ECONOMICS U$A
FEDERAL DEFICITS
PURPOSE:
To show that deficits can be helpful or harmful, depending on the circumstances.
OBJECTIVES:
1. Deficits can rise not only because policy makers raise spending or lower taxes, but also when the economy is in a recession. During recessions, unemployment benefits and welfare payments rise automatically while tax receipts drop. One way to separate the cyclical and structural components of the deficit is to estimate what the deficit would be if the economy were operating at full employment.
2. In the short run, deficits can have two potentially damaging effects on the economy. First, if the economy is at full employment, a government deficit is inflationary, because the excess of government spending over government revenues adds to aggregate demand pressures in the economy. Second, to the extent that federal deficits raise interest rates, they can retard growth in investment and housing activities, which are interest-sensitive.
3. In the long run, deficits can be harmful if they add to the debt burden. Persistent deficits mean a rising national debt. If the national debt rises fast than GNP, then this can have serious negative ramifications for the future growth potential of the U.S. Moreover, if a large portion of the debt is held by other countries, then this means that foreigners have a large claim on U.S. resources.
4. Government budgets should not necessarily be balanced at all times. Specifically, in a recession, balancing the budget means cutting spending and/or raising taxes—both of which have a contractionary effect on GNP. Nevertheless, in the long run the structural deficit (as measured by the full-employment deficit, for example) should be close to zero.
5. It is important to distinguish between balancing the budget and reducing the size of the government. A large government can have a balanced budget while s small government can run a large deficit.
KEY ECONOMIC CONCEPTS:
full employment budget, fiscal drag and fiscal dividend, annually balanced budget, debt-to-GNP ratio, cyclically balanced budget, internal versus external debt, public debt, size of the deficit vs size of the government
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Contemporary Issues After four years of U.S. federal budget surpluses (from 1998 to 2001), the red ink began to flow again in 2002. Much of this swing was due to large tax cuts and increases in defense and homeland security spending in the War Against Terror (a structural shift in the deficit). However, some of the deterioration on the U.S. fiscal balance was due to the recession of 2001 and the subsequent lackluster recovery (a cyclical shift in the deficit). Is a cyclical shift from surplus to deficit more or less problematic than a structural shift? Why? |
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Buy Bonds Most of us have been taught that to spend more money than we earn is to court financial disaster, but the federal government seems to plays by a different set of rules. Almost every year the country runs a deficit. Yet we’re told that deficit is necessary. Even beneficial. But deficits piled one on top of another create a growing national debt. And the interest payments on that debt add more dollars to the next year’s deficit. During a five year span back in the 1940’s our national debt more than quadrupled as we fought World War II. While taxes paid for some of the war, the rest was borrowed. The government issued war bonds and it was patriotic to buy war bonds and stamps to support the armed forces. The nation had gone deeply into debt to pay for the war. The debt never really went away. It just seemed to shrink in size compared to the total GNP. Comment and Analysis by Richard Gill Gill explains that basic costs of WWII were borne by the generation that lived and worked during WWII. In terms of guns and butter, we started before the war with an economy that was producing only civilian goods (butter). When the war came, we had to divert some of our resources to gun production. The economic cost of the war was borne right then and there and was basically the amount of butter we have to give up because we are producing armaments. But because we entered the war from the Great Depression, with enormous unused capacity and unemployment in the economy the cost of the war in terms of lost butter production was minimal.
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Budget Surplus President Eisenhower wanted to leave office with a balance budget so he began to push hard for a surplus in 1960. But Vice-President Nixon was running for President that year. He wanted a growing economy, so he argued for a deficit. Many economists agreed with Nixon, but Ike stuck to his guns. Many of Eisenhower’s advisors thought Eisenhower did not have time to oversee a complete recovery from the recession of 1958, that his drive for a budge surplus was premature. Nixon urged Eisenhower to stimulate the economy with an immediate tax cut. Ike declined. By mid-summer the economy had ground to a halt well short of full-employment. The budget surplus was holding money out of the economy and costing workers their jobs. While John Kennedy campaigned on a promise to get the country moving again, Richard Nixon was forced to publicly support a policy he privately opposed. The country hit bottom just two weeks before the election. For Nixon, the damage had been done. Kennedy won the President with a narrow margin. Comment and Analysis by Richard Gill What the government ought to do, most economists in 1960 were saying, is follow this course: Budget deficits during the recessions to expand the economy; budget surpluses during the booms to keep things in check. The government ought to pursue a counter-cyclical policy.
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The Never-ending Deficit For at least the next thirty years, after President Eisenhower’s 1960 budget surplus there would be only one balanced budget. Many members of Congress were alarmed. Alice Rivlin, from the Congressional Buudget Office worried that the government was borrowing a large portion of our national savings, leaving little for investment in projects that might stimulate the economy. And a worsening economy brought lengthening unemployment lines and higher deficits. Then, in the 1990's came the dot com boom which brought about a huge rise in the stock market and with it capital gains taxes to provide a welcome boost to the treasury. A surplus of billions was predicted and in 2001, George W. Bush, the new President handed Americans a sizeable tax cut. Then... 9/11. The stock market tanked. Defense spending went sky high. The war on terrorism had begun and the surplus was gone. History had repeated itself and the rising deficit had once more raised its ugly head Comment and Analysis by Nariman Behravesh |