Transcript Politics, Surpluses, Deficits, and Debt Chapter 12

Politics, Surpluses,
Deficits, and Debt
Chapter 12
© 2003 McGraw-Hill Ryerson Limited.
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Introduction

After having run budget deficits for
many decades, in 1997 the federal
government began to run budget
surpluses.
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Introduction
In the long-run framework, surpluses
are good because they provide
additional saving for an economy.
 Deficits are bad because they reduce
saving, growth, and income.

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Introduction

In a short-run framework, the view of
surpluses and deficits depends on the
state of the economy relative to its
potential income.
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Introduction
If the economy is running below its
potential output, deficits are good and
surpluses are bad.
 Deficits increase expenditures,
increasing output by a multiple of that
amount.

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Introduction

Combining the long-and short-run
frameworks gives the following policy:
 Whenever
possible, run surpluses, or at
least a balanced budget, to help stimulate
long-term growth.
 This is especially true when the economy is
booming – when it is above its level of
potential income.
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Introduction

The argument for surpluses is
weakened, and likely reversed, when
the economy falls into a recession.
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Introduction

At the beginning of 2000 there was a
large surplus.
 The
economy was booming.
 Unemployment was low.
 There was general agreement that the
economy was closing in on its potential
output.
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Introduction
Both short- and long-term economic
frameworks would recommend cutting
the national debt.
 Instead of doing so, government looked
at ways to spend the surplus, either by
cutting taxes or by increasing spending.

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Defining Surpluses and
Deficits
A surplus is an excess of revenues
over payments.
 A deficit is a shortfall of revenues under
payments.
 Both are flow concepts.

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Financing the Deficit
The deficit must be financed.
 The government finances its deficits by
selling bonds – promises to pay back
the money in the future – to private
individuals and to the central bank.

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Financing the Deficit
Since the central bank's IOUs are
money, the loans can also be made by
printing money.
 Potentially, the central bank has an
unlimited source of funds.

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Financing the Deficit

However, printing too much money
would trigger inflation which can have a
negative effect on the economy.
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Arbitrariness in Defining
Surpluses and Deficits

Defining surpluses and deficits can be
arbitrary.
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Arbitrariness in Defining
Surpluses and Deficits
Whether or not a nation has a deficit
depends on what is included as a
revenue and what is included as an
expenditure.
 This accounting issue is central to the
debate about whether we should be
concerned about a deficit.

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Arbitrariness in Defining
Surpluses and Deficits

The Retirement Income system is
based on promises to pay.
 Retirement
Income System - social
insurance programs that provide financial
benefits to the elderly and disabled and to
their eligible dependents and/or survivors.
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Arbitrariness in Defining
Surpluses and Deficits

The way these programs is accounted
for plays an important role in whether
there is a budget deficit or surplus.
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Surpluses and Deficits As
Summary Measures

As a summary, a surplus or deficit figure
reduces a complicated set of accounting
relationships down to a single figure.
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Surpluses and Deficits As
Summary Measures

Deficit need not matter - what is
important is the health of the economy.
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Nominal and Real Surpluses
and Deficits
A nominal deficit is the deficit
determined by looking at the difference
between expenditures and receipts.
 A real deficit is the nominal deficit
adjusted for inflation.

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Nominal and Real Surpluses
and Deficits
Inflation wipes out debt (accumulated
deficits less accumulated surpluses).
 The larger the debt and the larger the
inflation, the more debt will be
eliminated by inflation.

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Nominal and Real Surpluses
and Deficits

If inflation is wiping out debt, and the
deficit is equal to the increases in debt
from one year to the next, inflation also
affects the deficit.
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Nominal and Real Surpluses
and Deficits

The real deficit is calculated by
adjusting the nominal deficit for inflation.
real deficit = nominal deficit - (inflation x total debt)
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Nominal and Real Surpluses
and Deficits
The lowering of the real deficit by
inflation is not costless to the
government.
 Persistent inflation becomes built into
expectations and causes higher interest
rates.

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Structural and Passive
Surpluses and Deficits
It is important to make a distinction
between structural and passive deficits.
 Not all government expenditures are
independent of the level of income in
the economy.

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Structural and Passive
Surpluses and Deficits

There is a difference between a budget
deficit being used as a policy instrument
to affect the economy and a budget
deficit that is the result of income
deviating from its potential.
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Structural and Passive
Surpluses and Deficits

A structural deficit or surplus is the
part of the budget deficit or surplus that
would exist even if the economy were at
its potential level of income.
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Structural and Passive
Surpluses and Deficits
A passive deficit or surplus is the part
of the deficit or surplus that exists
because the economy is operating
below or above its potential level of
output.
 The passive deficit is also known as the
cyclical deficit.

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Structural and Passive
Surpluses and Deficits
When an economy is operating above
its potential, it has a passive surplus.
 If the economy is operating below its
potential, the actual deficit would be
larger than the structural deficit.

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Structural and Passive
Surpluses and Deficits
There is a significant debate about what
is an economy’s potential income level.
 There is disagreement about what
percentage of a deficit is structural and
what part is passive.

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The Definition of Debt and
Assets
Debt is accumulated deficits minus
accumulated surpluses.
 Deficits and surpluses are flow
concepts.
 Debt is a stock concept.

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Debt Management
The debt must be managed.
 The Canadian government must
refinance the bonds that are coming
due by selling new bonds, as well as
sell new bonds when running a deficit.

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Debt Management
In the late 1990s, the federal
government ran a budget surplus.
 The government retired some of its
previously issued bonds by buying them
back and did not replace them as they
come due.

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The Need to Judge Debt
Relative to Assets
Debt needs to be judged relative to
assets.
 Debt is a summary measure of a
nation’s financial situation.
 As a summary measure, debt has even
more problems than deficit.

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The Need to Judge Debt
Relative to Assets
Debt by itself is only half the picture.
 The other half of the picture is assets.

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The Need to Judge Debt
Relative to Assets

For a government, assets include:
 Its
skilled work force.
 Natural resources.
 Its factories.
 Its housing stock.
 Holdings of foreign assets.
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The Need to Judge Debt
Relative to Assets

For a government, assets include:
 The
buildings and land it owns.
 A portion of the assets of the people in the
country, since government gets a portion of
all earnings of those assets in tax revenue.
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The Need to Judge Debt
Relative to Assets
When the government runs a deficit, it
might be spending on projects that
increase its assets.
 If the assets are valued at more than
their costs, then the deficit is making the
society better off.

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Arbitrariness in Defining
Debt and Assets
Defining debt and assets can be
arbitrary.
 As was the case with income, revenues,
and deficits, there is no perfect answer
as to how assets and debt should be
valued.

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Arbitrariness in Defining
Debt and Assets

Even after assets are taken into
account, you still have to be careful
when deciding whether or not to be
concerned about debt.
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Arbitrariness in Defining
Debt and Assets

The total stock of gross debt can be
broken down into market debt and nonmarket debt.
Market debt includes marketable bonds,
treasury bills and other securities.
 Non-market debt includes federal public
sector pension liabilities and other
federal liabilities.

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Arbitrariness in Defining
Debt and Assets

To calculate debt, we add market debt
and non-market debt, and subtract the
value of financial assets held by the
government, such as cash, reserves,
and loans.
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Difference Between
Individual and Government
Debt

Individual and government debt are
different.
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Difference Between
Individual and Government
Debt

Government debt is different from an
individual’s debt for three reasons:
 Government
debt is ongoing.
 Government can print money to pay off its
debt – individuals can’t.
 Three quarters of government debt is
internal debt – debt owed to other
government agencies or to its citizens.
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Difference Between
Individual and Government
Debt

Paying interest on the internal debt
involves a redistribution among citizens
of the country, but it does involve a net
reduction in income of the average
citizen.
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Difference Between
Individual and Government
Debt

External debt is more like an individual’s
debt.
 External
debt – government debt owed to
individuals in foreign countries.
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Government Deficits and
Debt: The Historical Record
Most economists do not look at absolute
figures of deficits and debt.
 They are much more concerned with
deficits and debt relative to GDP.

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Government Deficits and
Debt: The Historical Record

Deficits and debt relative to GDP rose
significantly in the 1970s and 1980s.

In the late 1990s debt started to fall,
reaching 50% of GDP in 2001.
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Canadian Budget Deficit
Relative to GDP, Fig. 12-1a, p 293
0.14
% fluctuation in deficit/GDP
0.12
0.1
0.08
0.06
0.04
0.02
0
1961
-0.02
1971
1981
1991
2001
-0.04
Years
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Canadian Debt Relative to
GDP, Fig. 12-1b, p 293
% fluctuations in debt/GDP
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1961
1971
1981
1991
2001
Years
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Government Deficits and
Debt: The Historical Record
Economists prefer the “relative to GDP
measurement” because it better
measures the government’s ability to
handle the deficit and pay off the debt.
 The ability to pay off a debt depends on
a nation’s productive capacity, the asset
side of the equation.

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The Debt Burden
Decrease of debt/GDP ratio was mainly
due to growth in GDP.
 There are two ways in which GDP can
grow:

 Through
inflation – a rise in nominal, but
not real GDP.
 Through real growth.
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The Debt Burden
When GDP grows, the debt the
government can reasonable handle also
grows.
 The economy becomes richer, and,
being richer, it can handle more debt.

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The Debt Burden
Real growth in Canada has averaged
about 2.5 to 3.5 percent a year.
 This means that Canadian debt can
grow at the same rate without
increasing the debt/GDP ratio.

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Debt Relative to Other
Countries
Canada has a relatively large debt
burden compared to other advanced
economies.
 The increasing trend of debt to GDP
has been reversed in the 1990s, when
government revamped its programs and
policies.

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Debt Relative to Other
Countries
There was a structural deficit in Canada
– even at full employment, spending
exceeded revenue.
 While Canada’s debt is still high, it is
much lower than it was in the 1990s.

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Debt Relative to Other
Countries, Fig. 12-2, p 294
120
100
80
60
40
20
0
Italy
Canada Germany
France
U.S.
Japan
U.K.
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Interest Rates and Debt
Burden

Besides the debt relative to GDP
figures, economists are concerned
about the interest rate paid on the debt
because interest rates affect debt
burden.
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Interest Rates and Debt
Burden

How much of a burden a given amount
of debt imposes depends on the interest
rate that must be paid on that debt.
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Interest Rates and Debt
Burden
The interest rate determines annual
debt service.
 Annual debt service – the interest rate
on debt times the total debt.

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Interest Rates and Debt
Burden
Ultimately, the interest payments are the
burden of the debt.
 That is what people mean when they
say a deficit is burdening future
generations.

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Interest Rates and Debt
Burden

Canada can actually afford more debt
since Canadian government securities
are considered to be very safe.
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Federal Interest Payments
Relative to GDP, Fig. 12-3, p 295
% fluctuations out of GDP
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
1961
1971
1981
1991
2001
Years
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The Modern Debate About
the Surplus

The modern debate about the
government budget concerns what to do
with the surplus.
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Why Did the Surpluses
Come About?
Keynesian economics made clear that
deficits could serve a positive function
when the economy was below its
potential.
 This view was never fully accepted by
politicians, nor by the public.

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Why Did the Surpluses
Come About?
The 1980s saw a change in the political
landscape.
 Politicians were pushing the economy
toward deficits by cutting taxes, and
expanding the deficits.

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Why Did the Surpluses
Come About?

In the 1990s, the federal government
realized it increased its spending to the
point it was running a structural deficit.

Even if the economy were operating at
the potential output, the budget would
be in deficit.
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Why Did the Surpluses
Come About?

The authorities raised taxes, cut many
social programs and redesigned
existing programs.
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Why Did the Surpluses
Come About?
The surpluses of the late 1990s were
brought about by the unexpected
growth of the economy and a low and
stable rate of inflation.
 Interest rates stayed low, holding down
government interest payments.

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Why Did the Surpluses
Come About?

Expected tax revenue also increased,
and deficit predictions moved in the
opposite direction, to surplus
predictions.
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Federal Deficit and Debt Are
Only Part of the Picture

Provinces and municipalities also run
deficits by borrowing to spend in excess
of their revenues, and thereby raise the
total amount of government debt in the
economy.
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Net Debt: Federal, Provincial
and Local, Fig. 12-4a, p 298
700000
600000
500000
Federal Net Debt
Provincial Net Debt
Local Net Debt
400000
300000
200000
100000
0
1977
1980
1983
1986
1989
1992
1995
1998
2001
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Net Debt: Federal, Provincial
and Local, Fig. 12-4b, p 298
20000
10000
0
1
2
3
4
5
6
7
8
9
10
11
12
13
-10000
-20000
Federal Deficit
-30000
Provincial and Local
Deficit
-40000
-50000
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Federal Deficit and Debt Are
Only Part of the Picture

Net provincial and territorial debt rose
significantly during the 1990s.
The increase in spending by the
provinces was partly a response to the
federal budget cuts.
 “Fiscal responsibility” is the agenda of
many newly elected politicians.

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A Different Type of
Crowding Out
High government deficits require more
and more borrowing, reducing the
capital available to government and
private enterprise.
 Interests rates increase as a result, and
this means that borrowing is more
expensive for firms who wish to fund
expansion by issuing debt (such as
bonds).

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A Different Type of
Crowding Out

Private sector investment is crowded
out – higher levels of government
spending raise interest rates, which in
turn reduce the level of private
investment.
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A Different Type of
Crowding Out

Increase in government spending
increases interest rates, and
appreciates domestic currency.

When domestic currency gains value,
exports decrease, and imports rise.
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Is the Deficit a Good Measure of
the Stance of Fiscal Policy?
Can we use deficit to find out if fiscal
policies are becoming more or less
expansionary – the stance of fiscal
policy?
 The answer is NO. Deficit can change
as a result of a shift in an autonomous
component of demand.

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Is the Deficit a Good Measure of
the Stance of Fiscal Policy?
If autonomous spending (investment, for
example) decreased, deficit would rise
because income would fall and reduce
tax revenues.
 This deficit increase was not a result of
expansionary fiscal policy.

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Is the Deficit a Good Measure of
the Stance of Fiscal Policy?

Budget surplus:
BS = T – G
G = G0
T = T0 + tY
BS = [T0 - G0] + tY
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The Budget Surplus
Function, Fig. 12-5a, p 299
BS
BS
0
BS0
Y1
BS1
Y0
Income
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Is the Deficit a Good Measure of
the Stance of Fiscal Policy?
A change in equilibrium income would
affect the budget surplus equation,
independent of policy variables (T0,G0
or t).
 A better measure of the stance of fiscal
policy is the structural deficit.

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Is the Deficit a Good Measure of
the Stance of Fiscal Policy?

Holding income at its potential level, we
can see how changes in fiscal policy
affect the budget surplus.
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The Budget Surplus
Function, Fig. 12-5b, p 299
BS
BS1
Increase
in tax shifts BS
BS0
0
Yp
BS0
BS1
Income
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Politics, Surpluses,
Deficits, and Debt
End of Chapter 12
© 2003 McGraw-Hill Ryerson Limited.