ECON 369

Outline Twelve:  Alternative Means of Financing Government Expenditures

 

Sources:  Various (see citations in the text).

There are typically three ways of financing government spending:  taxes, debt, and money.

Some governments also charge for the use of certain services as we have discussed.  For example, user fees for national parks, toll roads, and charging for public transportation are also used.

And governments can sell off assets, e.g., buildings, land, bombers, etc.

Can you think of others?

Common Wisdom:  If the economy is stronger than expected, federal government revenues increase and expenditures decrease.  If the economy is weaker than expected, federal government revenues decrease and expenditures increase.

Financing tends to be vastly dominated by taxes, bonds, and money.  We have already discussed taxes.  So now let's discuss debt and money.

The Chart Below shows the pattern of US Federal debt since 1790 as a percent of GDP. The government dramatically increased the stock of debt to finance its wars. This was usually followed by a long period of declining debt as the US paid off the

debt incurred during the war.  It should be noted that the chart does not include intergovernmental bonds, i.e., bonds transacted between agencies in the government. One of the main sources of these bonds is the social security trust fund, which began accumulating in the early 1980s.

 

 

Let's review some terms:

 

 

How does the government go into debt?

 

 

Government Debt vs. Private Debt (private businesses engage in both equity financing and debt financing - know the difference) -- the government simply goes into debt to pay for its expenditures.

 

 

        Treasury Bonds or Bills:

 

 

 

        Balanced Budget:

 

 

        Budget Surplus:

 

 

        Budget Deficit:

 

 

       

Budget Deficit: (Billions of Dollars)

 

https://research.stlouisfed.org/fred2/series/M318501A027NBEA

 

 

 

 

    Federal or National Debt - the total amount borrowed from investors to finance deficit spending by the federal government.  The accumulated borrowing from all past deficits minus debt that has been retired with past surpluses.

    Gross National Debt - Value of all outstanding government securities of any maturity held by private investors or in government accounts.

    Net National Debt - subtract out the debt held by the federal government (intra-governmental holdings)

 

The Debt Clock

 

 

Debt as % of GDP

 

https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

 

 

 

 

 

 

 

 

Who holds the debt?

 

Source to find numbers:
The Treasury Bulletin, available online from the Financial Management Service categorizes ownership of U.S. Government securities by types of investors.

The Debt Held by the Public is all federal debt held by individuals, corporations, state or local governments, foreign governments, and other entities outside the United States Government less Federal Financing Bank securities. Types of securities held by the public include, but are not limited to, Treasury Bills, Notes, Bonds, TIPS, United States Savings Bonds, and State and Local Government Series securities.

 

 

Here's a picture of it:  https://www.nationalpriorities.org/campaigns/us-federal-debt-who/ )

 

 

There are two basic categories of debt owners: 1) the public, which includes foreign investors and domestic investors and, 2) federal accounts, also known as "intragovernmental holdings.

  

Debt Held by the Public: Domestic Investors    

Public debt is also held domestically. Domestic private investors - which includes regular American citizens as well as institutions like private banks.

The U.S. Federal Reserve Bank buys and sells Treasury bonds as part of its work to control the money supply and set (manipulate) interest rates in the U.S. economy, so they hold some of the debt (about 13%).

Finally, U.S. state and local governments have also lent money to the federal government.

 

Debt Held by the Public: Foreign Investors    

About 34 percent of the U.S. debt is held internationally by foreign investors (i.e. foreign governments, foreign institutions, and individual people in foreign countries) who buy U.S. Treasury bonds as investments.

 

Debt Held by Federal Accounts  (intragovernmental holdings)

Debt held by federal accounts is not considered public debt - it is the amount of money that the Treasury has borrowed from itself. That may sound funny, but it means that the Treasury borrows surplus money from one trust fund and gives it to another trust fund. For example, the Treasury might borrow money from Social Security to finance current government spending in another area. At a later date, the government must pay that borrowed money back.

(Note: The Federal Reserve is not counted as "debt held by federal accounts" because the Federal Reserve is considered independent of the federal government - well at least its budget is!

 

What about New Money

   

        U. S. Treasury vs. The FED (central bank of the U.S.):

 

 

 

        Monetizing the Debt and Inflation:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Economic Analysis

 

 

 

 

 

 

Probably the most prolific economist on the topic of government debt:  James Buchanan (all of the following quotations are by Buchanan).  Beginning with his Public Principles of Public Debt, published in 1958.

Buchanan says (from your reading):

 

1. The primary real burden of a public debt is shifted to future generations.
2. The analogy between public debt and private debt is fundamentally correct.
3. The external debt and the internal debt are fundamentally equivalent.

 

1.  Discussion of the problem of the burden on future generations.  Moral dimension to the debt. Buchanan disagreed with Keynesian economist Abba Lerner, who stated:  the "national debt is not a burden on posterity because if posterity pays the debt it will be paying it to the same posterity that will be alive at the time when the payment is made."  In other words, the same group of people will be paying interest on the debt -- to themselves (those that hold the bonds).  Taxed one day, receive interest the next.  So the "burden" of the debt falls on those who own the government bonds.

So quotation from reading:  "perhaps the best clue provided in a statement from Brownlee and Allen:  'The public project is paid for while it is being constructed in the sense that other alternative uses for these resources must be sacrificed during this period.'"

As Buchanan states -- this is obviously true.  But, "the mere shifting of resources from private to public employment does not carry with it any implication of sacrifice or payment."

 

Buchanan's argument: 

Bob buys a government bond (his choice) because in his mind this is a good exchange -- he lends the money today in order to earn interest in the future.  He benefits from this exchange.  He does not undertake the burden or sacrifice of a given public project even if the money he lends is used for that particular public project.

Bob does give up a current command over his resources -- but it is his choice to do so -- he freely does this in order to gain the interest. 

Putting aside the effects of the public spending -- no other individuals in the economy are affected at this time.

 

The problem is that the argument is only concerned with macro-economic variables and not with individual human beings!!  We must break down the economy into individuals (or families) in order to understand where the burden of deficit spending falls.

Buchanan:  "The public project is purchased, and paid for, by those individuals who sill be forced to give up resources in the future . . . ."  "The burden must rest, therefore, on the taxpayer in future time periods and on no one else.  He now must reduce his real income to transfer funds to the bondholder, and he has no productive asset in the form of a public project to offset his genuine sacrifice."

If the public expenditure was wasteful (or the benefit from it only gained by individuals at the time of the public expenditure) then there is no further analysis.  However:

"If the debt is created for productive public expenditure, the benefits to the future taxpayer must, of course, be compared with the burden so that, on balance he may suffer a net benefit or a net burden."

In other words, if the expenditure was made on something that might still be around to benefit future taxpayers -- then that has to be considered.  But again, this should be looked at on an individual basis.  If the money was spent on a highway in Colorado - and a federal taxpayer in New York never visits Colorado -- he has no gain!

 

So he attacked the notion that "we owe it to ourselves."  His use of subjective cost concepts was important here in demonstrating that we do not owe the debt to ourselves, but that the burden is shifted to future generations.  Individual subjective cost analysis vs. aggregate "welfare" analysis.

 

So are Deficits OK -- or do they really do harm to the economy?

Remember that is was Keynes, in the 1930s, who suggested that deficits be used as a policy tool (not just to finance war or other abnormal spending).

Keynesians more typically today:  On the perpetual question of whether budget deficits matter and if so why, the Neo-Keynesian answer distinguishes between cyclical and structural deficits. 

 

 

Structural deficits might matter because they decrease savings, crowd out private domestic investment and reduce future national income (explained below). 

But the automatic tendency of tax collections to fall and government transfers to rise during an economic downturn, creating larger deficits in the Federal budget, serves as a vital economic shock absorber that cushions private spending and mitigates fluctuations.  Remember, to a Keynesian, spending (aggregated demand) is what drives an economy.  So cyclical deficits are OK -- fiscal policy to manipulate the economy is OK.

 

Buchanan's Response (and that of others) was to bring back the Classical Model of Crowding Out.  To him (and others) why the government is deficit spending doesn’t matter:  Crowding Out

When the government borrows, it enters the loanable funds market as a borrower (demander of savings).  This increase in demand drives up interest rates -- making borrowing by private investors more expensive -- thereby decreasing productive private investment.

Government spending is not as productive as private investment - hence there is a decrease in the overall pie!

 

 

What are Keynesians saying today about "crowding out?"

Again -- if deficits are structural, than even Keynesian might agree that large deficits might harm economic growth.  However, today they are saying that due to the large amount of excess reserves in banks (due to expansive monetary policy by the FED), there is no crowding out.  In other words -- the FED has increased the money supply such that the supply of loanable funds (although NOT from real savings) -- are high enough to offset any increase in the demand for loanable funds - thus the interest rate has not increased.

Plus -- if the deficits (and the debt) are an issue -- the solution is to tax the rich.  Why?  Because the rich will pay the taxes out of savings, not consumption -- therefore, aggregate demand will not suffer.

 

What About Savings?  The argument then centered on (and still does in some circles) the Ricardian Equivalence Theorem:  farsighted, rational taxpayers would be indifferent to the timing of taxes.  That is, they would treat deficits as equivalent to higher future taxes and surpluses as equivalent to lower future taxes.  Therefore, with deficits, taxpayers would save now in order to pay the future taxes -- bringing interest rates back down.  Deficits would, therefore, not matter with respect to economic growth, etc.

David Ricardo proposed this in the 1800's and then himself identified several reasons why this "equivalence" may fail:

 

a.  How much should taxpayer's save now for the future?

b.  Will taxpayers really anticipate the higher future taxes?

c. Some taxpayers may think the future taxes will be levied after they are dead, so why save now?

d.  Some taxpayers may think the future taxes will come after they are retired -- so they will fall on the next generation of workers - so why not let them deal with it?  Let the next generation pick up the tab (i.e., tax)!

 

Does Ricardian Equivalence actually hold in the world as it is? That's an empirical question, and there is an ongoing debate among economists over which side's evidence is weaker.

 

 

 

 

 

 

2.  With respect to the analogy between private debt and public debt - Again - "When an internal debt is created, resources for public use are withdrawn from private uses within the economy. Therefore, the creation of debt and the correspondent financing of the public project does nothing toward increasing or adding to the wealth of the society. This is, of course, fundamentally correct as a first approximation and requires no difficult reasoning for its comprehension." 

In both public and private debt -- there is an opportunity cost of the resources used to finance the debt.  This is the correct part of the analogy.

 

However, the government borrows but does not invest or increase productivity in order to pay the interest on the debt -- and there is an opportunity cost of those resources -- they are "withdrawn from the private uses within the economy."  This is just a redistribution of the pie -- not creation of the pie.

 

This is a fundamental difference between private and public debt:

When a private business borrows to finance its operations, it uses those resources to produce more wealth in society and pays back the debt with interest with the new wealth creation (or it goes out of business).  The pie gets larger in order to finance the private debt.

 

Is it possible that the public debt does increase the pie -- yes, but not anywhere as likely as with private debt.  Rules - Incentives - Actions - Outcomes.

 

 

 

 

 

 

 

 

3.  With respect to:  if the debt is held outside of the issuing jurisdiction, it is called external; if it is held within the jurisdiction, it is called internal - are these fundamentally equivalent?

 

The argument that is given by those who say that external and internal debt are different claim that in one case (internal) - interest on the debt is paid by taxpayers within the jurisdiction -- but they are also the lenders who will gain the interest - so it is a wash, so-to-speak.  On the other hand, with external debt -- the interest is paid by taxpayers within the jurisdiction, but the interest is going to those outside of the jurisdiction.

 

In both cases the jurisdiction borrowing must pay the interest on the loan.  But, again Buchanan didn't want to aggregate the community, but instead looked at individuals -- so, not all who pay taxes (to pay the interest on the public debt) will be gaining interest (will own bonds). 

So, in the case of internal debt, can't say it's a wash.  In the case of external debt, certainly isn't a wash.

 

 

 

So let's end with Buchanan's public choice focus on the erosion of “inherited traditions of discipline” that held deficits in check -

 

"If you recognize the natural proclivity of democratic politics to generate deficits, you recognize that we did have a constitutional norm against deficits.  It was basically a moral norm:  It was a 'sin' to create deficits prior to the Keynesian period.  If you remove that moral norm you have this natural proclivity."  (Sep. 1995 - from an interview published in The Region, a publication of the Woodrow Federal Reserve Bank of Minneapolis).

He later maintained, that citizens will typically favor deficit financing because:  "Constituents enjoy receiving the benefits of public outlays, and they deplore paying taxes.  Elected politicians attempt to satisfy constituents."  (The Moral Dimensions of Debt Financing" in Fink and High, 1987). 

 

 

Let's Review our Public Choice Theory as to why we have such large government deficits - Think about it:  How can the government debt be financed?

a.  Higher taxes

b.  Monetize the debt - higher taxes through inflation

c.  Cut spending - use the surplus to pay

d.  Sell off government assets - like the Lincoln Memorial

e.  More debt - the most politically expedient  (you can buy more votes with deficit spending)

 

Rather than making the burden obvious, politicians prefer to borrow for now and to leave us all to guess about just what will happen after election day. (from Do Deficits Matter? by Lawrence H. White and Roger Garrison).

 

Buchanan's Solution:  Balanced Budget Amendment -- constitutional amendment requiring government to spend no more than it collects in tax revenues.  Is it feasible?

 

       Or maybe even better -- not just a Balanced Budget Amendment, but also a Spending Limit Amendment!

 

Buchanan:  "I was influenced by the Swedish economist Wicksell, who said if you want to improve politics, improve the rules, improve the structure.  Don't expect politicians to behave differently.  They behave according to their interests." (Sept. 1995 - from an interview published in The Region, a publication of the Woodrow Federal Reserve Bank of Minneapolis).

 

Can you tell I studied under Buchanan?  RULES - INCENTIVES - ACTIONS - OUTCOMES!  AND POLITICIANS ARE NO DIFFERENT FROM ANYONE ELSE!

 

 DO ICE THIRTEEN