Government and the New Economy [d]efict reduction of this magnitude could be 'costless... Three events could offset the contraction from cutting the deficit. First, traders could buy and sell bonds at lower long-term rates...Second, the Federal Reserve could lower short-term interest rates...Third, increased foreign buying from more trade could provide a boost to the American economy. Introduction In the early 1990s the press was filled with gloom and doom stories of the economy and government finances that were out of control. The Times Square National Debt clock that had been installed in New York City just a few years ago reached $4 trillion and there was talk of an amendment to the US Constitution to force the federal government to balance its books. By the end of the decade the economy was booming and the distance between the US and its closest competitors had widened significantly leaving the US as the sole economic superpower. Talk of jobless recoveries were replaced by talk of a "New Economy" that was breaking records for months of uninterrupted economic growth without inflation and those deficits had been replaced by surpluses. In fact Fed Chair Alan Greenspan was even expressing concerns about the prospect of the government paying off all of its debt. These were the best of times with parallels being drawn between the Information Revolution of the 1990s and the Industrial Revolution of the 1890s. No one foresaw that within another decade the economy would be mired in the worst recession since the 1930s that closed a decade in which the country actually lost employment and a new competitor had surfaced to challenge US supremacy. As the US struggled to escape the Great Recession, it spread across Europe where it turned Europeans against Europeans – mostly northerners against southerners in a modern version of a civil war that threatened the euro – and it brought some countries close to bankruptcy. In the US once again there were calls for a balanced budget amendment as the debt clock actually ran out of digits as it passed the $10 trillion mark. In this unit we will examine more closely government finances, a topic of considerable debate since at least the Reagan years that is only intensifying. We begin with a look at the government’s finances, and then review the transformation of Bill Clinton from a deficit dove presidential candidate into a deficit hawk president. This is followed by the boom and bust era George Bush presided over, and an examination of Obama’s fiscal, and Bernanke’s monetary, policy responses to the Great Recession. You will find an eerie similarity between the debates of the Great Depression and we started the course with those of the Great Recession. The unit closes with a look at the financial crisis that overwhelmed much of Europe and led some countries to the verge of bankruptcy and Depression era unemployment rates. Government Finances You can tell a good deal about a person's life and his/her priorities if you had their credit card records or tax returns for a year to see how much they earned and where they spent their money, and the same is true when we look at a government's "books." The financial condition of the government, like your financial position, is summarized in income and balance sheet statements. The government’s income statement is called the budget, and for the federal government we even have a government agency devoted to keeping the books – the Office of Management and Budget) (OMB) that is the source of most of the data in this unit. We are doing this because most of what we hear in the news pertains to the federal government, 1 although you should know that it is the state and local governments where spending and taxes are rising more rapidly.i The income statement simply records the money coming in and the money going out for some specified period of time. Governments get their money from taxes and fees (Receipts) and spend on many things including roads, law enforcement, nuclear weapons, public schools, parks, and pensions (Outlays).ii Often there, however, is an imbalance in the finances. For example, I need to borrow money to buy a $600,000 house, you to pay $45,000 for a year of college, or the US government to pay $400 billion to fight a war. In each case the money coming in is less than the money going out, which we call a deficit. Somehow the money needs to be raised to finance the deficits, so in my case I get a mortgage on the house and you get a student loan that allows us to spread the payment over a number of years. For example, I would try to get a 30-year mortgage to spread the cost out over 30 years, and at a rate of 4.5% I would “own” the $600,000 house with monthly payments of about $3,000. In the case of a student loan, if you could spread the $45,000 out over 10 years at 4.5%, the monthly payment would be $466. In the case of the government, because of its size and power, it has another option for borrowing the money. Where you and I might go to the bank to finance our borrowing, the federal government issues bonds (US Treasuries) that investors buy. Below right is an image of a US Savings Bond that is an example of a bond issued by the federal government. The US federal government prints these bonds and investors all over the world buy them. This is no different from governments all over the world that run deficits and pay their bills by issuing bonds. Below left is an image of an ad poster from WW II. Today investors all over the world buy these bonds, but in WW II when the government ran HUGE deficits it ran promotional campaigns with posters such as the one below left to get Americans to buy bonds. It also helped that some goods were rationed so people had limited uses for their funds. The investors get the bonds with a promise to redeem them at a specified date in the future (6-months and 10-years are two examples) and the government gets the money to pay its bills. These bonds have a specified length indicating how long the government can spread the payments over. If you purchase a one year $1,000 government bond at 3% interest, then the government pays you interest of $300 for borrowing the money for a year and then pays you back the principal of $1,000 at the end of the year. The government could also try to borrow money for 30 years, just as I would do with a home mortgage. The advantage to the government of borrowing for shorter periods of time is the interest rate is lower – something discussed in the macro course. The disadvantage is that when the debt comes due the government will need to borrow again to pay the holder of the original debt – a problem encountered by Greece that we examine at the end of the unitiii If the income statement is a moving picture of what is earned and spent, the balance sheet is a snapshot of net worth. In my case I would add up the value of my home and car and other assets and then subtract the value of my liabilities (loan and mortgage balances) to get my net worth. When we look at the federal government we add up all of the bonds that are in the hands of investors, we have the national debt. One 2 difference between the federal and state and local governments is that most state and local governments are required by law to balance their budgets, while the federal government has no such restriction.iv Government finances and functions: How to interpret the numbers When talking about the size of government spending and taxes, you need to be careful because this is such a contentious issue there are a lot of numbers thrown around, and not all of them are that meaningful. For example, is it “crazy” for a government to spend $876 billion? Should we be worried that in 2010 the US government borrowed 26 times more than the most it borrowed in any year in WW II? The short answers are NO because these numbers are irrelevant. As for the borrowing figures, many things have changed between the 1940s and the 2010s that matter in any comparison over time. The actual numbers are not what are important; for the meal it would be the cost of the meal relative to monthly income, for the government’s spending and borrowing, you would want to make some adjustments to reflect the fact there are more people today, that prices are much higher today, and that the economy is much larger today. The adjustments exist - per capita figures for population adjustment, real figures for inflation adjustment, and outlays/GDP and receipts/GDP to adjust for the size of the economy. The impact of the alternative measures can be seen in the graphs below. The growth in government revenues and outlays during the 20th century is evident in left-side diagram. In 2010 federal government outlays were approximately $3.72 trillion – about $9,700 per person or nearly $6 million a second - and revenues were $2.16 trillion. These were by far the highest in US history, but barely visible are the surges in outlays in the late 1910s and early 1940s associated with the two world wars and the Reagan tax cuts in the early 1980s.