Final: Deficits and Debt Flashcards
Why care about rising US debt?
To leave funds for domestic investment, US govt. must sell bonds to rest of world
Burdens the next generation who must service the debt
Strengthens the dollar, making it harder to sell goods to RoW (“twin deficits”)
How are deficits not like current taxes?
Taxpayers who do not plan bequests for future taxes will consider a future tax less burdensome than a current tax.Larger deficit shifts some of the tax burden of financing current spending forward, on to future taxpayers
Deficit finance may make a higher level of government spending politically palatable
Traditional view of why debt matters
G increases and then C increases and I decreases due to higher IR’s (Crowding out)
In the open economy:
Capital inflows: causes currency to appreciate and net exports to fall
LR: less national saving. Thus, lower capital stock, more debt, likely lower output
Ricardian Equivalence Theorem
Consumers/taxpayers are perfectly forward looking
Don’t discount the future whatsoever
A debt-financed tax cut has no effect on consumption
Households save the extra income to pay the future tax liability the current tax cut incurs
Increase in private saving perfectly offsets government borrowing (decrease in public saving)
Since they are forward looking, they know the increase in income is only transitory.
Policy implications for Ricardian Equivalence Theorem
A deficit-financed tax cut has no effect on the economy
No effect on AD (Take that Keynesians)
Not all fiscal policy is inert
For example, if the government permanently reduces spending, people will consume more today, and vice-versa
But this can’t be done through borrowing
Problems With RET according to Myopia
How forward looking are taxpayers/consumers?
Myopia:
People don’t understand what government budget deficits mean
Uncertainty regarding future taxation
People inherently discount the future, so they cannot be perfectly forward looking
A temporary deficit financed tax cut may increase economic activity because it may not be well understood to be temporary
Problems With RET according to borrowing constraints
A person expects future income to be higher, and wants to consume outside of their current ability given wealth
IRL, there are borrowing constraints, you likely cannot borrow enough to perfectly “smooth” your consumption across your life
Therefore, current income is more important than lifetime income, as it more closely determines spending
Sovereign Debt Trap
A typical western government rolls over about 1/3rd of its debt each year
If rollover interest rate > economy’s growth rate, debt outgrows GDP even with zero annual deficit
As debt-to-GDP ratio grows with no credible commitment to reverse it, creditworthiness declines further
Increased default risk premium manifests in investors demanding higher interest rates on government bonds
Borrowing costs (interest on government debt rises) further
Methods of Financing Fiscal Expenditures
taxation
borrowing
inflationary finance
2 cases for using inflationary finance for financing fiscal expenditures
Inflationary Finance
G-T = ΔD + ΔM
Case 1: Government buys debt back from the public
G and T stay the same
D decreases and M increases by the same amount (“Monetizing the debt”)
Inflation
Case 2: Inflationary finance
Government issues new money to finance spending
G and M increase by the same amount, T and D are constant
Inflation
Unpleasant Monetarist Arithmetic
G - T = (δ - r)D + μM
Suppose chosen deficit path produces ever-rising D
real r on debt rises with D
Bond finance will max out at high D
At that point only M expansion remains as a way to meet ongoing deficits (absent default to reduce D)
absent (1) default, (2) external gifts
The Unpleasant Paradox
If r rises above economy’s real growth rate n, then keeping μM low (to keep inflation low) implies rolling over the debt plus interest with new borrowing
Debt compounds, rising relative to GDP without limit
Eventually forcing μM to rise
M rises not to inflate away the debt – you can’t fool the public persistently that way – but merely to provide needed seigniorage
Tight money today leads to higher inflation tomorrow
Monetary restraint can lead to
Monetary restraint can lead to high inflation (and worse debt) when fiscal authority moves first
To avoid high inflation calls for “monetary restraint” must include…
To avoid this, calls for “monetary restraint” must include calls to have the monetary authority move first
and thus restrain the feasible path of deficits, given downward-sloping demand for government bonds
Monetary authority could announce path for future money growth
Alternatively, commodity money standard or other precommitment that restricts path of M
Options Once Debt Finance Has Maxed Out
(1) Change deficit path (Reduce Spending
(2) Inflationary Finance
(3) External gifts
(4) Default
