Lesson 8 Macroeonomic Policy: Out Of Bullets?


It is one thing for a government to have a temporary government deficit. A temporary deficit might arise and peak within a couple of years – and then go away. It might have large impacts, but if the source of the impacts stops, then the impacts should diminish over time. It is another thing for a government to have sustained or persistent deficits. In this case we have to deal with other complications that might arise. Maybe this analogy will help.

If you drink one can of pop now and then, you know that the caffeine or sugar might have impacts on your system. But the impacts come and go. If instead, you had a can of pop several times a day for many years in a row, then the sugar and caffeine in your system may build up – they might accumulate enough over time so as to cause damage to some of your organs.

With that pleasant thought we move forward to discuss the impacts of persistent deficits and accumulating government debt.

We can see why fiscal policy can have these enduring effects if we concentrate on debt and investment spending – two key variables that link the long-run future to the present. Let’s start with debt. Finance teaches us that debt isn’t bad. The concept of leverage suggests that any person or company can be advantaged by judicious borrowing. Judicious generally means a couple of things:

  • First, you don’t borrow more than you can pay back.
  • Second it usually means that you borrow for purposes that will help you increase your ability to pay back.

That’s why people often borrow money for schooling and training – and why companies borrow to buy better plant and equipment. Borrowing creates problems, however, when it does not meet those conditions and you find that you cannot repay the lender.

A bank won’t lend money to a company unless its project proposal convinces the bank they will be repaid. People do not lend their money to governments if they think the government is wasting their money and/or they think they will not be paid back. Whether or not that is the case depends on many factors (see for an interesting discussion of these issues.):

  • The type of expenditures financed with the debt issued by the government under consideration. Governments financing transfer payments by issuing debt are in a more critical situation than governments financing infrastructure investments that raise the production capacity of their countries.
  • The long-term growth prospects of the economy. Fast rising countries can afford higher debt levels than slow-growing countries. This includes a consideration of demographics. Countries with declining or ageing populations face a decline of their working forces and, hence, a decline in their productive capacities.
  • The scope for generating new government revenues. This includes a look at the tax burden. Countries with large tax burdens usually find it harder to raise additional tax revenues than countries with low tax burdens.
  • The scope for cutting expenditures.
  • The currency in which the debt was issued. Foreign currency debt is more risky for governments, because its value is subject to exchange rate risk and the government cannot print money to pay its lenders.
  • Political constraints. Weak governments may not have the political power to pass the legislation necessary to cut expenditures or raise taxes.

A government’s debt is called sustainable if the government can be reasonably expected to be able to service its debt in the future, that is, if its future revenues are sufficient to pay interest and repay its lenders. We usually look at the size of the national debt relative to the size of the economy – as measured by GDP. Judging the sustainability of the debt of a given government is a complex and difficult task and, therefore, subject to much discussion and disagreement. See the above link for a discussion. History suggests a a guideline of 25% – 40% for emerging market economies — that is, until a country’s nominal national debt exceeds those levels, we usually consider the country as a reasonable financial risk. But there are countries that have defaulted on debt at lower ratios, while others have fared well with higher ratios. For mature industrialized economies, history suggests a ratio of 60% to 75% as compatible with sustainability. When a country’s public debt exceeds the level compatible with sustainability, it often has to pay a risk premium on their debt to wary investors. This higher interest premium means higher outlays on interest, a higher deficit, and even higher debt. This risk premium typically also affects the interest international investors charge on corporate debt issued by firms in the same country. Therefore, business leaders typically dislike excessive levels of government debt.  

Problems with national debt bring up the issue of solvency. An insolvent government cannot readily meet its obligations. An insolvent government needs to reduce spending and raise tax revenues – but the internal politics and economics are such that it cannot. One way to resolve the problem is to ask for emergency loans from other countries (or world organizations like the International Monetary Fund or World Bank). If such aid cannot be obtained, governments may try to use the money printing press to reduce the value of their debts. Thus, most hyperinflations in history (situations of extremely high rates of inflation) have been caused by overborrowing and insolvent governments (For a historical review see Thayer Watkins, Solvency crises can cause severe economic crises and disruptions in the financial system, as the recent Argentine debt crisis has shown, see Finally, such crises often lead to changes in government in elections or revolutions that removes the government from office.

Thus, solvency can be a very serious matter and most countries do not want to get into such an extreme situation. In the U.S. there is little concern about solvency in the near future, but some experts are beginning to question how the U.S. will get through its baby-boom crisis. A very conservative estimate of the unfunded liability of the U.S. social security system for the next 75 years is about $3.5 trillion (2003 Trustees Report). Another way to see the size of the problem is that the same report estimates that the payroll tax rate would have to immediately rise from 12.4% to 19.07% of payroll if current law was unchanged. Of course these estimates do not consider the health care system and various other uncertainties about the future. These numbers are serious for even a rich country like the U.S. and both political parties seem interested in finding solutions. Of course, progress is impeded by the usual philosophical positions and other differences of opinions.

The second important connection between the present and the future is investment spending. Recall that what macroeconomics calls investment includes many purchases that are keys to a country’s increase in business productivity – purchases of:

  • new tools
  • equipment
  • plant, etc.

A country with persistent and strong investment has a bigger and better stock of capital for the future. This stock depreciates each year, but if the investment is strong enough, it not only replaces the depreciated amounts but it adds enough to empower workers to be able to produce more.

So investment is very important. What do government deficits and debt have to do with a nation’s investment?

The answer is that companies generally borrow to finance their investment purchases.

So the nation’s saving is a very important source of investment because it is the nation’s savings that ends up in banks (and other financial institutions) and capital markets. A nation’s internal saving comes from three main sources: households, retained earnings of business, and from government.

When a government has a deficit it is not saving – it is dis-saving. That means it is reducing the amount of a nation’s saving available to firms that want to invest. Recall that governments with deficits must sell bonds to the public – they are trying to borrow from the same public that the firms are borrowing from. So governments with deficits are competing with private firms for the nation’s saving. This not only leaves less for the firms but this capital market competition also tends to drive up interest rates. Either way, the end result is that government deficits crowd out private investment spending. Governments with persistent deficits can have a large cumulative impact on the nation’s capital stock over a period of years. This means the country’s capital is not as large or as new or as productive as it might have been.

Thus we say that government deficits can reduce national growth and lead to a lower standard of living than might have been attainable.

International Applications – deficits and debt

We learned in the late 1990s that government deficits do not always appear to harm investment spending. In fact, we learned that sometimes the international scene can create the opposite – it appeared that a lack of domestic saving was associated with a reduction in the government’s deficit and lower interest rates. How could that happen? The story is very international. The answer is that the U.S. economy was enjoying a surge of growth in the late 1990s despite very low national saving. A surge in productivity in information technology seemed to be spilling over into the whole economy. Foreigners saw this as a chance for good financial returns and they invested in record amounts in U.S. companies and various financial assets. Once this foreign money came into U.S. financial institutions, it became largely indistinguishable from domestic savings. Interest rates remained low and investment soared despite the lack of domestic savings.

As a result, the economy grew very rapidly, tax revenues swelled, and the government enjoyed the first surpluses in many years.

International considerations cushioned or prevented the impact of low national savings on investment. But this plus was not without an offset. A side effect of all this activity was its impact on the value of the dollar. Before foreigners can buy U.S. financial assets they have to convert their currencies into dollars. During the late 1990s there was, therefore, a very large demand for dollars on world currency markets. This increased demand for dollars caused the value of the dollar to rise. More will be said about this in the note on exchange rates – but one impact of this rising dollar was on trade in goods and services. A rising dollar value meant that U.S. goods became expensive relative to foreign goods. As a result, U.S. exports were negatively impacted relative to imports and the U.S. trade deficit swelled. This impact of a rising dollar was not a new phenomenon. It occurred back in the early 1980s as well and was dubbed the problem of twin deficits. This terminology emphasizes that government deficits can cause trade deficits. As we will point out more in the note on trade, persistent trade deficits can also be a problem for many countries.  In both cases – the early 1980s and late 1990s – the issue was one of domestic saving being insufficient for domestic investment. In the late 1990s the insufficiency was caused in part by rapidly growing investment. In the early 1980s the culprit was more the result of low national savings caused by government deficits.

The U.S. and other countries can learn important lessons from the late 1990s.

  • First, foreign savings are mobile.
  • Second, for a country with stable or strong economic growth, these international financial inflows can offset a lack of domestic savings.
  • Third, these flows can disappear as fast as they came.

Low domestic saving will not always be offset by foreign money. While the U.S. was greatly helped by inflows of foreign money in the late 1990s, they should not take them for granted. Of course, as the trade deficit illustrates, not all parts of the U.S. economy were improved by the foreign inflows of saving. It is better not to let persistent government deficits make a country overly reliant on foreign savers. Strong domestic saving is important to a nation’s long-term health. Persistent government deficits are not consistent with strong long-term saving.

At this point someone who reads the note on AD usually says, “But if we save more won’t we spend less? If we spend less, then won’t aggregate demand be too low?” The answer to that good question is that anything can be overdone or underdone. Every country has an “optimal” spending/saving ratio for a given time period. For the U.S., most people agree that we save too little relative to this optimal amount. For Japan and Germany, some people believe they save too much. In the case of the U.S., a smaller government deficit and more national saving could have a short-term negative effect on some parts of AD but the positive impact on investment and net exports would more than compensate. For Japan and Germany, they could benefit greatly from more household spending. The belief is that the longer term harm to investment and trade deficits would be minimal.

The EU felt very strongly about the risk of unsustainable public debt in one of the member states of the European Monetary Union. When the monetary union was devised in the late 1980s, people in the countries with relatively low levels of debt were worried that other countries might run into fiscal troubles which might eventually undermine the stability of the new, common currency, the euro. As a result, the Maastricht Treaty, which was signed in 1992 and establishes the monetary union and the procedures for countries to become members of it, set a limit of 60% debt relative to GDP as a condition for countries to enter the European Monetary Union. The logic behind the 60% was simple enough, it just happened to be the European average in the early 1990s. They also agreed to keep their government deficits to no more than 3% of GDP. In 1998, however, when the countries to form the monetary union were determined, too many countries exceeded the 60% limit including Germany which, as the economic center of the EU, could be excluded from the monetary union. As a result, the debt limit was discarded and the deficit limit was moved to the forefront, allowing 11 countries to adopt the euro..

In the late 1990s, the EU countries also agreed on the “Stability and Growth Pact”. This Pact commits the member states to keep their budgets “close to balance or in surplus” in the medium run and effectively makes zero-deficits the target of fiscal policy. However, many governments proved unwilling or unable to abide by the rules of the Pact. In practice, the focus on numerical limits has induced governments to play tricks with accounting concepts and practices and hide deficits from the public view, an experience which is not unlike that of states in the US whose governments are subject to numerical fiscal constraints. The 2005 “reform” of the Stability and Growth Pact has made the agreement more flexible by introducing many excuses governments can take for running large deficits.

Developing countries also have to grapple with deficits and debt. Developing countries are generally poorer countries that are trying to improve their standard of living through a whole set of new policies. In some cases they are moving from very poorly run economic systems and are trying to impose market-oriented reforms in places that have had little experience with capitalism and competition.

In terms of spending and production, this often means that the government must become a smaller part of the national economy while at the same time it has to find ways to raise revenues.

These kinds of marked changes take time and often the government in a developing country finds itself with too little tax revenue and large deficits. Their reform plans are aimed at reducing these deficits and debt burdens over time. But they know it will take time. The world’s investors watch these countries as they face these challenges. The ones that appear to be succeeding are the ones that receive strong inflows of much-needed capital investment from abroad. The ones that appear to be floundering find that world capital is less interested in them, and sometimes what capital they do have can leave in a hurry. Recent history is full of financial crises of this type including lately in Mexico, Russia, Turkey, Thailand, Brazil, and Argentina.

A view of government budget deficits internationally as of 2011 may be found here: Some numbers of note: Countries with the largest government budget deficits were USA, Ireland, Japan, New Zealand, Greece, and UK. Several countries had surpluses – Norway, Hungary, Korea, Sweden and Switzerland. Ireland’s deficit in 2010 was more than 32% of GDP. It came down to 10.1% in 2011.  OECD forecasted improvements in 2012 for most countries with the exception of Hungary and Estonia.

Fiscal Policy and Stagflation

Issues with solvency and investment make it clear why countries do not want persistent government deficits. Another reason is stagflation. In the Note on Monetary Policy we discussed how an overly aggressive monetary policy can lead to stagflation. The reasoning applies to fiscal policy and is even more important – because persistent fiscal deficits are often the reason that monetary policies are so loose.

Why would a fiscal deficit cause monetary policy to be too stimulatory?

Recall that a fiscal deficit means that the government competes with companies for a given amount of national saving. This competition can raise interest rates.

Recall also that the central bank does not like it when interest rates rise and threaten to reduce investment and economic expansions.

The central bank may want to prevent interest rates from rising. How do they do that? By open market purchases that end up injecting more money into the system.

So fiscal deficits can actually put pressure on the central bank to increase the money supply. Of course when the central bank is not independent, the process can be more direct. In that case the government simply “prints money” to meet its fiscal needs. Economists called this process the “monetization of fiscal deficits.” Notice that this can happen whether or not the central bank is independent.

But this is not the only reason that government deficits stimulate the AD.

Recall that a deficit itself, because of the changes in spending or taxes, directly impacts the AD curve.

As we explained in the Note on Monetary Policy,  if AD shifts too far and causes output to above potential, then this can lead to:

  • higher inflation
  • inflationa expectations
  • higher wage demands
  • increases in business costs
  • and a time period of even more inflation coupled with economic slowdown.

Persistent government deficits in the 1960s and 70s were believed to have caused stagflation in the U.S. Policymakers around the world learned from these lessons and generally try to prevent the repeat of these kinds of stagflation episodes in their own countries. Anti-stagflation policies were quite evident in several time periods in the U.S. including the end of the 1970s, the end of the 1980s, and the end of the 1990s. In each of these episodes, the Fed and/or the government became concerned with strong growth and high inflation and used policy to try to slow down the growth of aggregate demand – slow it down before inflation and inflation expectations rose too much. The Fed appeared to be starting a similar process in 2004. It was still at it as of late 2006.

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Industry Application
That leaves a lot of planners with plenty of uncertainty about fiscal policy and AD. Fiscal policies can have very significant short- and long-run impacts. It behooves us to know more about future fiscal policies. This note defines some of the vocabulary and theories that one needs to be familiar with as they start to learn more about this topic.

  • Fiscal policy impacts the business environment in many ways.
  • Many companies directly or indirectly sell their goods to the government.
  • A large government spending cutback could immediately affect firms as diverse as Boeing and Staples.
  • Construction companies and aggregates producers also have a lot at stake when the roads and highways budgets are altered.
  • Governments also employ a lot of people. When governments have significant spending cutbacks they might discharge office workers, researchers, analysts, teachers, and prison guards.
  • When transfer payments are reduced companies that provide goods to poor and the elderly may quickly feel these changes.
  • Of course, increases in taxes, depending on which taxes are raised could impact anyone anywhere at any income level.
    • Taxes that disproportionately affect people with higher incomes might have their largest impacts on saving rather than spending.
    • Therefore taxes on higher incomes might affect people in banks and other financial intermediaries.
    • If higher tax rates reduce national saving then cost of capital could increase and impact investment. Producers of new plan and equipment could feel the impact.

It is wrong, therefore, to try and single-out any particular firm or industry. All consumers and firms can be impacted by fiscal policies. Since there are so many ways governments can impact us, we do our best to keep track of the latest policy debates and try to determine who and when they will be impacted. It isn’t an easy task but it isn’t enough to be fed-watchers — most planners need to be government-watchers too.