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Humanities Libertexts

10.2: Debt and Deficits

LEARNING OBJECTIVES

In this section, you will learn:

  1. How the European debt crisis came to be.
  2. How much the U.S. budget deficit matters.

A current problem is many parts of the world is debt. Nations spend a lot of public money to provide people with the services they say they want. If tax revenues exceed expenditures in these public budgets, the nation has a budget surplus. If, however, spending exceeds revenue, nations have a budget deficit. Nations fund budget deficits in one of two ways—either by printing money, which is fortunately fairly rare anymore, or by borrowing on the open market. If you have a U.S. Savings Bond, you are helping the fund the federal budget deficit. Governments sell bonds, which are financial obligations that come in specific denominations ($1,000, $5,000 and $10,000 for U.S. treasury securities) to cover expenditures in the short term. Investors lend money to governments by buying the bonds, collecting interest payments for the life of the bond and getting their initial investment back when the bond matures, in say 10 or 20 years.

Figure 10.3 [To Come] International budget deficits

Part of the recent debt problem has been in Europe. In 1999, 17 nations in Europe adopted a single currency, the euro. The goal was that by lowering the transaction costs that follow from having to turn francs into deutschmarks, the single currency would in fact raise gross domestic product (GDP) by 1 percent. That may not sound like a lot, but 1 percent across an economy that’s bigger than that of the United States is both a lot of money and a huge economic gain.

As always, however, there were tradeoffs. It meant that all the member nations of the Eurozone would have the same monetary policy. In practical terms, this means the monetary policy of the German central bank, since they are the biggest economy in Europe. The Germans, dating back to their experience of hyperinflation in the 1920s—which helped Hitler take power—are fairly obsessed with keeping inflation at bay. But what’s good for one country might not be good for another. One nation wants to control inflation; another nation wants monetary stimulus. Under the Eurozone, that’s not happening.

For whatever reason, the economies of northern Europe—Germany, France, the Netherlands, Sweden—are stronger than the economies of southern Europe, in particular Spain, Italy and Greece. So the latter three nations have been running larger budget deficits. But without the ability to engage in monetary policy on their own, they cannot inflate their currencies so as to pay back their debts with cheaper money.

Why are these governments budgets’ so out of whack? In Greece, for example, tax evasion is apparently a way of life, so that the Greek government is not collecting all the taxes it should. Government benefits are extraordinarily generous, so people retire after age 50, and even more taxable earnings are lost to the state. It should be easy to see why the government pays out such benefits: Government largesse is a key source of maintaining legitimacy in the eyes of voters. Voters come to view this every-day-is-Christmas approach to governing as a social contract, and change becomes difficult to achieve.

As Greece’s debts have mounted, lenders begin to demand higher interest rates so as to cover the risk of Greece defaulting on its debts. Default would mean that investors lose a lot of money. You might be tempted to think, “sucks to be them,” but the losses would mean investors would be more wary of loaning money to anybody, raising borrowing costs all over the world, and making the global economy shrink. Even in the U.S., a Greek default would have echoes, beginning with higher interest rates on credit cards and on home and auto loans. In short, it would be a lose-lose situation.

European policy makers, particularly the leaders of Germany and France, have responded by bailing out the Greeks, the Spaniards and the Italians, in exchange for tight “austerity” budgets, in which government spending is greatly reduced. The problem with this is that quick, large-scale reductions in government spending will mean that those three economies go toward if not into recession, impacting their neighbors and trading partners as well as making the governments’ revenue problems even worse.

The Greeks could pull out of the Eurozone, but that would mean high inflation on imports and a substantial whack to the Greek economy. So there are no easy answers here, at least until the Greek government can convince people that what they need to do is pay their taxes. But, the world over, telling people that they need to tighten their belts and pay their taxes is never politically very popular. And saying “revenue enhancements” instead of taxes doesn’t fool as many people as perhaps it once did.

The American Problem

The United States faces a somewhat similar problem with regard to its budget deficit, although the U.S. economy is much larger than the Greek economy, giving the U.S. a lot more wiggle room when it comes to monetary and fiscal policy. The U.S. budget deficit is not nearly as serious as, say, the Greek deficit, and the U.S. can still engage in monetary policy to suit the needs of the moment.

Nonetheless, the budget deficit became a very big political issue in the 2012 presidential campaign, with Republicans decrying the deficits of the Obama administration. Where did they come from?

In 2001, George W. Bush became president and inherited a budget surplus. He convinced Congress to pass rather substantial tax cuts, thus reducing revenue and ending the surplus. Then, following 9.11, the president and Congress got the U.S. involved in two wars, and the budget deficit returned with a vengeance.

And then came the financial meltdown. With low interest rates in the 2000s, and a financial industry that discovered it could make a lot of money on the fees on home loans to people who couldn’t really afford them, the nation got a bubble in the housing market. A bubble is when investment exceeds potential in a particular market. In the case of housing, which represents about a quarter of the entire U.S. economy, the bubble was of substantial proportions, perhaps $1.4 trillion. This was fine as long as housing prices continued to rise, but as with any bubble, prices could not and would not rise forever. In 2007, prices began to fall, and the housing market collapsed. People could no longer sell their homes for more than they paid for them. Once your home is worth less than you paid for it, you are unable to sell it any price. As a home represents the single largest investment most people will ever make, overall wealth in the economy shrank and the entire economy went into recession.

Economists expected a recession; we’ve had lots of bubbles before, most recently in internet and technology stocks in the late 1990s, and going all the way back to railroads in the 1800s. People lose their jobs, some wealth evaporates, and eventually the economy recovers and we move ahead. It’s not pretty, but since the Great Depression, we’re usually able to recover in a year or so.

But this time, the problem was much bigger than a typical bubble. People used to say “safe as houses” with regard to home loans, because financial institutions subjected prospective borrowers to intense scrutiny. The loans are then bundled into blocks of loans, and resold to big borrowers who want a safe, profitable place to park their money. So the new bundled home loans, which included loans to people who were likely to default, were sold to investors all over the world.

What economists didn’t realize was that the biggest banks had made side bets on the mortgage loans. Called derivatives, because they derive their value from the value of something else, such as a bundle of home loans, they were unregulated bets on which way the market would go. In some instances, banks even bet against the people they were lending to (without telling them, of course). In some senses, these were insurance policies on the loans. But if everybody files a claim at once, you have a problem. Say I’m Lehman Bros., a big Wall Street investment bank. I’ve sold billions in bundled home loans to investors. Then I go to AIG, the world’s largest insurance firm, and buy an insurance policy on the loans, in case they go bad.

Then say everybody else does this. (They did.) Then say many of the loans go bad. (They did.) With everybody having bet the same way, like everybody betting on the same horse at the race track, there’s nobody left on whom to lay off the risk. And so instead of a $1.4 trillion mortgage bubble, we were faced with a $60 trillion derivative bubble, or more than four times the size of the entire U.S. economy. It’s worth noting that U.S. investment banks had lobbied heavily to prevent the regulation of the derivatives market in the 1990s. So the derivatives bubble threatened to destroy the financial system and provoke a second Great Depression.

Even with bailouts of the banking system and a fiscal stimulus package to help right the economy, the United States still endured the steepest recession since the Great Depression of the 1930s. Increased federal expenditures and reduced state, federal and local revenues meant a bigger budget deficit. As of 2012, the economy hasn’t fully recovered, with private sector job gains offset by reductions in public sector employment.

So how important is the budget deficit? As a percentage of GDP, the U.S. budget deficit is slightly higher than Greece’s, both at around 10 percent. Then again, at $15 trillion, the U.S. economy is 50 times larger than Greece’s. So the scope of the problem is not quite the same. We should understand that no one in or near government in the United States, Republican or Democrat, conservative or liberal, thinks the United States can sustain that level of deficit forever. Nor do they plan to.

Conservatives propose to cut spending and taxes and shrink the overall size of the federal government. If they just proposed cutting spending, this would help balance the budget, but cutting taxes as well will probably not fix the deficit. First, cutting spending would lower overall demand in the economy, threatening the push the nation back into recession. The argument for cutting taxes is that lower tax rates will help the economy grow, but tax cuts have a somewhat uninspiring record for spurring economic growth. It’s not difficult to grasp how they should work: Tax cuts mean more money in people’s pockets, which, hopefully, they will go out and spend, creating more economic activity and percolating throughout the economy. Firms get more business, place more orders and hire more people. However, that doesn’t happen as often as you might expect. The problem could be that tax cuts most often come in response to a soft economy. So that people who have jobs, despite having more money in their wallets, are afraid that they, too, will get laid off or have their hours cut, so rather than spending the money, they save it. Increased saving is not bad for the economy, or for people, but it doesn’t generate the rapid bounce that policymakers are hoping for.

Liberals propose to address the deficit by raising taxes and trying not to bust the piggy bank on spending, while maintaining public investment in things such as infrastructure and public education. They argue that this kind of spending will in fact make the economy grow more than tax cuts will. In their defense, it was the combination of a growing economy, small tax increases and restraint on federal spending that allowed Democrat President Bill Clinton and a Republican-controlled Congress to balance the federal budget in the 1990s. On the other hand, government has to have the political will to spend on things that will generate economic recovery, and it has to be just as willing to use any budget surplus in the future to reduce the deficit. None of that is a given.

Are budget deficits a problem? As then-Vice President Dick Cheney said, responding to criticism of the Bush-era budget deficits, “Deficits don’t matter.” Or maybe they do, as in 2012 the budget deficit was a big campaign issue for many Republican candidates. In political terms, deficits seem to matter more if somebody else is responsible. The usual argument against deficits is that if the federal government borrows too much, it will crowd out private sector borrowing, hurting the economy. There is no evidence that this ever happens. A more serious problem is that the bigger the deficit, the more of the federal budget that is spent on interest on the debt. That leaves less money available for everything else, from investment to tax cuts.

U.S. Debt Abroad

A third complaint you may hear is that the trade deficit and budget deficit together mean we have to borrow money from China. China holds around $1.2 trillion of the United States’ total outstanding debt of around $14 trillion. Nonetheless, repeat after me: We do not borrow money from China. First, China holding U.S. debt is not a remarkable thing. In fact, foreign nations hold close to half (47 percent) of outstanding U.S. debt. Why? Because they end up holding more dollars than they know what to do with in their foreign currency accounts. They could use the money to buy things, or invest, and one safe place to invest is U.S. government treasury securities. If you were left more Euros than you know what to do with, you might buy Eurozone bonds. Ditto for yen and Japanese bonds, or Canadian dollars and Canadian bonds. At this point, you probably only buy Greek bonds if you’re feeling frisky and risky. It’s important to note that no foreign investor, public or private, buys U.S. debt instruments directly from the U.S. Treasury. They buy them in the open market, sold by other investors such as the large banks that participate in Treasury auctions.

There is small potential risk in having foreign states holding U.S. debt. If, for example, China were to dump its U.S. debt holdings on the world market, the value of the dollar would fall and U.S. consumers would experience inflation in the price of imported goods. And that would mean that they would buy fewer Chinese-made goods as well, hurting China along with the U.S. For better or worse, the U.S. and Chinese economies are currently joined at the wallet if not the hip.

What is likely to happen with the U.S. deficit? Most U.S. states by law must balance their budgets, and so they have tried various methods to restrain spending. However, items such as sunset laws and line-item vetoes also have proved incapable of reining in spending. A line-item veto allows an executive the ability to strike only part of a bill as opposed to the whole thing. States where governors have line-item vetoes do not have budgets noticeably more in balance than do states without. Sunset laws require legislatures to reauthorize state agencies, or they go the way of the sunset. But sunset laws typically haven’t been effective at ending the lives of government agencies, which tend to find new reasons to exist once their original tasks are complete. Congress went so far as to give the president a line-item veto in 1996, but the Supreme Court invalidated it as an unconstitutional delegation of budgetary power to the executive branch. In 1985, the Gramm-Rudman Act, named for its two authors, was to pare down non-essential spending when Congress failed to balance the budget. However this was voided by the courts because it gave executive power to the Congressional Budget Office, which is simply a tool of Congress.

Rest assured that the deficit dilemma will not persist forever. American politics look like this: There’s a lot of posturing, particularly in election years, and then the problem gets serious enough that Democrats and Republicans come to some kind of compromise, so that between growth, taxes and spending restraint, the budget is balanced again. The simple answer then becomes using the resulting budget surplus to buy back and retire the debt, at least to a more manageable level. And sometimes that looks like the harder task.

KEY TAKEAWAYS

  • Nations can sustain budget deficits for a while, but not forever.
  • Too much debt raises borrowing costs for the government and leaves less money available for other things.

EXERCISE

  1. Look at the U.S. federal budget. What categories of spending would you cut? What would be the consequences of those cuts?

 

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