Archive for the 'Debt' Category

Feb 27 2013

Sequestration – a basic economic analysis

Ben Bernanke Lectures Congress on Austerity Economics : The New Yorker

In just two days, the United States will enact a massive contractionary fiscal policy known as the “sequester”, which includes over $1 trillion in federal spending cuts rolled out over the next ten yeas. The imminent sequester (which is defined as “to isolate, or hide away”) is the result of the failure of Democrats and Republicans to agree upon an acceptable combination of spending cuts and tax increases to put the US government on a more sustainable budgetary path (meaning lower national debt in the future). The sequester was never intended to occur, rather it was put in place to force the two parties to come up with a budget compromise that would cause less harm to the economy than the cuts that the sequester will impose.

The $1.2 trillion cut in spending will have several negative effects on the US economy, including 

…up to 2,100 fewer food inspections, 373,000 mentally ill adults and children going without treatment, 70,000 kids being kicked out of preschool, 2,700 schools losing federal funding, about 30,000 teacher layoffs, a reduction in federal law enforcement capacity equivalent to the loss of 1,000 federal agents, 1,000 fewer criminal prosecutions, and the list goes on and on. The chairman of the Joint Chiefs of Staff, Gen. Martin Dempsey, recently said before the Senate Armed Services Committee that sequestration will “make it much harder for us to preserve readiness after more than a decade of fighting in Iraq and Afghanistan.”

The effects on national output and employment in the US economy, which is still recovering from the Great Recession of 2009, will likely be devastating. According to the Federal Reserve Bank Chairman Ben Bernanke,

“Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant… Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”

Bernanke, a Republican himself, recognizes that any cut in government spending (known as a contractionary fiscal policy) will harm the US economy’s growth potential both in the short-run and the long-run. Bernanke believes that the primary goal of the government right now (and the Central Bank, which he is the head of) should be to promote increased employment to bring the nation’s unemployment rate down (back to its natural rate).

So what is the argument FOR a contractionary fiscal policy? Why would the Democrats and Republicans let this sequestration take place even when America’s leading economic voice is calling for it to be avoided? If you ask many of the Republicans in Washington, D.C., America’s biggest macroeconomic problem is not slow growth or high unemployment, it’s the large national debt. The debt (which is the sum of all of the country’s past budget deficits), has grown to nearly 80% of the nation’s GDP. This means that the nation owes the holders of that debt nearly as much as its total income in a year. If an individual had a debt level this high, that individual would probably have to cut back on his own spending (cut up those credit cards!), to begin paying back that debt; obviously, high personal debt ultimately leads to a decrease in the standard of living of the indebted person as it eventually has to be paid back.

But a nation’s debt is a little different than that of an individual. If the US government cuts back on spending to reduce the debt, the result is rising unemployment, lower incomes, reduced confidence among households and firms, a reduction in economic growth, and possibly, a recession. The goal of reducing the debt could ultimately reduce the national output and income, which could ironically make the debt an even bigger deal than it already is. Let me explain why.

Imagine two countries, Country A and Country G. Country A has a national debt of $12,000 billion dollars. Country G has a national debt of $355 billion dollars. Obviously, Country A’s debt is around 35 times the size of Country G’s. So if I asked you, which of these countries is facing a “debt crisis”, you’d probably say Country A, right? Well, you’d be wrong. Country A is America, and Country G is Greece. So why does Greece’s national debt of $355 billion, which represents 182% of Greece’s GDP of $195 billion, constitute a “crisis”, while America’s debt of $1,200 billion, or just around 80% of its GDP, is simply a cause of concern among one of the country’s political parties? The answer is, it’s not how large a nation’s debt is in dollar terms that matters, rather how large the debt is relative to the country’s GDP. A millionaire could handle a $100,000 debt just fine, while for an individual earning minimum wage, a debt of $100,000 would present a crushing burden that is unlikely ever to be overcome without that individual declaring himself bankrupt.

If the sequestration takes place, America’s GDP may fall, as Bernanke has warned. But its debt will continue to grow (albeit less slowly than it would without the sequester). If the GDP falls while the debt grows, the country’s debt burden actually increases, despite the desired outcome of the sequester, a reduction in debt. In other words, the sequestration will make America more like Greece (the guy on minimum wage) and less like America (the millionaire!).

Rather than working towards debt reduction, as the mainstream of the Republican party advocates, Ben Bernanke would prefer the federal government focus on policies that reduce unemployment. Unemployment, defined as “the state of actively seeking a job, but being unable to find one”, has several negative effects on individuals and the economy as a whole. Here’s Bernanke explaining to the US Congress the consequences of unemployment:

High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole. Lengthy periods of unemployment and underemployment can erode workers’ skills and attachment to the labor force or prevent young people from gaining skills and experience in the first place—developments that could significantly reduce their productivity and earnings in the longer term. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending, thereby leading to larger deficits and higher levels of debt.

Many economists believe that America’s huge national debt (in dollar terms) is really not all that bad when compared to its even huger GDP. A nation’s debt really only becomes a problem when that nation, like an individual burdened with a high level of personal debt, is forced to reduce its spending and begin paying that debt off. A nation can maintain a high level of debt as long as it can continue to borrow more money to pay off its past debt. And in the current global economy, no nation can borrow money more easily than the United States of America.

The cost of borrowing money is the interest rate that must be paid on loans made to an individual or government. At present, the US government can borrow money at very low interest rates (it pays between 1% and 3% on most of the government bonds it issues). This fact indicates that America’s debt, while it is a primary concern of the Republican party, is not a major concern among those to whom the US government owes money, nor to those who may lend it money in the near future.

The tradeoff America faces as it enters this period of sequestration, government spending cuts, and the resulting reduction in aggregate demand, income, output and employment, is one between future debt and future prosperity. The sequester may reduce the level of debt in the future, but it will also increase the debt burden (as Bernanke explained). In exchange for a smaller dollar value of its debt, America may have to accept  increased unemployment and a slower recovery from the Great Recession, which together will make the US less competitive, reduce standards of living, and make it more difficult for future generations to enjoy the quality of life experienced by their parents and grandparents.

Discussion Questions:

  1. What is the Unemployment Rate in the United States today? What is thought to be the US’s “natural rate of unemployment” How is unemployment measured (simply state the formula)?
  2. Based on America’s current unemployment rate, where would you expect the US to be on its business cycle? Draw a business cycle model and indicate where the US is most likely to be.
  3. Based on America’s current unemployment rate, where do you think current US equilibrium output is compared to full employment output? Draw an AD/AS model and indicate the likely equilibrium the US is currently experiencing.
  4. If you were in charge of fiscal policy, identify two possible policy recommendations that the US should consider given its current level of unemployment. Explain how each would impact the level of unemployment in the economy.
  5. Assume the marginal propensity to consume in the United States is 0.6, and the government decides to cut military and domestic spending by $85 billion. Calculate the effect this will have on America’s GDP.
  6. On the business cycle and AD/AS diagram you drew above, show the effect of the $85 billion spending cut.
  7. Explain how the spending cut will will impact the level of unemployment in the economy.
  8. Discuss with your table the wisdom of the $85 billion spending cut described above.

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Nov 06 2012

A closer look at the crowding-out effect

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.

To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occurred.
Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
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In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the government  now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
  • If the private demand for loanable funds is extraordinarily low, or
  • If the private supply of loanable funds is extraordinarily high.
When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
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Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
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Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

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