Lecture Thirty Two
Effects of the Deficit
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
April 26, 1996
Short Run Effects
Long Run Effects
Very Long Run Effects
Static Supply Side Effects
Short Run Effects
First, short-term closed-economy Keynesian (if not offset by monetary
policy); IS-LM; stimulus--but we think that effects of everything not
automatic stabilizers are offset by monetary policy in the
context of today's Federal Reserve.
Long Run Effects
Second, closed-economy long-run (chapter 3): investment down,
government spending and consumption up...
Third, small open-economy long-run (chapter 7): borrowing from abroad
up; trade deficit; investment stays high; loss of institutional
capital in traded-goods industries; growing gap between GDP and GNP.
- Large open economy case: investment down some; trade deficit
up some (with loss of inst. K and growing gap between GDP and
Fourth, very long run. Solow growth model, national savings and
investment share down; steady-state capital-output ratio down. A less
capital intensive economy... A lower level of consumption and output
in the long run...
Supply-Side Effects of a Large National Debt
A drag on U.S. productivity through higher tax rates... 60% of GDP x
2.5% real interest rate means that 1.5% of U.S. real GDP is taxed
just to be transferred.
What does it mean that the federal government has to collect an extra
1.5% of GDP in taxes--has to raise taxes from, say, 20% of GDP
(needed to pay for government programs) to 21.5% of GDP?
- Net of tax rate down from, say, 60%; to 58.5%--a fall of
- Return on investment down by perhaps 1/40; return on labor
income down by perhaps 1/40; do people invest more (and consume
less) to reach their target rate of accumulation? Do people invest
less because of the lower rate of return? Do people work less
because of the lower real wage? Do people work more because more
hours of work are needed to meet their target income?
- We don't know. But the fact that we don't know means that such
effects are relatively small, in all likelihood.
- Say, an elasticity of labor and capital supply of -0.5--would
mean that we are now poorer by about 0.75% of GDP as a result of
the fact that we have a large accumulated national debt to service
than if we were, say, debt-free.
- In one sense, it is as if we had an unemployment rate 0.75%
higher forever; in another sense not--distributional impact is
very, very different
(a) I'm not sure why this section is in the book (maybe because
Robert Barro, its major exponent, is down the hall from Greg Mankiw).
Barro seems to think that a tax cut (unaccompanied by a spending cut)
would lead to an increase in savings because people would say
"Hmmm... Look at all this spending. At some point they are going to
have to tax to pay for it.... I had better save more", and thus that
national savings should be invariant to the government budget
deficit because private savings rises when the government deficit
There are a lot of holes in this argument:
- Who gets taxed to pay for accumulated debt?--not me who
benefits from the expanded deficit; shift in wealth from future to
- How do they get taxed?--incidence, inflation tax, and so forth
("Hmm. I'd better save less, because when the government inflates
to run down the real value of the debt my assets will fall in
value). International tax issues--I'll move my money abroad until
the value of the debt falls.
- What do you mean by "saving"--buying a refrigerator with free
cash is, in a sense, "saving", but so is going to Maui...//when my
wife and I went to Russia, China, and Japan the three years before
our first kid was born, we were "saving" in some sense, but not in
the macroeconomically-relevant sense...
- "Dynasties:" "everything" neutral?
(b) I've seen a lot of Barro on this topic:
- In 1983, claiming that the Reagan tax cuts would not
lead to a long-run structural deficit.
- In 1985, claiming that although the Reagan tax cuts had led to
a long-run structural deficit, they would not produce a persistent
fall in national savings (because private savings would rise).
- In 1987, claiming that even though the Reagan tax cuts had led
to a long-run structural deficit, and that even though they had
been associated with a persistent fall in national savings, the
real cause of low savings was the booming stock market--which
meant that people's wealth had been growing rapidly, hence they
had cut back on their savings out of the flow of income--and that
when the stock market stopped booming we would see private savings
- Never mind that private savings had not risen in the 1970s,
when the stock market had crashed
- In 1989, claiming that the U.S. experience was
anomalous, that other episodes--like savings in Israel
during the Israeli hyperinflation--bore him out (never mind that a
lot of other macroeconomic things were going on during that
hyperinflation), and that the U.S. experience was unlikely to
continue to be anomalous.
- In 1991--but then Barro seemed uninterested in talking about
deficits, and only interested in talking about long-run economic
So what I want to ask Greg is: "How many strikes does Barro get
before you declare him 'out', and pull section 16.2 from the