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surplus. Finally, columns 3 and 4 break the overall surplus into its on-budget and off-budget
components. The table tells the following story about the evolution of the budget deficit.
The large Reagan tax cuts in the early 1980s ballooned the budget deficit from $79 billion
to $212 billion, and more than 100 percent of this deterioration was structural (see column
2). Late in the 1980s, the deficit started rising again”even though Social Security began to
run sizable surpluses (see column 4). The overall deficit reached $269 billion in 1991, but
then began to shrink. One reason was the burgeoning Social Security surplus, which in-
creased by $115 between 1993 and 2001. The strong economy helped, too. Notice that the
actual surplus rose more than the structural surplus. But most of the deficit-reducing
“work” was on-budget and structural, as tax increases and expenditure restraint during
the Clinton years finally got the budget under control”briefly, as it turned out.
By 2003, a combination of large tax cuts, a burst of spending on antiterrorism and the
war in Iraq, and weaker economic growth had pushed the deficit up to a record
$378 billion”a record that was topped in fiscal year 2004. But both the actual budget
deficit (column 1) and the structural budget deficit (column 2) have fallen since then.

Now that we have gained some perspective on the facts, let us consider the charge that
budget deficits place intolerable burdens on future generations. Perhaps the most fre-
quently heard reason is that future Americans will be burdened by heavy interest payments,
which will necessitate higher taxes. But think about who will receive those interest
payments: mostly the future Americans who own the bonds. Thus, one group of future
Americans will be making interest payments to another group of future Americans”
which cannot be a burden on the nation as a whole.3

However, the future taxes that will have to be raised to pay the interest may reduce the efficiency of the economy.

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Part 3
308 Fiscal and Monetary Policy

But there is a future burden to the extent that the debt is held by foreigners. The share
of the net U.S. national debt owned by foreign individuals, businesses, and governments
has been rising rapidly and is now over 52 percent. Paying interest on this portion of the
debt will indeed burden future Americans in a very concrete way: For years to come, a
portion of America™s GDP will be sent abroad to pay interest on the debts we incurred in
the 1980s, 1990s, and 2000s. For this reason, many thoughtful observers are becoming con-
cerned that the United States is borrowing too much from abroad.4 Thus, we conclude that
If the national debt is owned by domestic citizens, future interest payments just trans-
fer funds from one group of Americans to another. But the portion of the national debt
owned by foreigners does constitute a burden on the nation as a whole.
Many people also worry that every nation has a limited capacity to borrow, just like
every family and every business. If it exceeds this limit, it is in danger of being unable to
pay its creditors and may go bankrupt”with calamitous consequences for everyone. For
some countries, this concern is indeed valid and serious. Debt crises have done major
damage to many countries in Latin America, Asia, and Africa over the years.
But the U.S. government need not worry about defaulting on its debt for one simple
reason. The American national debt is an obligation to pay U.S. dollars: Each debt certificate
obligates the Treasury to pay the holder so many U.S. dollars on a prescribed date. But
think about where those dollars come from. The U.S. government prints them up! So, in
the worst case, if the U.S. government had no better way to pay off its creditors, it could
always print whatever money it needed to do so. In a word, no nation need default on debts
that call for repayment in its own currency.5 However, printing up the necessary money is not
an option for countries whose debts call for payment, say, in U.S. dollars, as a number of
Southeast Asian countries learned in 1997 and as Argentina learned in 2001.
It does not, of course, follow that acquiring more debt through budget deficits is neces-
sarily a good idea for the United States. Sometimes, it is clearly a bad idea. Nonetheless:
There is a fundamental difference between nations that borrow in their own currency
(such as the United States) and nations that borrow in some other currency (which is,
normally, the U.S. dollar). The former need never default on their debts; the latter might
have to.

We now turn to the effects of deficits on macroeconomic outcomes. It often is said that deficit
spending is a cause of inflation. Let us consider that argument with the aid of Figure 6, which
is a standard aggregate supply-and-demand diagram.
Initially, equilibrium is at point A, where demand curve D0D0 and supply curve SS inter-
sect. Output is $7,000 billion, and the price index is 100. In the diagram, the aggregate de-
mand and supply curves intersect precisely at potential GDP, indicating that the economy is
operating at full employment. Let us also assume that the budget is initially balanced.
Suppose the government now raises spending or cuts taxes enough to shift the aggre-
gate demand schedule outward from D0D0 to D1D1. Equilibrium shifts from point A to
point B, and the graph shows the price level rising from 100 to 106, or 6 percent. But that
is not the end of the story, because point B represents an inflationary gap. We know from
previous chapters that inflation will continue until the aggregate supply curve shifts far
enough inward that it passes through point C, at which point the inflationary gap is gone.
In this example, deficit spending will eventually raise the price level 12 percent.
Thus, the cries that budget deficits are inflationary have the ring of truth. How much
truth they hold depends on several factors. One is the slope of the aggregate supply curve.

We will discuss the linkages between the federal budget deficit and foreign borrowing in greater detail in

Chapter 19.
However, Russia astounded the financial world in 1998 by defaulting on its ruble-denominated debt.

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Chapter 15 309
Budget Deficits in the Short and Long Run

Figure 6 clearly shows that a steep Aggregate supply
curve shifts
supply curve would lead to more Potential
inward as wages rise
inflation than a flat one. A second
factor is the degree of resource uti- S
lization. Deficit spending is more 112
inflationary in a fully employed

Price Level
economy (such as that depicted in
Figure 6) than in an economy with 106
lots of slack.
Finally, we must remember
that the Federal Reserve™s mone- 100
tary policy can always cancel out A D1
the potential inflationary effects
Deficit spending
of deficit spending by pulling the
boosts aggregate
aggregate demand curve back to D0 demand
its original position. Once again, $5,000 $6,000 $7,000 $8,000
the policy mix is crucial. Real GDP

F I GU R E 6
NOTE: Real GDP amounts are in billions of dollars.

The Monetization Issue The Inflationary Effects
of Deficit Spending
But will the Federal Reserve always neutralize the expansionary effect of a higher budget
deficit? This question brings up another reason why some people worry about the infla-
tionary consequences of deficits. They fear that the Federal Reserve may feel compelled to
“monetize” part of the deficit by purchasing some of the newly issued government debt. The central bank is said to
Let us explain, first, why the Fed might make such purchases and, second, why these pur- monetize the deficit
chases are called monetizing the deficit. when it purchases bonds
Deficit spending, we have just noted, normally drives up both real GDP and the price issued by the government.
level. As we emphasized in Chapter 13, such an economic expansion shifts the demand
curve for bank reserves outward to the right”as depicted by the movement from D0D0
to D1D1 in Figure 7. The diagram shows that, if the Federal Reserve takes no action to
shift the supply curve, interest rates will rise as equilibrium moves from point A to
point B.
Suppose now that the Fed does not want interest
rates to rise. What can it do? To prevent the incipient
rise in r, it would have to engage in expansionary mone-
F I GU R E 7
tary policy that creates new bank reserves, thereby
Fiscal Expansion and Interest Rates
shifting the supply curve for reserves outward to the
right”as indicated in Figure 8 on the next page. With
the blue supply curve S1S1, equilibrium would be at
point C rather than at point B, leaving interest rates un- D0 S
changed. Because the Federal Reserve usually pursues
expansionary monetary policy by purchasing Treasury For given
Fed policy
bills in the open market, deficit spending might there-
fore induce the Fed to buy more government debt. B
Interest Rate

But why is this process called monetizing the deficit?
The reason is simple. As we learned in Chapter 12,
Shift in demand
creating more bank reserves generally leads, via the A for reserves caused
multiple expansion process, to an increase in the money by rising Y and P
supply. By this indirect route, then, larger budget deficits
may lead to a larger money supply. To summarize:

S D0
If the Federal Reserve takes no countervailing ac- D1
tions, an expansionary fiscal policy that increases
the budget deficit will raise real GDP and prices, Quantity of Bank Reserves
thereby raising the demand for bank reserves and

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Part 3
310 Fiscal and Monetary Policy

driving up interest rates (Figure 7). If the Fed does not
F I GU R E 8
want interest rates to rise, it can engage in expansion-
Monetization and Interest Rates
ary open-market operations; that is, it can purchase
more government debt. If the Fed does so, both bank
D1 S0 reserves and the money supply will increase (Figure 8).
D0 S1
In this case, we say that part of the deficit is monetized.
Monetized deficits are more inflationary than non-
monetized deficits for the simple reason that expan-
Interest Rate

sionary monetary and fiscal policies together are more
inflationary than expansionary fiscal policy alone. But
is this a real worry? Does the Fed actually monetize any
Fed policy
A substantial portion of the deficit? Normally, it does not.
The clearest evidence is the fact that the Fed managed
to reduce inflation in the 1980s, and again in the early
years of this decade, even as the government ran huge
budget deficits. But over the years, monetization of
S0 D0 D1
deficits has been a serious cause of inflation in many
other countries, ranging from Latin America to Russia,
Quantity of Bank Reserves
Israel, and elsewhere.

So far, we have looked for possible problems that the national debt might cause on the
demand side of the economy. But the real worry comes on the supply side. In brief, large
budget deficits discourage investment and thereby retard the growth of the nation™s
capital stock.
The mechanism is easy to understand by presuming (as is generally the case) that the
Fed does not engage in any substantial monetization. In that case, we have just seen,
budget deficits tend to raise interest rates. But we know from earlier chapters that the rate
of interest (r) is a major determinant of investment spending (I). In particular, higher r
leads to less I. Lower investment today, in turn, means that the nation will have less
capital tomorrow”and the size of potential GDP will be smaller. This, according to most
economists, is the true sense in which a larger national debt may burden future
generations”and, conversely, a smaller national debt may help them:
A larger national debt may lead a nation to bequeath less physical capital to future gen-
erations. If they inherit less plant and equipment, these generations will be burdened
by a smaller productive capacity”a lower potential GDP. By that mechanism, large
deficits may retard economic growth. By the same logic, budget surpluses can stimulate
capital formation and economic growth.
Phrasing this point another way explains why this result is often called the crowding-out
Crowding out occurs
when deficit spending by effect. Consider what happens in financial markets when the government engages in deficit
the government forces pri- spending. When it spends more than it takes in, the government must borrow the rest. It
vate investment spending
does so by selling bonds, which compete with corporate bonds and other financial instru-
to contract.
ments for the available supply of funds. As some savers decide to buy government bonds,
the funds remaining to invest in private bonds must shrink. Thus, some private borrowers


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