passed, and the Senate defeated by one vote, a new piece of legislation designed to "force" a balanced budget.  The balanced budget amendment was based on the premise that democracies have a flaw and as a result Congress could never be expected to constrain its spending. The problem with democracy is it is not a good system for making tough choices and thus they have a tendency to put them off, to move the costs of today's decision into the future.

  As it turned out, the was no need for legislation to balance the budget since strong economic growth, combined with the 1993 legislation, virtually eliminated the budget deficit by 1999 when the President and Congress began haggling over how to divide up the projected surplus.  Clinton's about face on expenditures and taxes - from a candidate pushing for a Keynesian expansionary stimulus package to a president pushing potentially contractionary spending cuts and tax increases - appeared to work.  What we learned from the Clinton experience is expectations matter and the spending multiplier could actually be zero.  The logic, based in large part on the thinking of Fed Chairman Alan Greenspan, was the reduction in the deficit would "send a message to the bond market" which would push down long-term interest rates which would stimulate private sector investment.  As the government lowered spending and raised taxes, which should have created a decline in output because of the multiplier, the reduced interest rates pushed investment and consumption spending higher so there was no net change in demand and the multiplier was zero.

What about the future?

Where do we go from here?  The question is how do we raise money and spend it?   The allocation of resources has been increasingly toward income protection - the safety net.  The difficulty is that the government will have difficulty raising the money.  The governments will need to look at where they get their money, a question we will now examine in a section on taxation.