Macroeconomics

Dr. Karim Kobeissi

Arts, Sciences and Technology University in Lebanon

Chapter 12: Surpluses, Deficits, and Debt

Keywords: Surpluses and Deficits

A budget surplus is an excess of government revenue over

government spending (revenue > spending).

A budget deficit is a shortfall of government revenue under

government spending (spending > revenue).

Both are flow concepts [they are defined relative to a

period

of

time

(e.g.,

year

2014)].

D e b t Vs D ef i c i t
While the National Debt is a RUNNING TOTAL of all deficits minus all

surpluses, the Deficit is equal to the increases in debt from one year
to the next.

The United States has borrowed more that is has saved during its 239
years (since George Washington), so the United States owes its
citizens and foreign governments in 13 Dec 2014 about:

The US National Debt has continued to increase an average of

$2.41 Billion PER DAY since September 30, 2012! ! !

Introduction
In the short-run framework:

The view of surpluses and deficits depends on the state of

the economy relative to its possible income. If the economy

is running below its potential output, deficits are good and

surpluses are bad.
Deficits

increase expenditures, increasing output

by a multiple of that amount of expenditures.

Introduction (con)
In the long-run framework:
Surpluses are good because they provide additional

saving for an economy.

Deficits are bad because they reduce saving,
growth, and income.

Introduction (con)
Combining the long-and short-run frameworks
gives the following policy:
Whenever possible, run surpluses, or at least a
balanced budget, to help stimulate long-term
growth.
This is especially true when the economy is
booming when it is above its level of potential
income.
The argument for surpluses is weakened, and likely
reversed (a deficit is favored), when the economy
falls into a recession.

Introduction (con)
Both short- and long-term economic
frameworks would recommend cutting the
national debt.
Instead

of doing so, various governments

have looked at ways to spend the
surpluses, either by cutting taxes or by
increasing spending.

Financing the Deficit

Deficits must be financed.
The U.S. finances its deficits by issuing treasury bonds, which
are IOUs (Investor Owned Utilities) from the federal

government. These bonds are purchased by U.S. companies

and households, and foreign governments, companies, and

households. Treasury bonds are a very safe investment, which

makes them very popular.

Financing the Deficit (con)

Since the central bank's IOUs (Investor Owned
Utilities) are money, the deficit can also be paid by
printing money.

Potentially,

the central bank has an

unlimited source of funds.

Financing the Deficit (con)

However, printing too much money would
trigger inflation which can have a negative
effect on the economy.

Arbitrariness in Defining Surpluses and Deficits

Defining surpluses and deficits can be arbitrary.
Whether or not a nation has a deficit depends on what is
included as a revenue and what is included as an
expenditure (e.g., The Retirement Income system which is
based on promises to pay).
The way these programs is accounted for plays an
important role in whether there is a budget deficit or
surplus.
This

accounting issue is central to the debate about

whether we should be concerned about a deficit.

Nominal and Real Surpluses and Deficits

Another distinction that economists make when discussing
the budget deficit and surplus picture is the real/nominal
distinction:
Nominal deficit The deficit determined by looking at the
difference between expenditure and revenue. It's what
most people think of when they think of the budget deficit;
it's the value that is generally reported.
Real deficit is the nominal deficit adjusted for inflation.

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( co n )
To understand this distinction, it is important to recognize that
inflation wipes out debt (accumulated deficits less accumulated
surpluses).
For example, if inflation is 4 percent per year, the real value of all assets

denominated in dollars is declining by 4 percent each year. If you had

$100, that $100 will be worth 4 percent less at the end of the year
the equivalent of $96 without inflation. By the same reasoning, when

there's 4 percent inflation, the value of the debt is declining 4 percent

each year. If a country has a debt of $2 trillion, 4 percent inflation will
eliminate $80 billion of the real value of the debt each year.

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( co n )
The larger the debt and the larger the inflation, the more debt

will be eliminated by inflation.

For example, with 10 percent inflation and a $2 trillion debt, $200 billion
of the debt will be eliminated by inflation each year. With 10 percent

inflation and a $5 trillion debt, $500 billion of the debt would be

eliminated.

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( c o n )

If inflation is wiping out debt, and the deficit is

equal to the increases in debt from one year
to the next, inflation also affects the deficit.

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( c o n )
We can calculate the real deficit by subtracting the decrease

in the value of the government's total outstanding debts

due to inflation. Specifically:
Real Deficit = Nominal Deficit (Inflation X Total Debt)
For example, Say that the nominal deficit is $280 billion,
inflation is 4 percent, and total debt is $3 trillion.
Substituting into the formula gives us a real deficit of $160
billion [$280 billion (0.04 $3 trillion) = $280 billion

$120 billion = $160 billion].

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( c o n )

This insight into debt is directly relevant to the budget

situation in the United States.
For example, back in 1990, the nominal U.S. deficit was $221
billion, while the real deficit was $79 billion; in 2006 the
nominal deficit was $248 billion; there was 2.9 percent
inflation and a total debt of about $8.5 Trillion. That means

the real deficit was only $1 billion.

N o m i n a l a n d Re a l S u r p l u s e s a n d D ef i c i t s ( c o n )

The lowering of the real deficit by inflation is

not costless to the government:

Persistent

inflation becomes built into

expectations and causes higher interest
rates.

Passive Surpluses and Deficits

A passive (also known as cyclical) surplus or deficit is the part of the
deficit or surplus that exists because the economy is operating below
or above its potential level of output.
A passive deficit can be attributed to the weak economy. A recession
drives down government revenue because many workers and
businesses are no longer earning as much taxable income. At the

same time, government spending rises because more people need

assistance through programs such as unemployment benefits and
food stamps. The result is a temporary, or cyclical, increase in the

deficit. Once the economy recovers, tax revenue and government

spending on assistance programs should return to normal levels.

Structural Surpluses and Deficits

A structural surplus or deficit is the part of the budget deficit or surplus that
would exist even if the economy were at its potential full employment
income.

If government spending exceeds tax revenue even when the

economy is strong, then the deficit is deemed to be structural.
Unlike cyclical deficits, structural deficits reflect a chronic
problem that must be addressed through changes in tax and
spending policies.

Structural Vs Passive Deficits

Structural deficits are of greater concern than passive

(or cyclical) deficits. Economic growth can eliminate

passive deficits but not structural.
Actual Deficit = Structural deficit + Passive deficit

Structural Vs Passive Deficits (con)

The United States currently (2014) faces both a
cyclical and a structural deficit. The cyclical
deficit is caused by severe recession from which
the country is still recovering. The structural
deficit reflects a chronic mismatch between
government revenue and spending that under

current policies will dramatically worsen as

healthcare costs rise and the population ages.

The Definition of Debt and Assets

Debt is accumulated deficits minus accumulated surpluses.
Whereas deficits and surpluses are flow measures (they are defined for a
period of time), debt is a stock measure (it is defined at a point in time).
For example, say you've spent $30,000 a year for 10 years and have had annual
income of $20,000 for 10 years. So you've had a deficit of $10,000 per year
(a period of time) a flow. At the end of 10 years (a point in time), you will
have accumulated a debt of $100,000a stock. (Spending more than you
have in income means that you need to borrow the extra $10,000 per year

from someone, so in later years much of your expenditure will be for

interest on your previous debt).

Debt Management
The debt must be managed.

The U.S. government must continually refinance the bonds that are
coming due by selling new bonds, as well as sell new bonds when
running a budget deficit. This makes for a very active market in U.S.
government bonds, and the interest rate paid on government bonds
is a closely watched statistic in the economy. If the government runs a
budget surplus, it can either retire some of its previously issued
bonds by buying them back or simply not replace the previously
issued bonds when they come due.

The Need to Judge Debt Relative to Assets

Debt is a summary measure of a nations financial situation.
Unlike a deficit, which is the difference between outflows and
inflows, and hence provides both sides of the ledger (the principal
book for recording and totalling economic transactions measured in
terms of a monetary unit of account by account type, with debits and
credits in separate columns and a beginning monetary balance and
ending monetary balance for each account), debt by itself is only half

of a picture. The other half of the picture is assets.

The Need to Judge Debt Relative to Assets

For a government, assets include:

Its skilled work force.

Natural resources (crude oil, gas ..).
Its factories (civil and military).
Its housing stock.
Holdings of foreign assets.
The federal buildings and land it owns.

Financial assets held by the government (cash, reserves,

and loans).

A portion of the assets of the people in the country, since

government gets a portion of all earnings of those assets as
tax revenue.

The Need to Judge Debt Relative to Assets

To get an idea of why the addition of assets is
necessary to complete the debt picture, consider
two governments:
one has debt of $3 trillion and assets of $50 trillion;
the other has only $1 trillion in debt but only $1
trillion in assets. Which is in a better financial
position?
The government with the $3 trillion debt is, because
its debt is significantly exceeded by its assets. The
point is simple: To judge a country's debt (or a
person), we must view its debt in relation to all its
assets.

The Need to Judge Debt Relative to Assets

This need to judge debt relative to assets adds an

important caution to the long-run position that

government budget deficits are bad:

When the government runs a deficit, it might be spending

on projects that increase its assets. If the assets are

valued at more than their costs, then the deficit is

making the society wealthier. Government investment
can be as productive as private investment or even
more productive.

Subjectiveness in Defining Debt and Assets

Defining debt and assets can be subjective.
As was the case with income, revenues, and
deficits, there is no perfect answer as to how
assets and debt should be valued.
Even after assets are taken into account, you

still have to be careful when deciding whether

or not to be concerned about debt.

Subjectiveness in Defining Debt and Assets

The total stock of gross debt can be broken down
into (1) market debt and (2) non-market debt.
Market

debt includes any tradable financial asset of any

kind (e.g., banknotes, bonds, common stocks, and swaps).

Non-market

debt includes federal public sector pension

liabilities and other federal liabilities (e.g., social security

and retirement pensions).

Subjectiveness in Defining Debt and Assets

To calculate debt, we add market debt and nonmarket debt, and subtract the value of
financial assets held by the government, such
as cash, reserves, and loans.

Government Deficits and Debt: The Historical Record

Most economists do not look at absolute figures of deficits
and debt. They prefer the relative to GDP measurement:
debt/GDP % ratio because it better measures the

governments ability to handle the deficit and pay off the

debt.

The

ability to pay off a debt depends on a

nations productive capacity, the asset
side of the equation.

Debt Relative to Other Countries

Lebanon has a relatively large debt compared to
other underdeveloped economies.
There is a structural deficit in Lebanon even at
full employment, spending exceeded revenue.

The Debt Burden

When GDP grows, the debt the government
can reasonable handle also grows.

The

economy becomes richer, and,

being richer, it can handle more debt.

The Debt Burden

If the real growth of the GDP in a country (e.g.,
Lebanon) is about X % this year.
This

means that the debt of the Lebanese

government can grow this year at the same
rate (X %) without increasing the debt/GDP
ratio.

Interest Rates and Debt Burden

Besides the debt relative to GDP figures, economists
are concerned about the interest rate paid on the
debt because interest rates affect debt burden.

How much of a burden a given amount of debt

imposes depends on the interest rate that must be

paid on that debt.

Interest Rates and Debt Burden

The interest rate determines annual debt
service.
debt service the interest rate
on debt times the total debt.

Annual

Interest Rates and Debt Burden

Ultimately, the interest payments are the
burden of the debt.
That

is what people mean when they

say a deficit is burdening future
generations.

The Modern Debate About the Surplus

The modern debate about the government
budget concerns what to do with the surplus
(e.g., in China, in Germany).

Why Did the Surpluses Come About?

Keynesian economics made clear that deficits
could serve a positive function when the
economy was below its potential.
This view was never fully accepted by
politicians, nor by the public.

Why Did the Surpluses Come About?

The 1980s saw a change in the political view.

Politicians

were pushing the economy

toward deficits by cutting taxes, and
expanding the deficits.

Why Did the Surpluses Come About?

In the 1990s, the federal government realized
it increased its spending to the point it was
running a structural deficit.

Even

if the economy were operating at

the potential output, the budget would
be in deficit.

Why Did the Surpluses Come About?

In response, the authorities raised
taxes, cut many social programs and

redesigned existing programs.

Why Did the Surpluses Come About?

The surpluses of the late 1990s were brought
about by the unexpected growth of the economy
and a low and stable rate of inflation.
Interest

rates

stayed

low,

holding

down

government interest payments.

Expected tax revenue also increased, and deficit
predictions moved in the opposite direction, to
surplus predictions.

Federal Deficit and Debt Are Only Part of the Picture

States and local municipalities also run deficits by
borrowing to spend in excess of their revenues, and
thereby raise the total amount of government debt

(Federal debt+ states debt + local municipalities

debt ) in the economy.

Net Debt: Federal, Provincial and

Local, Fig. 12-4a, p 298
700000
600000
500000

Federal Net Debt

Provincial Net Debt
Local Net Debt

400000
300000
200000
100000
0
1977

1980

1983

1986

1989

1992

1995

1998

2001

Net Debt: Federal, Provincial and Local

20000
10000
0

10

11

12

13

-10000
-20000

Federal Deficit

-30000

Provincial and Local

Deficit

-40000
-50000

A Different Type of Crowding Out

High government deficits require more and
more borrowing, reducing the capital available
to government and private enterprise.
Interests

rates increase as a result, and this

means that borrowing is more expensive for
firms who wish to fund expansion by issuing
debt (such as bonds).

A Different Type of Crowding Out

Private sector investment is crowded out
higher levels of government spending raise
interest rates, which in turn reduce the level
of private investment.

A Different Type of Crowding Out

Increase in government spending increases
interest rates, and increase the value of
domestic currency.
When

domestic currency gains value,

exports decrease, and imports rise.

Is the Deficit a Good Measure of the Stance of Fiscal

Policy?
Can we use deficit to find out if fiscal policies are
becoming more or less expansionary the

??

stance of fiscal policy

The answer is NO. Deficit can change as a result

of a shift in an autonomous component of
demand.

Is the Deficit a Good Measure of the Stance of

Fiscal Policy?
If autonomous spending (investment, for example)

decreased, deficit would rise because income would

fall and reduce tax revenues.
This

deficit

increase

was

not

result

of

expansionary fiscal policy.

A better measure of the stance of fiscal policy is
the structural deficit.