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Federal Budget 101, Part 5 of 5: Deficits and the Debt

Federal Budget

Federal Budget 101, Part 5 of 5: Deficits and the Debt


Understanding the Federal Budget: The Process, Revenue, Expenditures, Deficits



Part 1: The Budget Overview and Process
Part 2: Revenue
Part 3: Expenditures
Part 4: Putting it all Together
Part 5: Deficits and the Debt (this page)

Part 5 of a 5-part Series: Deficits and the Debt



When it comes to the federal budget, many people tend to focus on the deficit more than anything else. A lot of misunderstanding and misconceptions get mixed into the conversations.

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Here is a line graph showing annual budget deficits and surpluses since 1930. Take a close look at this graph. The following discussion will refer to it quite often.


Some points from this graph:

  1. According to the scale, this graph measures the size of deficits in terms of their size relative to the size of the overall economy, not in terms of nominal dollar amounts. This method provides a much more accurate comparison of deficits over time. It also provides a more accurate look at our ability to repay the resulting debt.
  2. Anything below the 0% line is a deficit, and anything above the 0% line is a surplus. You can see that in most instances, our country has run a budget deficit rather than a budget surplus.
  3. Deficit financing of WWII brought us deficits that were much larger than anything we have seen since. But notice that as we transformed to a peacetime economy, these deficits turned into surpluses in some years and relatively small deficits in other years.
  4. Recessions create deficits. Look at the dip during the Great Depression years of the 1930s and the Great Recession years 2008-2010.
  5. Notice that deficits increased in size when trickle-down policies were instituted; the trend was reversed throughout the Clinton administration, culminating in surpluses; returned to deficits following the tax cuts of George W. Bush; became much larger during the Great Recession, a trend that was reversed following the Obama stimulus package.



The line graph above provides the historical record for some other points that might not be so obvious from just looking at the graph:

  1. Deficits increase during recessions due to budget items known as automatic stabilizers. During a recession, demand is low because the masses have less disposable income. The economy goes into a downward spiral. Less income means less demand, and less demand means more layoffs and less income, which means less demand, etc. But with less income, plus a progressive income tax structure, these same people are dropped into lower tax brackets, making their loss of disposable income less severe than it would have been otherwise. The recession is less severe, but the government collects less tax revenue, increasing deficits. At the same time, recessions mean more transfer payments – welfare and unemployment compensation – which give recipients more disposable income. This helps to mitigate the loss of income and demand in the economy caused by the recession, while increasing government expenditures and deficits.
  2. Deficits also increase during recessions because the government often passes stimulus packages aimed directly at ending recessions. Stimulus packages increase demand in the economy but also increase deficits in the short run. Think of the New Deal programs of Roosevelt and the American Recovery and Reinvestment Act of 2009, better known as Obama’s stimulus package. Take a look at the times of these programs in the line graph above, and their results. In the immediate time frame of the spending for these programs, deficits increased due in part to the cost outlays for the programs. In the immediate aftermath of the spending, however, deficits decreased nearly as quickly as they had increased during the recessions.
  3. In order to help generate public support for trickle-down policies, conservatives in the 1970s and 1980s developed and promoted the Laffer Curve. The Laffer Curve is an economic model designed to show that lower top-end tax rates would decrease deficits. The historical record proves that this argument has backfired. Trickle-down policies created modern-sized deficits. This would be clearer in the bar graph above if the graph’s scale was not skewed to include the massive deficits of WWII.
  4. There is a very important difference between long term deficits and short term deficits. Long term deficits are also known as structural deficits, and short term deficits are also known as cyclical deficits. Short term deficits are created by policies designed to decrease the effects of economic downturns, while long term deficits are created by policies that are unrelated to economic downturns. This difference is easy to see when deficits are measured according to opportunity cost instead of actual cash outlays. Measuring deficit spending according to opportunity cost essentially means comparing the results with what would have happened if the spending had not taken place. For example, at the time of the 2009 stimulus package, the economy had been in a free-fall, and there simply were no economic forces to stop it. Economists warned that the world was heading towards a Great Depression worse than the first one, and economic data supports that claim. With the economy in a free-fall, deficits were soaring, and would have continued to do so as the economy continued to lose demand and jobs, and the misfortunes of the people would have continued to worsen to historical levels. The stimulus package was the only economic force that came along to reverse this trend. As a result, deficits have been cut in half instead of continuing to rise. The stimulus package (a short term deficit) actually decreased deficits in the longer run. Tax cuts during times of economic growth, however, increase deficits in the long run. The Bush-era tax cuts spent the entire Clinton-era surplus and created additional deficits. These deficits were long term deficits, because they were not designed to be temporary steps to correct for an economic downturn. When somebody talks about deficits associated with certain time frames, politicians, or policies – with no regard for differentiating between long term and short term deficits – then they are measuring deficits incorrectly. The estimated $831 billion total cost of the 2009 stimulus package is often cited as being a huge budget killer, but it actually reduced deficits from what they would have been without this expenditure. According to opportunity cost measurements, the stimulus turned into a budget plus, not an increase in deficits.
  5. Many people incorrectly associate large deficits with big-government policies of presidents from the Democratic Party as well as with Keynesian economics. They are wrong on both counts. In the past 50 years, much larger deficits have occurred with a Republican in the White House than with a Democrat in the White House. As for Keynes, people tend to look at his advocacy of deficit spending to end the Great Depression, and assume that he favored big-government and big deficits. He favored neither during normal economic times. He simply favored drastic measures to deal with drastic economic times. Take another look at the line graph above. Keynes favored the deficit spending that occurred in the 1930s; in fact, he wanted more of the same. But he was absolutely furious about the much larger deficits of the 1940s, because he believed that financing wars through deficit spending was fiscally irresponsible. Keynes believed in short term (cyclical) deficits, but not long term (structural) deficits. The easiest way to understand the difference between Keynesian economics and the common misconceptions about it is to go back a few thousand years and read the Biblical story in Genesis 41. This is the story in which Joseph interprets the dreams of Pharaoh, and the advice is to build surpluses in good economic times in order to pay for bad economic times. That advice is the essential message of Keynesian economics. Instead of allowing suffering to increase during bad times, we should smooth out the business cycle by using the excesses from the good times to help decrease suffering during bad times. The Bush tax cuts which wiped out the surpluses from the Clinton era meant that fighting the subsequent Great Recession would result in a much larger national debt than would be needed without the tax cuts. Since the economy has always been cyclical, a recession was bound to follow the tax cuts sooner or later. By the time it did, the surplus was already gone.


Debts vs Deficits



The deficits discussed above should not be confused with the national debt. Deficits and debts are related, but they are not the same thing. For the federal government, a deficit is the amount by which the current budget’s expenditures exceed tax revenue. A debt is the outstanding balance of past debt incurred. In terms of stocks and flows, a deficit is a flow: it is a measurement over a specified period of time (in this case, one year). A debt is a stock: it is a measurement of a cumulative balance at one specific point in time.


When the federal government engages in deficit spending, it borrows money to cover a budget shortfall. The U.S. Treasury issues investment securities to be sold on the open market, and the sales proceeds are used to finance the budget shortfall. These investment securities are high quality: U.S. Treasury Bonds, U.S. Treasury Notes, and U.S. Treasury Bills. This money has to be repaid, of course, with interest. T-Bills are short term financial instruments which are issued at a discount from par value and are redeemed at par value; the difference between par value and the discount price is the amount of interest. T-Bonds and T-Notes are long term financial instruments with a stated par value and a stated interest rate as a percentage of par value. Interest payments are made semi-annually, according to the stated rate of interest. Since these bonds are sold on the open market, the actual sales price will be determined by the market, and this in turn will determine the effective interest rate. Since U.S. Treasury securities are considered to be the safest investments in the world, based in large part on the United States government’s history of never defaulting, the interest rates are very low compared to other types of borrowing.


The federal debt is simply the balance of all outstanding U.S. Treasury securities.


It’s important to note that these are investment securities. Just like corporate debt – including corporate bonds, preferred stock, and commercial paper – Treasury securities represent debt to the issuer, but they represent an investment to the buyer. U.S. Treasuries are not only considered safe, but they are also very popular. This keeps the interest rates low compared to other investment securities. It is a relatively cheap way for the federal government to finance debt. Since these securities are sold on the open market, anybody with enough funds and the desire to invest in the safety of the United States government can do so.


The following pie chart shows who “owns” the federal debt. These individuals and organizations “own” the U.S. debt, not because we choose to be obligated to them, but because they have decided to invest in United States Treasury securities.



The federal government has options for financing its expenditures.

  1. It can pay for expenditures through tax receipts.
  2. It can pay for expenditures through additional debt.
  3. It can simply print more money.
  4. To some extent, it can choose not to spend, which is what much of the budget negotiation process and much of the political rhetoric are all about.



Each one of these options provides benefits. Each one of these options involves new costs. There is no one option that is always the best option in every circumstance. Only a cost/benefit analysis of each option will determine the opportunity costs involved.



The Constitution does not provide for a debt ceiling. That is something that Congress has created over the years. The Constitution DOES, however, require that Congress authorize payment for debts incurred. The debt ceiling is the only thing that can prevent these debts from being paid.

  1. Increasing the debt ceiling will NOT increase debt; it will only allow Congress to pay for debts that have already been incurred.
  2. Refusal to increase the debt ceiling will NOT lower debt; it will only prevent Congress from performing its constitutional duties.
  3. Refusal to increase the debt ceiling will NOT cause the debt to go away; it will only cause the United States to default on its obligations for the first time in history, which among other things will increase the cost of servicing the debt.



The United States has never defaulted on its obligations. This is the reason U.S. Treasury securities are considered to be the safest investments in the world; the reason these Treasuries allow the government to finance its debt with very low interest rates; the reason the U.S. dollar is a global currency. All of this goodwill, which has helped to raise the United States into an economic superpower, can only be undone if the United States defaults on its debt. And that can only happen if Congress refuses to increase the debt limit at a time when a higher debt limit becomes necessary in order to pay bills that have already come due.


Currently, debt servicing accounts for 6% of the federal budget, which is the only real cost of the national debt.


See on blue-route.org


Author: 
Jerry Wyant
Date: 
2014-09-10
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