Government Debt - Harvard University

1 Government DebtDouglas W. ElmendorfFederal Reserve BoardN. Gregory MankiwHarvard University and NBERJ anuary 1998 This paper was prepared for the Handbook of Macroeconomics. We are gratefulto Michael Dotsey, Richard Johnson, David Wilcox, and Michael Woodford forhelpful comments. The views expressed in this paper are our own and notnecessarily those of any institution with which we are paper surveys the literature on the macroeconomic effects of governmentdebt. It begins by discussing the data on debt and deficits, including thehistorical time series, measurement issues, and projections of future fiscalpolicy. The paper then presents the conventional theory of Government debt ,which emphasizes aggregate demand in the short run and crowding out in thelong run.

2 It next examines the theoretical and empirical debate over thetheory of debt neutrality called Ricardian equivalence. Finally, the paperconsiders the various normative perspectives about how the Government shoulduse its ability to Nos. E6, H61 IntroductionAn important economic issue facing policymakers during the last twodecades of the twentieth century has been the effects of Government debt . Thereason is a simple one: The debt of the federal Government rose from 26percent of GDP in 1980 to 50 percent of GDP in 1997. Many European countriesexhibited a similar pattern during this period. In the past, such largeincreases in Government debt occurred only during wars or depressions. Recently, however, policymakers have had no ready episode raises a classic question: How does Government debt affectthe economy?

3 That is the question that we take up in this paper. It will notsurprise the reader to learn that macroeconomists are divided on the answer. Nonetheless, the debates over Government debt are fascinating and useful tostudy. They are fascinating because they raise many fundamental questionsabout economic behavior. They are useful to study because learning thesources of disagreement can help an impartial observer reach a judgment of survey of the effects of Government debt is organized as follows. Section I considers some of the data on Government debt . These data give somesense of the history of Government debt in the United State and elsewhere. This section also discusses some recent projections for the beginning of thetwenty-first II then examines the conventional view of the effects ofgovernment debt .

4 We call this view "conventional" because it is held by mosteconomists and almost all policymakers. According to this view, the issuanceof Government debt stimulates aggregate demand and economic growth in theshort run but crowds out capital and reduces national income in the long III turns to an alternative view of Government debt , calledRicardian equivalence. According to this view, the choice between debt and 1We take GNP data from Berry (1978, table 1B) for 1791 to 1868, fromRomer (1989) for 1869 to 1928, and from the National Income and ProductAccounts since 1929. The end-of-year debt comes from Bureau of the Census(1975, series Y493) for 1791 to 1939, from Congressional Budget Office (1993,table A-2) for 1940 to 1961, and from CBO (1997a, table F-4) since 1962.

5 Wesplice the series multiplicatively at the break points and convert debt fromfiscal-year to calendar-year finance of Government expenditure is irrelevant. This section discussesthe basis of this idea, its history and importance, and the debate over IV moves from positive to normative analysis. It considersvarious perspectives on the question of how the Government should use itsability to borrow. The discussion highlights the potential significance ofcountercyclical fiscal policy, optimal national saving, and intertemporal taxsmoothing. I. The DataIn this section we present some basic facts about Government debt anddeficits in the United States and other countries. We give the official data,and then examine a number of issues regarding the appropriate measurement offiscal policy.

6 We conclude the section by considering projections of futurefiscal policy in a number of debt and Deficits in the United States and Other CountriesWe begin with data from the United States. Panel A of Figure 1 federal debt as a percentage of gross national product over the past It is common to exclude the debt of state and local governments, aswe do, although for many purposes it is more appropriate to consider theconsolidated debt of all levels of Government . Most state governments holdpositive net assets, because they are prohibited from running deficits intheir operating budgets, and because the assets they accumulate to fund 2 The budget surplus comes from Bureau of the Census (1975, series Y337)for 1791 to 1928, from Bureau of the Census (1975, series Y341) for 1929 to1961, and from CBO (1997a, table F-4) since 1962.

7 We convert these numbersfrom a fiscal-year basis to a calendar-year basis. Note that the deficit doesnot equal the annual change in federal debt . Roughly speaking, the change indebt reflects the Government 's cash outlays and receipts, while the unifieddeficit involves a limited amount of capital budgeting. We return to thisissue pensions exceed the debt they issue to finance capital projects. Thefigure shows federal debt "held by the public," which includes debt held bythe Federal Reserve System but excludes debt held by other parts of thefederal Government , such as the Social Security trust primary cause of increases in the debt -output ratio has beenwars: The War of 1812, the Civil War, World War I, and World War II allproduced noticeable upswings in federal indebtedness.

8 The Great Depressionand the 1980s are only two peacetime intervals when this ratio increasedsignificantly. Between these sharp increases, the debt -output ratio hasgenerally declined fairly steadily. An important factor behind the dramaticdrop between 1945 and 1975 is that the growth rate of GNP exceeded theinterest rate on Government debt for most of that period. Under suchcircumstances, the Government can collect taxes equal to only its non-interestspending, finance the interest payments on the outstanding debt by issuingmore debt , and still watch its debt grow more slowly than the economy. Thissituation has potentially important implications for the effect of governmentdebt, as we discuss later. Panel B of Figure 1 shows the federal budget deficit as a share ofGNP over the past 200 These deficit numbers are for the so-called"unified budget," which includes both "on-budget" items like national defenseand "off-budget" items like Social Security, thus capturing essentially all ofthe fiscal activities of the federal Government .

9 Once again, the effect ofwars is quite apparent. The small deficits between 1955 and 1975 wereconsistent with a declining debt -output ratio for the reason just mentioned:4 Although the debt was growing, output was growing faster. After 1975, largerdeficits and a less favorable relationship between the interest rate and thegrowth rate caused the debt -output ratio to debt and deficits in other industrialized countries span awide range, as shown in Table 1. The first column presents general governmentnet financial liabilities as a percentage of GDP. This measure differs inseveral respects from that shown in panel A of Figure 1: It includes alllevels of Government , nets out financial assets where the data are available,and normalizes by GDP rather than GNP.

10 Nevertheless, the value for 1996matches the last point shown the figure. The second and third columns showthe budget surplus and primary budget surplus as percentages of GDP. Theprimary surplus equals taxes less all non-interest spending. The highestreported debt -income ratios are in Italy and Belgium; their high debt servicepayments induce substantial budget deficits despite primary budget Measurement IssuesThe official data on federal Government debt and deficits obscure anumber of interesting and important issues in assessing fiscal policy. We nowdiscuss some of these measurement Adjusting for Economic ConditionsOfficial data on debt and deficits are often adjusted to reflect threeeconomic variables: the price level, interest rates, and the business cycle.