Fiscal Macroeconomics in 2011. Debts and Deficits. Last time: Conceptual issues of debts and deficits Deficits and slower growth of potential Y in the closed economy Deficits and foreign borrowing and lower Y in the open economy Today: Economics of an internal debt
Fiscal Macroeconomics in 2011
Assume that we “owe the debt to ourselves”
Empirical estimates: 20 – 40 cents of DWL per $ of taxes from higher tax rates
= incremental DWL of higher taxes
~ increase revenues
Economics of External Debts
“Political incentives for additional borrowing could change quickly if financial markets began to penalize the United States for failing to put its fiscal house in order.
If investors become less certain of full repayment or believe that the country is pursuing an inflationary course that would allow it to repay the debt with devalued dollars, they could begin to charge a “risk premium” on U.S. Treasury securities. That could happen suddenly in a confidence crisis and ensuing financial shock.
There is precedent for a financial disruption first contributing to large, chronic deficits and then in some cases contributing to the loss of investor confidence and even to a default on a nation’s debt.
[However,] the unique position of the United States—because of its economic dominance and the dominant role of the dollar internationally—make it difficult to extrapolate from the experience of other nations in estimating the risk or timing of a financial crisis arising from failure to address the projected U.S. fiscal imbalance.
[National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009]
“When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.”
[Erskine Bowles, Chair, President’s Commission]
* BTW: This is completely wrong analytically.
Problem arises because have an unstable equilibrium where country’s liquid liabilities >> its liquid assets.
A higher debt → higher probability of default (π)→ higher r → requires more budget cuts and less likely to pay → higher π → eventually the country decides to default or restructure.
Greece β=1.4. If markets put π =5%, primary surplus ratio must be 7% of GDP. If Greeks start revolting, π =10%, then required surplus goes to 14% of GDP. So have a good and bad equilibrium like bank runs.
Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts
Rising risk premium and interest burden
Default as function of interest rate
Zero profit line for investors
π = probability of default.
R = (1+r) = interest factor
T = taxes
A = stable equilibrium
B = unstable equilibrium
Stable dynamics; good
EZ interest rates
European interest rates
UK and Spain have virtually identical fiscal positions. Why is Spain in trouble and UK not?
The two faces of saving and the deficit dilemma
1. In short run:
2. In long-run, neoclassical growth model
Dilemma of the deficit: Should we raise G today or lower G?
Impact of fiscal stimulus
Real output (Y)
Compare (1) a deficit spending program to reach full employment with
(2) a balanced budget program
This numerical example combines our AS-AD and Solow models:
- Potential output from AF[K,(1-u*) LF], closed economy
- Actual output from calibrated Mankiw AS-AD
- Assumes closed economy (but not essential)
These are “plausible” simulations but not projections or forecasts.
Have higher debt-GDP ratio for long time
Slower growth in potential with stimulus, but it doesn’t make up the difference.
Conclusions on Debt and Deficits