Budget Deficits and Public Debt - Essay Example

Hernani M Jover Order # 416629 25 February Seminar Topic: Budget Deficits and Public Debt Introduction This paper focuses on budget deficits, the resulting public debt and their impact on a country’s economy. US trade policy is also integrated in the paper, but only to the extent that it impacts on budget deficits and public debt. There are three underlying considerations of this work. First, governments have been running on budget deficits for longer than two decades. Secondly, prospects for global growth have been deteriorating over the past few months. Third, there is a growing sense of unease among many sensible people about government’s inclination for foreign borrowings and deficit spending. Government for the People Historically, one of the main challenges to government leaders is the generation, and the application of a country’s wealth and resources towards “three main duties of great importance. These are as follows: protecting the country from violence and invasion; protecting, as far as possible, every member of the society from oppression and injustice, and thirdly, erecting and maintaining public works, public institutions, which can never be for the interest of any individual or group of individuals. Financing the state was basically through revenue raised through “taxes of one kind or another (Smith 476).1 Public debt was not unheard of, but was held suspect. In the last two decades, most countries have been experiencing periods where their outlays exceed their revenues, with no balanced budget in sight. Governments faced the formidable task of managing runaway budget deficits and growing public debts, both internal (owed to nationals), and external (owed to foreigners). To cover the shortfall or deficit, governments sell public assets, levy taxes, print and/or borrow money. Government borrowings to finance deficits create “public” debts, which need to be serviced through interest payments or through refinancing. Obligations of government resulting from issuing guarantees for a public sector enterprise added to the public debt become what are known as the “federal debt (Iqbal 2)2.” Public Debt Situation Available data showed that by 2007, 124 countries had been running on borrowings and that many of these countries had breached the acceptable level of public debt -to -GDP ratio. The US debt-to-GDP ratio had risen to 60.8 % in 2007. Other countries exhibited higher debt-to- GDP ratio; Japan’s debt-to-GDP ratio reached 170%, Germany, 64.9%, and Canada, 64.2 %( Nationmaster1)3. Public debt and budget deficits had become a global phenomenon and the principles of balanced budget and surplus became part of a 10-year,15-year and 20-year projections. Against the backdrop of rising deficits and the growing public debt, Anthony de Jasay’s articles entitled “Who is Afraid of National Debt?,” “To Spend or Not To Spend,” “Shall we Borrow from the Children” assume some significance (de Jasay1)4. These three articles address the future in an environment of sustained large deficit. Policy Debates on Budget Deficit and Public Debts A number of studies and researches have been done on the subject of budget deficits and public debt and how they impact on the economy and the future generation. Iqbal’s research on “Lessons for Economies in Transition” provide an in-depth analysis of the classical and new classical thinking on the nature and burdens of public debt and the limits on deficits and debts as instruments of fiscal policy.(1-32 )5 Adam Smith, David Hume, and other classical economists opposed public debt because of the following considerations: 1) Public debt could have adverse long term effects on savings and private capital formation, which would lead to less future productive capacity; 2) Foreign borrowings, obtained so conveniently, would encourage government profligacy and fund unnecessary wars and other unexplainable expenditures; 3) Long term projections on substantial deficits, too far into the future could cause a substantial shift in market expectations, and as a consequence, result in a general loss of confidence in a country’s economy. As volatile as the economic situation is, a negative cycle could be triggered, which could be damaging to financial markets, and the real economy (Iqbal 19)6. There are also those economist who share the popular view that following nature’s way of self-adjusting, deficit financing will have long -term, and painful costs in terms of the following: rise in prices, fall in savings, crowding out of investments, imbalances in external accounts , and impairment of capital formation . As to the nature and burden of debt, these economies agreed that public debt would take its toll on the public expenditure that it funds, as servicing the debt is projected into the far future, a type of “ borrow now, pay much later” scheme. The catch is that future taxes could develop into disincentives. This school sees little conceptual difference between internal and external debt, but distinguishes private and public debt. Iqbal cited the opposite view of a minority, who believe that individuals foresee the impact of all government fiscal policy and offset it in advance by taking measures opposite to that of the government. This means “ debt and taxes as alternative means of financing government expenditure are essentially similar and will not impact differently on aggregate demand ( 19)7” . Further, this group does not believe that public debt could put a burden on future generation. In the realm of theory, it is difficult to make right and wrong judgments, only wise and prudent choices. US – A Case Study The United States may not be the best model for a case study on budget deficits and public debt because of the complexity, a well as the enormity of its economic system, not to mention the more complex political mechanisms at play. Nonetheless, the US is also the only country that provides the most information on any subject under the sun, whether or not this is to its interest. Consequently, although instructive, what is presented below is really a drop in the ocean of information available on US budget deficits, and public debt, leaving much to be done by the student of US economy. The Federal Debt Based on available data, the US is the world’s largest debtor. A closer look at the US federal budget reports reveals, that since the war years, US public debt, borrowings, and budget deficits have continued to rise. The US debt is the largest in the world. Even before the economic crisis, from 2000 to 2007, the US debt had already increased from $6 to $9 trillion. By December 2008, the $700 billion bailout increased the debt to $10.5 trillion ( Bureau of Public Debt-Input Dates1/1/2001 and 12/31/2008)8. As of Dec. 21 2009, the US debt reached over $12 trillion. This figure represents the sum total of all outstanding debt owed by the Federal Government to the people, business and foreign governments that bought treasury bills, notes and bonds. The remaining amount is owed by the government to itself. Some are owed to Social Security Trust Funds and the others to unfunded Medicare liability. The Office of Management and Budget (OMB) forecasts the budget deficit to rise to $1.7 trillion in FY 2009 and $1.7 trillion in FY2010. The US debt can increase to over $13 trillion by 2013. The US debt as a percentage of the Gross Domestic Product (GDP) is now 83%. GDP is now $14.4 trillion. China holds $801.5 billion in treasury bonds and is the largest foreign financier of the US public debt. Japan has $751 billion. UK, Brazil and the oil exporting countries hold about $100-$250 billion each. Total foreign holdings are $3.5 trillion. Foreign countries in 2009 have total holdings of 28% of Treasury bonds ,up from 13% in 1988(About.com 1)9. How a Large Trade Deficit Will Affect the US Economy Less attention has been given to “the other deficit,” also known as “current account deficit”. Since 1976, the US has incurred trade deficits with other countries and since 1982, current account deficits. By 1980, the trade deficit grew drastically as the US strong -dollar policy adversely affected US manufacturers and companies moved their production offshore. Only the US has accepted continuing trade deficits. By 1998, trade deficit reached new highs and by last year, deficit had reached $489 billion. Economists are of the view that current account deficits could pose both short and long term problems for the US economy10. The US economic performance in the global trading system over the past thirty years suffers continuous and consistently growing deficits. In 2009, the US economy (business, households and the federal government) had to borrow $540 billion from foreign creditors. Over the past fifteen years, it has accumulated nearly $3 trillion in debt obligations. Foreign debt is expected to double in the next seven years at the current pace. Under these circumstances, US initiatives in NAFTA, CAFTA and other similar free trade agreement systems, especially since there have been some objections to some of their protectionist provisions, may not help the US trade deficit situation (FPIF Special Report 2005)11. William Greider, in his article in The Nation, concluded that the US economy was “being kept afloat by enormous foreign lending so that consumers can keep buying more imports, thus increasing the bloated trade deficits(1)12. The lopsided arrangement will end when the foreign creditors-major trading partners like Japan, China and Europe - decide to stop the lending or to simply reduce it substantially. He warned that the United States is sinking into financial dependency and has become dangerously indebted to rival nations . Can Economies Survive a Sustained Large Budget Deficit Environment? Economists cautioned that a large budget deficit can have adverse consequences on the economy if sustained over many years. Given the prevailing tax structure, the marginal tax rates, and the level and composition of government spending, such deficit spending can cause a substantial shift in market expectations, which could result in loss of confidence in the government and the economy. A much feared negative cycle among the underlying fiscal deficit, financial markets and the real economy could ensue . Policy makers were also worried about the “crowding- out” effect of government spending on private loans for investment by competing, as it were, for scarce resources. The “crowding out” effect, results because of the higher interest rates, as opposed to the “crowding in” effect, which is a plus factor, increasing private expenditure and private borrowing(The Deficit Debates Again 1-7)13, Another serious concern is the possible reduction of consumer spending. Further, the rising deficit could result in an arbitrary redistribution of income, this time, from taxpayers to bondholders. Hence, depending on prevailing conditions and other factors, a large sustained budget deficit from additional expenditures can have varying effects in both the short run and the long run. Given the dramatic increases in US budget deficits and its public debt, the questions that need to be asked and answered are: How did the United States manage to escape the severity of economic consequences mentioned above? More importantly, how long can the US defy the consequences of a sustained budget deficit environment? To the first question, Iqbal points to a number of factors, which has placed the US in a unique position vis-à-vis other borrowers (22-23)14. These are as follows: 1. The burden of public debt is based not on the size of the debt itself but in the capacity of the country to repay such debt. On this basis, using debt-to-GDP ratio as indicator, that of the US lies in the vicinity of 60% which compares favorably with other industrialized countries. 2. There have been structural changes in the US economy and in the international economic environment in the past two decades that have favorably impacted on the economic consequences of the US budget deficits and public debt. Specifically, deregulation, globalization and technology have contributed significantly. Also importing manufactured goods from China removes the limitations of domestic productive capacity, thus removing the threat of goods price inflation. Also liberalization and integration of capital markets have helped against the restrictions imposed by domestic financial markets on borrowers. 3. The US is considered a safe haven for capital. 4. The US Dollar enjoys the status of being a currency for international reserves and the US Treasury a natural outlet for investments for countries with large trade surpluses. 5. The US Treasury is so large that the liquidity it offers is valued by investors, reducing the normal required rate of return. The above conditions give the US a distinct advantage vis-à-vis other countries in so far as budget deficit and public debt consequences are concerned. Conclusion So when should countries say enough is enough? Who should determine the limits to spending and borrowing? Alan Greenspan, testifying before the House Budget Committee in 2004 and 2005, concerned about the increasing federal budget deficits, urged that government exercise serious restraint in spending, urged government to take the necessary steps to reduce the deficit, reiterating concerns of many, stressed that government borrowing could crowd out private investment spending, resulting n a slower rate of economic growth. He also expressed concern about the continuing budget deficit and the possible Social Security shortfalls. He warned of an unsustainable growth because of the budge deficit (Greenspan 2004-2005)15 (Alan Greenspan, “March 2, 2005 Testimony before the House Budget Committee, also February 25, 2004, November 3, 2005). Robert Barro resurrected the Ricardian Equivalence Theorem, which is a 19th century argument against government spending. To put a cap on debts, Ricardo offered a formula that any amount borrowed by the government should be equivalent to the current value of the taxes that would be paid to service such borrowing (and could be in perpetuity). He suggested that the only acceptable government borrowing was a year-on-year balancing of the public budget (Iqbal 11-12)16. It may be advisable to consider a rather simplistic approach to a complicated issue. An increase in debt in one period has implications for government’s budgetary policy in the subsequent period. In particular, to service the debt, either government spending must be reduced in the future or taxes must increase. “But public expenditure cannot be reduced to zero and taxes cannot rise forever (Grieber 1)17” . By implication there is a prudent limit on the level of debt in relation to the productive capacity of the economy. In response to the call for restraint in spending, EU countries incorporated provisions in The Maastricht Treaty, which meant to discipline its members, explicitly mentioning the need to avoid excessive public deficits. The Treaty set thresholds which should not be exceeded: public deficits as a share of GDP should not be higher than 3 per cent; gross public debt should be contained within 60 per cent of GDP( Caporale 1)18. Unfortunately, it is near impossible to find a one-size-fits-all solution, or a single prudent debt-to-GNP level. Budget deficits continue to soar out of control in Eurozone, Germany, US, UK, Japan, reads the headline of a newspaper. An IMF study on Required Average primary balance to stabilize public debt-to- GDP ratio at 2007 level shows that 12 OECD countries will still be in debt, at 1.6% of GDP (Portugal), at the very least and at its highest, at 4.5% of GDP (Japan), over the next 20 to 50 years. In the long run, the impact of sustained massive budget deficits and public debt will depend on several factors converging to provide the right climate for leaders, policy makers and the people to make the right choices (Iqbal 23)19. Among these are the following : 1. Larger trends affecting financial asset markets, growth and inflation. 2. Policy responses to these variables and how these in turn influence lender expectation. 3. Expenditure priorities and policies. 4. Global political environment. 5. Status of the US Dollar as reserve currency. 6. Economic viability of activities/investments funded from any incremental public borrowing over and above that for rolling over the existing debt. 7. A stronger macroeconomic policy response. Fiscal stimulus can be effective if it is well targeted, supported by accommodative monetary policy, and implemented in countries that have fiscal space. 8. Financial sector policies be reinforced and better coordinated. END NOTES Read More