Transcript Slide 1

Fiscal Macroeconomics in 2011
Debts and Deficits
Last time:
-
Conceptual issues of debts and deficits
Deficits and slower growth of potential Y in the closed economy
Deficits and foreign borrowing and lower Y in the open economy
Today:
-
Economics of an internal debt
The death spiral of debt and default
Keynes and the classical economist on deficit financing
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Taxes and debt for a purely internal debt
Assume that we “owe the debt to ourselves”
- Many identical people
- All get benefits and pay taxes to service debt
- Suppose that we have program which provides $1 in PV of C;
and finances it by $1 of debt.
Classical case:
- Suppose no change in path of output.
- Higher interest payments with present value of $1.
- Taxes cause efficiency losses with a dead-weight loss (DWL).
- If marginal DWL on taxes is 30%, then have cost of $0.30.
- Net value of government program is minus $0.30.
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The marginal dead weight loss of debt/taxes
Empirical estimates: 20 – 40
cents of DWL per $ of taxes
from higher tax rates
= incremental DWL of higher taxes
P(1+τ2)
~ increase revenues
P(1+τ1)
DWL
P
X2
X1
X0
Economics of External Debts
Debt and financial crises
“Political incentives for additional borrowing could change quickly if financial
markets began to penalize the United States for failing to put its fiscal house
in order.
If investors become less certain of full repayment or believe that the country is
pursuing an inflationary course that would allow it to repay the debt with
devalued dollars, they could begin to charge a “risk premium” on U.S.
Treasury securities. That could happen suddenly in a confidence crisis and
ensuing financial shock.
There is precedent for a financial disruption first contributing to large, chronic
deficits and then in some cases contributing to the loss of investor
confidence and even to a default on a nation’s debt.
[However,] the unique position of the United States—because of its economic
dominance and the dominant role of the dollar internationally—make it
difficult to extrapolate from the experience of other nations in estimating
the risk or timing of a financial crisis arising from failure to address the
projected U.S. fiscal imbalance.
[National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009]
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A less nuanced view by the Deficit Commissioner
“When the markets lose confidence in a country, they act swiftly
and they act decisively. Look at Greece, look at Portugal, look
at Ireland, look at Spain.* If they markets lose confidence in
this country and we continue to build up these enormous
deficits and debt, they will act swiftly and decisively.”
[Erskine Bowles, Chair, President’s Commission]
* BTW: This is completely wrong analytically.
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Country crises as bank runs
Problem with financial crisis is that have an additional risk element, where
r
risky
 r
riskfree

where  = risk premium on country debt = risk of default. New stable debt is
  / t   0  ( r riskfree    g)  PS /Y
So again assuming that i  g, now primary surplus (PS) must be higher:
PS /Y  
Problem arises because have an unstable equilibrium where country’s liquid
liabilities >> its liquid assets.
A higher debt → higher probability of default (π)→ higher r → requires more
budget cuts and less likely to pay → higher π → eventually the country
decides to default or restructure.
Examples:
• Greece β=1.4. If markets put π =5%, primary surplus ratio must be 7% of
GDP. If Greeks start revolting, π =10%, then required surplus goes to 14% of
GDP. So have a good and bad equilibrium like bank runs.
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Country fiscal
position
Fiscal deficits plus loss of
confidence pushes over
the tipping point to where
cannot refinance debts
Rising risk premium and interest burden
Romer’s analysis
Default as
function of
interest rate
Zero profit line
for investors
π = probability of default.
R = (1+r) = interest factor
T = taxes
A = stable equilibrium
B = unstable equilibrium
ΔR= Δ(1+r)
Stable
dynamics;
good
equilibrium
Unstable
dynamics
A
B
  prob of default
EZ interest rates
European interest rates
20
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Greece
Ireland
16
Italy
14
Spain
12
France
10
Austria
8
Germany
6
Romania
4
Czech
Republic
2
United
Kingdom
0
Sweden
UK and Spain
have virtually
identical fiscal
positions. Why is
Spain in trouble
and UK not?
Two
ofsaving
the Great
Unraveling
(I):
The
twoViews
faces of
and the
deficit dilemma
Soft Landing
What is the effect of deficit reduction on the economy?
1. In short run:
• Higher savings is contractionary
• Mechanism: higher S, lower AD, lower Y (straight Keynesian
effect)
2. In long-run, neoclassical growth model
• Higher savings leads to higher potential output
• Mechanism: higher I, K, Y, w, etc. (through neoclassical growth
model)
Dilemma of the deficit: Should we raise G today or lower G?
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Impact of fiscal stimulus
AS’
AS
Inflation
?
AD’
AD
Real output (Y)
The dilemma of the deficit
Compare (1) a deficit spending program to reach full employment
with
(2) a balanced budget program
This numerical example combines our AS-AD and Solow models:
- Potential output from AF[K,(1-u*) LF], closed economy
- Actual output from calibrated Mankiw AS-AD
- Assumes closed economy (but not essential)
These are “plausible” simulations but not projections or forecasts.
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Stimulus v. balanced budget
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Balance FE budget in 4 years
Stimulate enough to get to FE in 3 years
Size of stimulus, two runs (billions)
1,000
900
800
700
600
500
Balanced FE budget
400
Big stimulus
300
200
100
0
2011
2016
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Actual deficits
-
Actual deficit is still large because of recession.
Federal deficits, two runs (billions)
1,400
1,200
1,000
800
600
400
Balanced FE budget
200
Big stimulus
0
2003
2008
2013
2018
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The long-term debt
Have higher debt-GDP ratio for long time
Debt-GDP ratios:
fiscal stimulus v balanced budget
1.20
1.00
0.80
0.60
0.40
Big stimulus
0.20
Balanced FE budget
0.00
2010
2015
2020
2025
20
But the economy pays the price
-
With fiscal austerity, have long period of stagnation.
Actual /potential output, two runs
1.10
Balanced FE budget
1.05
Big stimulus
1.00
0.95
0.90
0.85
0.80
2003
2008
2013
2018
2023
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The dilemma of the deficit
Slower growth in potential with stimulus, but it doesn’t make up the
difference.
Potential output, two runs (billions)
21,000
20,000
Balanced FE budget
Big stimulus
19,000
18,000
17,000
16,000
15,000
14,000
13,000
2007
2012
2017
2022
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Conclusions on Debt and Deficits
• Central long-run impact of fiscal policy is on potential
economic growth through impact on national savings
rate.
• But in recessions, need to remember that country needs
less saving, not more saving, in the short run.
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