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get “crowded out” of the financial markets as the government claims an increasing share of
the economy™s total saving.
Some critics of deficit spending have taken this lesson to its illogical extreme by arguing
that each $1 of government spending crowds out exactly $1 of private spending, leaving
“expansionary” fiscal policy with no net effect on total demand. In their view, when G
rises, I falls by an equal amount, leaving the total of C 1 I 1 G 1 (X 2 IM) unchanged. Un-
der normal circumstances, we would not expect this to occur. Why? First, moderate budget
deficits push up interest rates only slightly. Second, private spending is only moderately



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Chapter 15 311
Budget Deficits in the Short and Long Run



sensitive to interest rates. Even at the higher interest rates that government deficits cause,
most corporations will continue to borrow to finance their capital investments.
Furthermore, in times of economic slack, a counterforce arises that we might call the
crowding-in effect. Deficit spending presumably quickens the pace of economic activity.
That, at least, is its purpose. As the economy expands, businesses find it more profitable Crowding in occurs when
to add to their capacity in order to meet the greater consumer demands. Because of this government spending, by
induced investment, as we called it in earlier chapters, any increase in G may increase invest- raising real GDP, induces
increases in private invest-
ment, rather than decrease it as the crowding-out hypothesis predicts.
ment spending.
The strength of the crowding-in effect depends on how much additional real GDP is
stimulated by government spending (that is, on the size of the multiplier) and on how
sensitive investment spending is to the improved business opportunities that accompany
rapid growth. It is even conceivable that the crowding-in effect could dominate the
crowding-out effect in the short run, so that I rises, on balance, when G rises.
But how can this be true in view of the crowding-out argument? Certainly, if the




Permission, Cartoon Features Syndicate
SOURCE: From The Wall Street Journal”
government borrows more and the total volume of private saving is fixed, then private
industry must borrow less. That™s just arithmetic. The fallacy in the strict crowding-
out argument lies in supposing that the economy™s flow of saving is really fixed. If
government deficits succeed in raising output, we will have more income and there-
fore more saving. In that way, both government and industry can borrow more.
Which effect dominates”crowding out or crowding in? Crowding out stems from the
increases in interest rates caused by deficits, whereas crowding in derives from the faster
real economic growth that deficits sometimes produce. In the short run, the crowding-in
“Would you mind explaining
effect”which results from the outward shift of the aggregate demand curve”is often
again how high interest rates
the more powerful, especially when the economy is at less than full employment. and the national deficit
In the long run, however, the supply side dominates because, as we have learned, affect my allowance?”
the economy™s self-correcting mechanism pushes actual GDP toward potential GDP.
When the economy is approximately at potential, the crowding-out effect takes over: Higher
interest rates lead to less investment, causing the capital stock and potential GDP to grow
more slowly. Turned on its head, this is the basic long-run argument for reducing the budget
deficit: Smaller budget deficits should raise investment and speed up economic growth.

The Bottom Line
Let us summarize what we have learned so far about the crowding-out controversy.
• The basic argument of the crowding-out hypothesis is sound: Unless the economy
produces enough additional saving, more government borrowing will force out some
private borrowers, who are discouraged by the higher interest rates. This process will
reduce investment spending and cancel out some of the expansionary effects of
higher government spending.
• But crowding out is rarely strong enough to cancel out the entire expansionary thrust
of government spending. Some net stimulus to the economy remains.
• If deficit spending induces substantial GDP growth, then the crowding-in effect will
lead to more income and more saving”perhaps so much more that private industry
can borrow more than it did previously, despite the increase in government borrowing.
• The crowding-out effect is likely to dominate in the long run or when the economy is
operating near full employment. The crowding-in effect is likely to dominate in the
short run, especially when the economy has a great deal of slack.


THE MAIN BURDEN OF THE NATIONAL DEBT: SLOWER GROWTH
This analysis of crowding out versus crowding in helps us understand whether or not the
national debt imposes a burden on future generations:
When government budget deficits take place in a high-employment economy, the
crowding-out effect probably dominates. So deficits exact a toll by leaving a smaller



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Part 3
312 Fiscal and Monetary Policy



capital stock, and hence lower potential GDP to future generations. However, deficits in
an economy with high unemployment may well lead to more investment rather than
less. In this case, in which the crowding-in effect dominates, deficit spending increases
growth and the new debt is a blessing rather than a burden.
Which case applies to the U.S. national debt? To answer this question, let us go back to
the historical facts and recall how we accumulated all that debt prior to the 1980s. The first
cause was the financing of wars, especially World War II. Because this debt was contracted
in a fully employed economy, it undoubtedly constituted a burden in the formal sense of
the term. After all, the bombs, ships, and planes that it financed were used up in the war,
not bequeathed as capital to future generations.
Yet today™s Americans may not feel terribly burdened by the decisions of those in
power in the 1940s, for consider the alternatives. We could have financed the entire war
by taxation and thus placed the burden on consumption rather than on investment. But
that choice would truly have been ruinous, and probably impossible, given the colossal
wartime expenditures. Alternatively, we could have printed money, which would have
unleashed an inflation that nobody wanted. Finally, the government could have spent
much less money and perhaps not have won the war. Compared to those alternatives,
Americans of subsequent generations probably have not felt burdened by the massive
deficit spending undertaken in the 1940s.
A second major contributor to the national debt prior to 1983 was a series of recessions. But
these are precisely the circumstances under which budget deficits might prove to be a bless-
ing rather than a burden. So it was only in the 1980s that we began to have the type of deficits
that are truly burdensome”deficits acquired in a fully employed, peacetime economy.
This sharp departure from historical norms is what made those budget deficits worri-
some. The tax cuts of 1981“1984 blew a large hole in the government budget, and the
recession of 1981“1982 ballooned the deficit even further. By the late 1980s, the U.S. econ-
omy had recovered to full employment, but a structural deficit of $100“$150 billion per year
remained. This persistent deficit was something that had never happened before. Such large
structural deficits posed a real threat of crowding out and constituted a serious potential
burden on future generations. After a brief interlude of budget surpluses in the late 1990s,
large structural deficits reemerged in the early years of this decade, caused by a combina-
tion of large tax cuts and rapid spending growth. Current projections also foresee very large
deficits in the future, which worries economists and budget analysts.
Let us now summarize our evaluation of the actual burden of the U.S. national debt:
• The national debt will not lead the nation into bankruptcy. But it does impose a bur-
den on future generations to the extent that it is sold to foreigners or contracted in a
fully employed, peacetime economy. In the latter case, it will reduce the nation™s cap-
ital stock.
• Under some circumstances, budget deficits are appropriate for stabilization-policy
purposes.
• Until the 1980s, the actual public debt of the U.S. government was mostly contracted
as a result of wars and recessions”precisely the circumstances under which new debt
does not constitute a burden. However, the large deficits of the 1980s and 2000s
were not mainly attributable to recessions, and are therefore worrisome.
• The shift from budget surpluses back to deficits in this decade may retard capital for-
mation and future economic growth.



ISSUE REVISITED: IS THE BUDGET DEFICIT TOO LARGE?
We are now in a position to address the issue posed at the beginning of this
chapter: Is the federal budget deficit too large? To tackle this question, we
need to understand how and why fiscal policy changed, and we need to
distinguish between the short-run (demand side) and long-run (supply side)
effects of budget deficits.



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Licensed to:

Chapter 15 313
Budget Deficits in the Short and Long Run



The federal budget was in surplus by $236 billion in fiscal year 2000 (which ended
September 30, 2000). By fiscal 2003, there was a deficit of $378 billion”a swing of
$614 billion in just three years. How did this happen? Three main factors
contributed.
One was the tax cuts of 2001 and 2003, which were even larger than George W. Bush
had proposed as a candidate in the 2000 campaign. As we have noted in this chapter,
whether such large tax cuts were wise or foolish policy is still hotly debated. But this
much is clear: Given the 2001 recession and the weak economy that followed it, the
stimulus to aggregate demand from the tax cuts was welcome. The debate is over
whether the government should have reduced the fiscal stimulus when the economy
strengthened in 2004“2006.
The second major factor was the recession of 2001 and its
aftermath”a period of time during which GDP was consis- F I GU R E 9
tently below potential. As we have emphasized in this chap- The Short-Run Effect of Larger Deficits or Smaller
ter (see especially Figure 5 on page 306), it is perfectly natural Surpluses
for the budget to deteriorate when the economy does”and
then to improve when the economy does. D1
The third major factor was a surge in federal spending
D0
during President Bush™s first term. From fiscal year 2001 to
fiscal year 2005, total federal spending increased by 33 per- S
cent while nominal GDP rose by just 22 percent. Some of
this additional spending was on the war in Iraq, another
Price Level B
policy whose wisdom is hotly debated. But other types of
A
spending rose, too.
Those were the fiscal policies. What were their effects?
In the short run, aggregate demand factors dominate S
economic performance, and the stimulus from both higher
spending and tax cuts provided an expansionary force just D1
when the economy needed one. Moving from surpluses to D0
deficits probably cushioned the recession and sped up the
recovery by boosting aggregate demand, as shown in
Real GDP
Figure 9.
But in the long run, however, output gravitates toward
potential GDP, no matter what happens to aggregate
demand. So aggregate supply rules the roost. And that is
FIGURE 10
where the long-run costs of fiscal stimulus emerge. Large
The Long-Run Effect of Larger Deficits or Smaller
budget deficits lead to higher real interest rates and hence
Surpluses
to lower levels of private investment. That makes the na-
tion™s capital stock grow more slowly, thereby retarding the
Potential
growth rate of potential GDP. This slower growth is
GDP
depicted in Figure 10, which shows budget deficits leading S1
to a potential GDP of Y 1 instead of Y 0 in the future. With
the same aggregate demand curve, DD, the result is lower
D
real GDP. S0
So, on balance, were the deficits appropriate? The answer
Price Level




is not clear. In the short run, the economy clearly did need
B
stimulus in 2001“2003, as it did once again in 2008. But be-
cause large deficits deter some investment spending, they
slow down the economy™s potential growth rate in the long S1 A
run. That is why thoughtful proponents of fiscal stimulus in
2001 urged the government to make any increases in spend- D
ing or reductions in taxes temporary. We should reduce the S0
budget surplus in the short run, they argued, but maintain it
in the long run. That advice was not heeded in 2001. But it Y1 Y0
was heeded when the government enacted a large stimulus Real GDP
package in 2008, which was explicitly temporary.



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Licensed to:
Part 3
314 Fiscal and Monetary Policy



THE ECONOMICS AND POLITICS OF THE U.S. BUDGET DEFICIT
Given what we have learned in this chapter about the theory and facts of budget deficits,
we can now address some of the major issues that have been debated in the political arena
for years.
1. Have the deficits of the 1980s, 1990s, and 2000s been a problem? In 1981“1982,
1990“1991, and again in 2001, the U.S. economy suffered through recessions.
SOURCE: From The Wall Street
Journal”Permission, Cartoon




And in late 2007-2008, the economy was very weak again. Under such circum-
stances, crowding out is not a serious concern, and actions to close the deficit
Features Syndicate




during or right after these recessions would have threatened the subsequent
recoveries. According to the basic principles of fiscal policy, growing deficits
were appropriate in each case.
But in each case, crowding out became a more serious issue as the economy
“The ˜Twilight Zone™ will not
recovered toward full employment. Budget deficits should decline under such
be seen tonight, so that
circumstances”as they did in the 1990s and again from 2004 to 2007. But the
we may bring you the
deficit did not fall in the 1980s nor in the period from 2002 to 2004. Instead, the
followng special on the

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