Worth: Mankiw Economics 5e CHAPTER FIFTEEN Government Debt Blessed are the young, for they shall inherit the national debt Herbert hoover When a government spends more than it collects in taxes, it borrows from the private sector to finance the budget deficit. The accumulation of past borrowin is the government debt. Debate about the appropriate amount of government debt in the United States is as old as the country itself. Alexander Hamilton be- lieved thata national debt, if it is not excessive, will be to us a national blessing, whereas James Madison argued that "a public debt is a public curse "Indeed, the location of the nations capital was chosen as part of a deal in which the federal government assumed the Revolutionary War debts of the states: because the Northern states had larger outstanding debts, the capital was located in the Although attention to the government debt has waxed and waned over the years, it was especially intense during the last two decades of the twentieth cen- tury. Beginning in the early 1980s, the U.S. federal government began running large budget deficits--in part because of increased spending and in part because of reduced taxes. As a result, the government debt expressed as a percentage of GDP roughly doubled from 26 percent in 1980 to 50 percent in 1995. By the late 1990s. the b deficit had come under control and had even turned into a budget surplus. Policymakers then turned to the question of how rapidly the debt should be paid off. The large increase in government debt from 1980 to 1995 is without prece- dent in U.S. history. Government debt most often rises in periods of war or de- pression, but the United States experienced neither during this time. Not surprisingly, the episode sparked a renewed interest among economists and poli cymakers in the economic effects of government debt. Some view the large bud- get deficits of the 1980s and 1990s as the worst mistake of economic policy since the Great Depression, whereas others think that the deficits matter very little. This chapter considers various facets of this debate. We begin by looking at the numbers. Section 15-1 examines the size of the S. government debt, comparing it to the debt of other countries and to the debt that the United States has had during its own past. It also takes a brief look at what the future may hold. Section 15-2 discusses why measuring changes in 405 User LUxpI: Job EFFo1431: 6264_ch15: Pg 405: 26545#/eps at 1004g Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 405:26545#/eps at 100% *26545* Wed, Feb 20, 2002 3:28 PM When a government spends more than it collects in taxes, it borrows from the private sector to finance the budget deficit.The accumulation of past borrowing is the government debt. Debate about the appropriate amount of government debt in the United States is as old as the country itself.Alexander Hamilton believed that “a national debt, if it is not excessive, will be to us a national blessing,” whereas James Madison argued that “a public debt is a public curse.” Indeed, the location of the nation’s capital was chosen as part of a deal in which the federal government assumed the Revolutionary War debts of the states: because the Northern states had larger outstanding debts, the capital was located in the South. Although attention to the government debt has waxed and waned over the years, it was especially intense during the last two decades of the twentieth century. Beginning in the early 1980s, the U.S. federal government began running large budget deficits—in part because of increased spending and in part because of reduced taxes. As a result, the government debt expressed as a percentage of GDP roughly doubled from 26 percent in 1980 to 50 percent in 1995. By the late 1990s, the budget deficit had come under control and had even turned into a budget surplus. Policymakers then turned to the question of how rapidly the debt should be paid off. The large increase in government debt from 1980 to 1995 is without precedent in U.S. history. Government debt most often rises in periods of war or depression, but the United States experienced neither during this time. Not surprisingly, the episode sparked a renewed interest among economists and policymakers in the economic effects of government debt. Some view the large budget deficits of the 1980s and 1990s as the worst mistake of economic policy since the Great Depression, whereas others think that the deficits matter very little. This chapter considers various facets of this debate. We begin by looking at the numbers. Section 15-1 examines the size of the U.S. government debt, comparing it to the debt of other countries and to the debt that the United States has had during its own past. It also takes a brief look at what the future may hold. Section 15-2 discusses why measuring changes in | 405 Government Debt 15 CHAPTER Blessed are the young, for they shall inherit the national debt. — Herbert Hoover FIFTEEN
Worth: Mankiw Economics 5e 406 PART V Microeconomic Policy Debates government indebtedness is not as straightforward as it might seem. Indeed,some conomists argue that traditional measures are so misleading that they should be We then look at how government debt affects the economy. Section 15-3 de scribes the traditional view of government debt, according to which go vernmen borrowing reduces national saving and crowds out capital accumulation. This view is held by most economists and has been implicit in the discussion of fisca olicy throughout this book. Section 15-4 discusses an alternative view, called Ricardian equivalence, which is held by a small but influential minority of econo- mists. According to the Ricardian view, government debt does not influence na tional saving and capital accumulation. As we will see, the debate between the traditional and Ricardian views of government debt arises from disagreements over how consumers respond to the government's debt policy. Section 15-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should try to always balance its the effects of government debt on monetary policy, the political process, dlass budget and, if not, when a budget deficit or surplus is desirable. It also examine role of a country in the world economy. 75-1 The Size of the Government Debt Let's begin by putting the government debt in perspective. In 2001, the debt of the U.S. federal government was $3.2 trillion. If we divide this number by 276 million, the number of people in the United States, we find that each per- son's share of the government debt was about $11, 600. Obviously, this is not a trivial number--few people sneeze at $11, 600. Yet if we compare this debt to able 15-1 How Indebted Are the World's Governments? Count Government Debt as Government Debt as a Percentage of GDP a Percentage of GDP Japan 119 Ireland Belgium Finland Canada Sweden Greece Denmark United States 0066s Austria Netherlands Australia orway rtuga Source: OECD Economic Outlook. Figures are based on estimates of gross government debt and GDP for 2001 User LUKBI: Job EFFo1431: 6264_ch15: Pg 406: 28036#/eps at 100sl Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 406:28036#/eps at 100% *28036* Wed, Feb 20, 2002 3:28 PM government indebtedness is not as straightforward as it might seem. Indeed, some economists argue that traditional measures are so misleading that they should be completely ignored. We then look at how government debt affects the economy. Section 15-3 describes the traditional view of government debt, according to which government borrowing reduces national saving and crowds out capital accumulation. This view is held by most economists and has been implicit in the discussion of fiscal policy throughout this book. Section 15-4 discusses an alternative view, called Ricardian equivalence, which is held by a small but influential minority of economists.According to the Ricardian view, government debt does not influence national saving and capital accumulation. As we will see, the debate between the traditional and Ricardian views of government debt arises from disagreements over how consumers respond to the government’s debt policy. Section 15-5 then looks at other facets of the debate over government debt. It begins by discussing whether the government should try to always balance its budget and, if not, when a budget deficit or surplus is desirable. It also examines the effects of government debt on monetary policy, the political process, and the role of a country in the world economy. 15-1 The Size of the Government Debt Let’s begin by putting the government debt in perspective. In 2001, the debt of the U.S. federal government was $3.2 trillion. If we divide this number by 276 million, the number of people in the United States, we find that each person’s share of the government debt was about $11,600. Obviously, this is not a trivial number—few people sneeze at $11,600.Yet if we compare this debt to 406 | PART V Microeconomic Policy Debates Country Government Debt as Country Government Debt as a Percentage of GDP a Percentage of GDP Japan 119 Ireland 54 Italy 108 Spain 53 Belgium 105 Finland 51 Canada 101 Sweden 49 Greece 100 Germany 46 Denmark 67 Austria 40 United Kingdom 64 Netherlands 27 United States 62 Australia 26 France 58 Norway 24 Portugal 55 Source: OECD Economic Outlook. Figures are based on estimates of gross government debt and GDP for 2001. How Indebted Are the World’s Governments? table 15-1
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 407 the roughly $1 million a typical person will earn over his or her working life, the government debt does not look like the catastrophe it is sometimes made be One way to judge the size of a government's debt is to compare it to the amount of debt other countries have accumulated. Table 15-1 shows the amount of government debt for 19 major countries expressed as a percentage of each ountry's GDP On the top of the list are the heavily indebted countries of Japan and Italy, which have accumulated a debt that exceeds annual GDP. At the bot tom are Norway and Australia, which have accumulated relatively small debts The United States is in the middle of the pack. By international standards, the U.S. government is neither especially profligate nor especially frugal. Over the course of U.S. history, the indebtedness of the federal government has varied substantially. Figure 15-1 shows the ratio of the federal debt to GDP since 1791. The government debt, relative to the size of the economy, varies from close to zero in the 1830s to a maximum of 107 percent of GDP in 1945 Historically, the primary cause of increases in the government debt is war. The debt-GDP ratio rises sharply during major wars and falls slowly during Peacetime. Many economists think that this historical pattern is the appropriate figure 15-1 Debt-GDP 0 Civi World War/ 179118111831185118711891191119311951197119912001 The Ratio of Government Debt to GDP Since 1790 The U.S. federal government debt held by the public, relative to the size of the U.S. economy, rises sharply during wars and declines slowly during peacetime. The exception is the period since 1980, when the debt-GDP ratio rose without the occurrence of a major military conflict. Source: U.S.Department of Treasury, U.S. Department of Commerce, and T.S. Berry, "Production and Population Since 1789, "Bostwick Paper No. 6, Richmond, 198 User LUKBI: Job EFFo1431: 6264_ch15: Pg 407: 28037#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 407:28037#/eps at 100% *28037* Wed, Feb 20, 2002 3:28 PM the roughly $1 million a typical person will earn over his or her working life, the government debt does not look like the catastrophe it is sometimes made out to be. One way to judge the size of a government’s debt is to compare it to the amount of debt other countries have accumulated.Table 15-1 shows the amount of government debt for 19 major countries expressed as a percentage of each country’s GDP. On the top of the list are the heavily indebted countries of Japan and Italy, which have accumulated a debt that exceeds annual GDP. At the bottom are Norway and Australia, which have accumulated relatively small debts. The United States is in the middle of the pack. By international standards, the U.S. government is neither especially profligate nor especially frugal. Over the course of U.S. history, the indebtedness of the federal government has varied substantially. Figure 15-1 shows the ratio of the federal debt to GDP since 1791.The government debt, relative to the size of the economy, varies from close to zero in the 1830s to a maximum of 107 percent of GDP in 1945. Historically, the primary cause of increases in the government debt is war. The debt–GDP ratio rises sharply during major wars and falls slowly during peacetime. Many economists think that this historical pattern is the appropriate CHAPTER 15 Government Debt | 407 figure 15-1 Year Debt–GDP ratio Revolutionary War Civil War World War I World War II 1.2 1 0.8 0.6 0.4 0.2 0 1791 1811 1831 1851 1871 1891 1911 1931 1951 1971 1991 2001 The Ratio of Government Debt to GDP Since 1790 The U.S. federal government debt held by the public, relative to the size of the U.S. economy, rises sharply during wars and declines slowly during peacetime. The exception is the period since 1980, when the debt–GDP ratio rose without the occurrence of a major military conflict. Source: U.S. Department of Treasury, U.S. Department of Commerce, and T.S. Berry, “Production and Population Since 1789,” Bostwick Paper No. 6, Richmond, 1988
Worth: Mankiw Economics 5e 408 PART V Microeconomic Policy Debates way to run fiscal policy. As we discuss more fully later in this chapter, deficit financing of wars appears optimal for reasons of both tax smoothing and gen- erational equity. One instance of a large increase in government debt in peacetime occurred during the 1980s and early 1990s, when the federal gov- ernment ran substantial budget deficits. Many economists have criticized this increase in government debt as imposing a burden on future generations without justification During the middle of the 1990s, the U.S. federal government started to get its budget deficit under control. A combination of tax hikes, spending cuts, and rapid economic growth caused the ratio of debt to gdp to stabilize and then de- cline. Recent experience has tempted some observers to that exploding government debt is a thing of the past. But as the next case study suggests, the st may be CASE STUDY The Fiscal Future: Good News and bad News What does the future hold for fiscal policymakers? Economic forecasting is far from precise, and it is easy to be cynical about economic predictions. But good policy cannot be made if policymakers only look backwards. As a result, econo- mists in the Congressional Budget Office(CBO) and other government agen cies are always trying to look ahead to see what problems and opportunities are likely to dev When George W Bush moved into the White House in 2001, the fiscal pic- ure facing the U.S. government was mixed. In particular, it depended on how far one looked ahead Over a ten- or twenty-year horizon, the picture looked good. The U.S. federal government was running a large budget surplus. As a percentage of GDP, the projected surplus for 2001 was the largest since 1948. Moreover, the surplus was expected to grow even larger over time. The surplus was large enough so that, without any policy changes, the government debt would be paid off by 2008 9 These surpluses arose from various sources. The elder George Bush had signed ax increase in 1990, and Bill Clinton had signed another in 1993. Because of these tax hikes, federal tax revenue as a percentage of GDP reached its highest level since World War II. Then, in the late 1990s, productivity accelerated, most comes led to rising tax revenue, which on technology. The high growth in in- likely because of advances in informatic pushed the federal governments budget from deficit to surplus a debate arose over how to respond to the budget surplus. The go vernment ould use the large projected surpluses to repay debt, increase spending, cut taxes, or some combination of these. The new Republican president George W Bush advocated a tax cut of $1.6 trillion over 10 years, which was about one-fourth of the projected surpluses. Democrats in Congress argued for a smaller tax cut and greater government spending. The end result was a compromise bill that cut taxes by a bit less than Bush had advocated User LUKBI: Job EFFo1431: 6264_ch15: Pg 408: 28038#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 408:28038#/eps at 100% *28038* Wed, Feb 20, 2002 3:28 PM way to run fiscal policy. As we discuss more fully later in this chapter, deficit financing of wars appears optimal for reasons of both tax smoothing and generational equity. One instance of a large increase in government debt in peacetime occurred during the 1980s and early 1990s, when the federal government ran substantial budget deficits. Many economists have criticized this increase in government debt as imposing a burden on future generations without justification. During the middle of the 1990s, the U.S. federal government started to get its budget deficit under control. A combination of tax hikes, spending cuts, and rapid economic growth caused the ratio of debt to GDP to stabilize and then decline. Recent experience has tempted some observers to think that exploding government debt is a thing of the past. But as the next case study suggests, the worst may be yet to come. 408 | PART V Microeconomic Policy Debates CASE STUDY The Fiscal Future: Good News and Bad News What does the future hold for fiscal policymakers? Economic forecasting is far from precise, and it is easy to be cynical about economic predictions. But good policy cannot be made if policymakers only look backwards.As a result, economists in the Congressional Budget Office (CBO) and other government agencies are always trying to look ahead to see what problems and opportunities are likely to develop. When George W. Bush moved into the White House in 2001, the fiscal picture facing the U.S. government was mixed. In particular, it depended on how far one looked ahead. Over a ten- or twenty-year horizon, the picture looked good.The U.S. federal government was running a large budget surplus. As a percentage of GDP, the projected surplus for 2001 was the largest since 1948. Moreover, the surplus was expected to grow even larger over time.The surplus was large enough so that, without any policy changes, the government debt would be paid off by 2008. These surpluses arose from various sources.The elder George Bush had signed a tax increase in 1990, and Bill Clinton had signed another in 1993. Because of these tax hikes, federal tax revenue as a percentage of GDP reached its highest level since World War II.Then, in the late 1990s, productivity accelerated, most likely because of advances in information technology. The high growth in incomes led to rising tax revenue, which pushed the federal government’s budget from deficit to surplus. A debate arose over how to respond to the budget surplus.The government could use the large projected surpluses to repay debt, increase spending, cut taxes, or some combination of these.The new Republican president George W. Bush advocated a tax cut of $1.6 trillion over 10 years, which was about one-fourth of the projected surpluses. Democrats in Congress argued for a smaller tax cut and greater government spending.The end result was a compromise bill that cut taxes by a bit less than Bush had advocated
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 409 While the 10-year horizon looked rosy, the longer-term fiscal picture was more roublesome. The problem was demographic. Advances in medical technology have been increasing life expectancy, while improvements in birth-control techniques and changing social norms have reduced the number of children people have. Be- cause of these developments, the elderly are becoming a larger share of the popula- tion. In 1990, there were 21 elderly for every 100 people of working age(ages 20 to 64); this figure is projected to rise to 36 by the year 2030. Such a demographic change has profound implications for fiscal policy. About one-third of the budget of the U.S. federal government is devoted to pensions and health care for the el- derly. As more people become eligible for these "entitlements, as they are some- times called, government spending automatically rises over time, pushing the budget toward deficit. The magnitude of these budgetary pressures was documented in a CBO re- port released in October 2000. According to the CBO, if no changes in fiscal policy are enacted, the government debt as a percentage of gDP will start rising around 2030 and reach historic highs around 2060. At that point, the govern- ment's budget will spiral out of control Of course, all economic forecasts need to be greeted with a bit of skepticism especially those that try to look ahead half a century. Shocks to the economy can alter the government's revenue and spending. In fact, only months after moving into the White House, George W. Bush saw the fiscal picture start to change First the economic slowdown in 2001 reduced tax revenue. Then. the terrorist attacks in September 2001 induced an increase in government spending. Both developments reduced the projected near-term government surpluses. As this book was going to press, there was great uncertainty about future government spending and the rate of technological advance--two key determinants of the fiscal situation Yet one thing is clear: the elderly are making up a larger share of the popula tion, and this fact will shape the fiscal challenges in the decades ahead. 75-2 Problems in Measurement The government budget deficit equals government spending minus government revenue, which in turn equals the amount of new debt the government needs to issue to finance its operations. This definition may sound simple enough, but in fact debates over fiscal policy sometimes arise over how the budget deficit should be measured. Some economists believe that the deficit as currently measured is not a good indicator of the stance of fiscal policy. That is, they believe that the budget deficit does not accurately gauge either the impact of fiscal policy on todays economy or the burden being placed on future generations of taxpayers. In this section we discuss four problems with the usual measure of the budget deficit. I Congressional Budget Office, The Long- Tem Budget Outlook, October 2000 User LUKBI: Job EFFo1431: 6264_ch15: Pg 409: 28039#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 409:28039#/eps at 100% *28039* Wed, Feb 20, 2002 3:28 PM 15-2 Problems in Measurement The government budget deficit equals government spending minus government revenue, which in turn equals the amount of new debt the government needs to issue to finance its operations.This definition may sound simple enough, but in fact debates over fiscal policy sometimes arise over how the budget deficit should be measured. Some economists believe that the deficit as currently measured is not a good indicator of the stance of fiscal policy.That is, they believe that the budget deficit does not accurately gauge either the impact of fiscal policy on today’s economy or the burden being placed on future generations of taxpayers.In this section we discuss four problems with the usual measure of the budget deficit. CHAPTER 15 Government Debt | 409 While the 10-year horizon looked rosy, the longer-term fiscal picture was more troublesome.The problem was demographic.Advances in medical technology have been increasing life expectancy, while improvements in birth-control techniques and changing social norms have reduced the number of children people have. Because of these developments,the elderly are becoming a larger share of the population. In 1990, there were 21 elderly for every 100 people of working age (ages 20 to 64); this figure is projected to rise to 36 by the year 2030. Such a demographic change has profound implications for fiscal policy.About one-third of the budget of the U.S. federal government is devoted to pensions and health care for the elderly.As more people become eligible for these “entitlements,” as they are sometimes called, government spending automatically rises over time, pushing the budget toward deficit. The magnitude of these budgetary pressures was documented in a CBO report released in October 2000. According to the CBO, if no changes in fiscal policy are enacted, the government debt as a percentage of GDP will start rising around 2030 and reach historic highs around 2060. At that point, the government’s budget will spiral out of control.1 Of course, all economic forecasts need to be greeted with a bit of skepticism, especially those that try to look ahead half a century. Shocks to the economy can alter the government’s revenue and spending. In fact, only months after moving into the White House, George W. Bush saw the fiscal picture start to change. First, the economic slowdown in 2001 reduced tax revenue.Then, the terrorist attacks in September 2001 induced an increase in government spending. Both developments reduced the projected near-term government surpluses. As this book was going to press, there was great uncertainty about future government spending and the rate of technological advance—two key determinants of the fiscal situation. Yet one thing is clear: the elderly are making up a larger share of the population, and this fact will shape the fiscal challenges in the decades ahead. 1 Congressional Budget Office, The Long-Term Budget Outlook, October 2000