Baumol & Blinder MACROECONOMICS (11th ed)

LICENSED TO:

| DISCUSSION QUESTIONS |

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

BUDGET DEFICITS IN THE SHORT

AND LONG RUN

Blessed are the young, for they shall inherit the national debt.

HERBERT HOOVER

M onetary policy and fiscal policy are typically thought of as tools for short-run economic stabilization—that is, as ways to combat either inflation or unemployment. Debates over the Federal Reserve’s next interest-rate decision, or over this year’s

federal budget, are normally dominated by short-run considerations such as: Does the economy need to be stimulated or restrained right now?

But the monetary and fiscal choices the government makes today also have profound effects on our economy’s ability to produce goods and services in the future. We began Part 2 by emphasizing long-run growth, and especially the role of capital formation (see Chapters 6 and 7). But for most of Part 3, we have been preoccupied with the shorter-run issues of inflation, unemployment, and recession. This chapter integrates the two perspectives by considering both the long-run and short-run implications of fiscal and monetary policy decisions. What differences does it make if we stimulate (or restrain) the economy with fiscal or monetary policy? Should we strive to balance the budget? What are the economic virtues and vices of large budget deficits, both now and in the future?

C O N T E N T S

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

Several of these questions were brought into sharp relief by the partisan debate over the budget deficit during the 2008 presidential campaign.

During the primary season, virtually all the Democratic candidates railed against the large budget deficits of the Bush years. Most—including both Hillary Clinton and Barack Obama—proposed to repeal parts of the tax cuts enacted in 2001 and 2003, especially those that benefited upper-

income groups, in order to shrink the budget deficit—which, they said, was a danger to the nation’s economic health.

By contrast, virtually all the Republican candidates, including John McCain, vowed to maintain the Bush tax cuts, arguing that repealing them would harm the economy. While these candidates also objected to large budget deficits, they stoutly defended most of the Bush administration’s spending initiatives as well. Since you cannot reduce the budget deficit without either raising taxes or cutting spending, they were implicitly saying that reducing the budget deficit was not a high priority.

Which side was right? Is it important to shrink the budget deficit? Or is it more advisable to maintain both the tax cuts and the spending? Politics aside, by the end of the chapter, you will be in an excellent position to make an informed judgment on this important policy issue for yourself.

SHOULD THE BUDGET ALWAYS BE BALANCED? THE SHORT RUN

Americans have long been attracted by the idea of balancing the government budget year after year—so much so that a constitutional amendment to require a balanced budget has been proposed and debated many times. Let us begin our examination of the virtues and vices of a balanced budget by reviewing the basic principles of fiscal policy that we have learned so far (especially in Chapter 11).

These principles certainly do not imply that we should always maintain a balanced budget, much as that notion may appeal to our intuitive sense of prudent financial management. Rather, they instruct fiscal policy makers to focus on balancing aggregate supply and aggregate demand. They therefore point to the desirability of budget deficits when private demand, C 1 I 1 (X 2 IM), is weak and of budget surpluses when private demand is strong. The budget should be balanced, according to these principles, only when C 1 I 1 G 1 (X 2 IM) under a balanced-budget policy approximately equals potential GDP. This situation may sometimes prevail, but it will not necessarily be the norm.

The reason why a balanced budget is not always advisable should be clear from our earlier discussion of stabilization policy. Consider the fiscal policy that the federal government would follow if its goal were to maintain a balanced budget every year, as most of the 50 states do. Suppose the budget was initially balanced and private spending sagged for some reason, as it did in 2007–2008. The multiplier would pull GDP down. Because personal and corporate tax receipts fall sharply when GDP declines, the budget would automatically swing into the red. To restore budget balance, the government would then have to cut spending or raise taxes—exactly the opposite of the appropriate fiscal policy response to a recessionary gap, and exactly the opposite of what the federal government actually did. Thus:

Attempts to balance the budget during recessions—as was done, say, during the Great

Depression—will prolong and deepen slumps.

This is precisely what many observers feel happened to Japan when it raised taxes in a weak economy in 1997. In fact, Ryutaro Hashimoto, Japan’s prime minister from 1996 to 1998, was disparagingly called the “Herbert Hoover of Japan” because he sought to

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

reduce the budget deficit despite Japan’s sinking economy. State and local governments in the United States also often raise taxes or cut spending during recessions because they have balanced-budget requirements.

This problem arises in both directions. Budget balancing also can lead to inappropriate fiscal policy under boom conditions. If rising tax receipts induce a budget-balancing government to spend more or to cut taxes, then fiscal policy will “boom the boom”—with unfortunate inflationary consequences.

The Importance of the Policy Mix

Actually, the issue is even more complicated than we have indicated so far. As we know, fiscal policy is not the only way for the government to affect aggregate demand. It also can influence aggregate demand through its monetary policy. For this reason,

The appropriate fiscal policy depends, among other things, on the current stance of monetary policy. Although a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another monetary policy.

How, then, can we tell whether any particular deficit is too large or too small? From the discussion so far, it would appear that the answer depends on the strength of privatesector aggregate demand and the stance of monetary policy. But those are not the only considerations.

SURPLUSES AND DEFICITS: THE LONG RUN

One implication of what we have just said is that various combinations of fiscal and monetary policy can lead to the same level of aggregate demand, and hence to the same real GDP and price level, in the short run. For example, the government could reduce

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

aggregate demand by raising taxes, but the Fed could make up for it by cutting interest rates. Or the reverse could happen: The government could cut taxes while the Fed raises interest rates, leaving aggregate demand unchanged. The long-run consequences of these alternative mixes of monetary and fiscal policy may be quite different, however.

In previous chapters, we learned that more expansionary fiscal policy (tax cuts or higher government spending) and tighter money should produce higher real interest rates and therefore lower investment. Thus, such a policy mix should shift the composition of total expenditure, C 1 I 1 G 1 (X 2 IM), toward more G, more C (from tax cuts), and less I.1 The expected result is less capital formation, and therefore slower growth of potential GDP. As we shall see shortly, it was precisely that policy mix—large tax cuts and very tight money—that the U.S. government inadvertently chose in the early 1980s and, to a lesser extent, in the years 2004–2006.

But the opposite policy mix—tighter budgets and looser monetary policy—should produce the opposite outcomes: lower real interest rates, more investment, and hence faster growth of potential GDP. That was the direction U.S. macroeconomic policy took in the 1990s—with excellent results. Lowering the budget deficit and then turning it into a surplus, economists believe, was an effective way to increase the investment share of GDP, which soared from 12 percent in 1992 to 17 percent in 2000. The general point is

The composition of aggregate demand is a major determinant of the rate of economic growth. If a larger fraction of GDP is devoted to investment, the nation’s capital stock will grow faster and the aggregate supply schedule will shift more quickly to the right, accelerating growth.

International data likewise show a positive relationship between growth and the share of GDP invested. Figure 2 displays, for a set of 24 countries on four continents, both investment as a share of GDP and growth in per-capita output over two decades (the 1970s and 1980s). Countries with higher investment rates clearly experienced higher growth, on average.

1 Assume for the moment that net exports, X 2 IM, are fixed. We will deal with the consequences of fiscal and monetary policy on exports and imports in Chapter 19.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

So it appears that when we ask whether the budget should be in balance, in deficit, or in surplus, we have posed a good but complicated question. Before attempting to answer it, we need to get some facts straight.

2 Reminder: The fiscal year of the U.S. government ends on September 30. Thus, fiscal year 2007 ran from October 1, 2006, to September 30, 2007.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

thing true of the U.S. government? No one knows for sure. How much is the White House worth? Or the national parks? And what about military bases, both here and abroad? Because these government assets are not sold on markets, no one really knows their true value. But some people think the value of the government’s assets may be almost as large as the value of its debt.

Figure 3 charts the path of the net national debt from 1915 to 2007, expressing each year’s net debt as a fraction of that year’s nominal GDP. Looking at the debt relative to GDP is important for two reasons. First, we must remember that everything grows in a growing economy. Given that private debt has expanded greatly since 1915, it would be surprising indeed if the public debt had not grown as well. In fact, federal debt grew more slowly than did either private debt or GDP for most of the period since World War II. The years from 1980 to about 1994 stand out as an aberration in Figure 3, with the debt-to-GDP ratio climbing sharply.

Second, the debt is measured in dollars and, as long as there is any inflation, the amount of purchasing power that each dollar represents declines each year. Dividing the debt by nominal GDP, as is done in Figure 3, adjusts for both real growth and inflation, and so puts the debt numbers in better perspective.

Figure 3 shows us how and when the U.S. government acquired all this debt. Notice the sharp increases in the ratio of debt to GDP during World War I, the Great Depression, and especially World War II. Thereafter, you see an unmistakable downward trend until the recession of 1974–1975. In 1945, the national debt was the equivalent of about a year’s worth of GDP. By 1974, this figure had been whittled down to just two months’ worth.

Thus, until the 1980s, the U.S. government had acquired most of its debt either to finance wars or during recessions. As we will see later, the cause of the debt is quite germane to the question of whether the debt is a burden. So it is important to remember that

Until about 1983, almost all of the U.S. national debt stemmed from financing wars and from the losses of tax revenues that accompany recessions.

But then things changed. From the early 1980s until 1993, the national debt grew faster than nominal GDP, reversing the pattern that had prevailed since 1945. This growth spurt happened with no wars and only one recession. By 1993, the debt exceeded five months’ GDP—nearly triple its value in 1974. This development alarmed many economists and public figures.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

At that point, the government took decisive actions to reduce the budget deficit. The ratio of debt to GDP then fell for years. But President Bush’s large tax cuts reversed the trend for a few years after 2001. Lately, the ratio of debt to GDP has been falling modestly again.

INTERPRETING THE BUDGET DEFICIT OR SURPLUS

We have observed that the federal government ran extremely large budget deficits from the early 1980s until the mid 1990s, and then again for a few years in this decade. As Figure 4 shows, the budget deficit ballooned from $79 billion in fiscal year 1981 to $208 billion by fiscal year 1983—setting a record that was subsequently eclipsed several times. As late as fiscal year 1995, the deficit was still $164 billion. These are enormous, even mind-boggling, numbers. But what do they mean? How should we interpret them?

The Structural Deficit or Surplus

First, it is important to understand that the same fiscal program can lead to a deficit or a surplus, depending on the state of the economy. Failure to appreciate this point has led many people to assume that a larger deficit always signifies a more expansionary fiscal policy—which is not the case.

Think, for example, about what happens to the budget during a recession. As GDP falls, the government’s major sources of tax revenue—income taxes, corporate taxes, and payroll taxes—all shrink because firms and people pay lower taxes when they earn less. Similarly, some types of government spending, notably transfer payments such as unemployment benefits, rise when GDP falls because more people are out of work. Recall that the deficit is the difference between government expenditures, which are either purchases or transfer payments, and tax receipts:

NOTE: Amounts are in billions of dollars.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

LICENSED TO:

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.