Video Transcript: Lesson 32

Okay, continuing along with Unit 11, let's discuss why governments run deficits.  It is evident during periods of war the debt is higher, right? So, what underlies  this relationship between wars and deficits? War is certainly expensive. Take, for example the conflicts in Iraq and Afghanistan. Congress has already  appropriated about a trillion dollars for these wars, and the Congressional  Budget Office study projected the conflicts would eventually cost the United  States about 2.4 trillion. When the government purchases increase due to a war, a government can either increase taxes to pay for the war or issue government  debt. Remember that when the government runs a deficit to pay for a war, it is  borrowing from the general public. The government's intertemporal budget  constraint reminds us that since government debt is ultimately paid for by taxes  in the future, the choice is really between taxing households now or taxing them  later. History tells us that deficits have been the method of choice. Governments have chosen to tax future generations to pay for current wars. There are two  arguments in favor of this policy: right, fairness. Number one, any gains from  winning a war will be shared by future generations. Hence, the cost should be  shared as well. The government should finance the war with debt so that the  future generations will repay some of the obligations. To take an extreme case,  suppose a country is fighting for its right to exist. If it wins the war, future  generations will also benefit. Number two, tax smoothing. A good fiscal policy is  one where tax rates are relatively constant in the face of a rapid increasing in  spending. Each, such as a war, the best policy is one that pays for the spending  increase over many periods of time, not just in one year. So taxation is  expensive to the economy because it distorts economic decision decisions such  as saving and labor supply. The amount people want to work depends on their  real wage after taxes. So if tax rates are increased to finance government  spending, this reduce reduces the benefit from working. Put differently, increase  income taxes increase the price of consumption relative to leisure. So the higher the taxes, the price of consumption is higher because taxes are up and leisure  will be less expensive, and I'll be willing to spend my time in leisure versus  consumption because the taxes are higher. The fact that people work less when  taxes increase is a distortionary effect of taxation. Instead of bunching all of this  distortionary taxation into a short amount of time, such as a year, it is more  efficient for the government to spread the taxation over many years. This is  called tax smoothing. So, by running a budget deficit, the government imposes  relatively small distortions over many years, rather than imposing a large  distortion over a single year. So, they want to spread out that obligation, pay it  back over time, and make it less expensive year over year, even though it may  be paid back in a longer period of time, 30 to 50 years. Similar arguments apply  to other cases in which governments engage in substantial spending. Imagine  that the government is considering putting a large amount of resources into  cancer research. The discovery of a successful cancer treatment would, of 

course, benefit many citizens in that generation. Because households would  share the gains in the future, the cost should be shared as well. By running a  deficit, the government is able to distribute the costs across generations of  citizens in parallel with the benefits from the perspective of both fairness and  efficiency, there are some gains to deficit spending. Now, more generally, we  might want to make a distinction among different types of government  purchases, just as we do among private purchases. We know that the national  accounts distinguish consumption purchases. Speaking broadly here, things  from which we get short-run benefits such as food or movies, etc. From  investment purchases, things that bring long-term benefits such as factories and machinery. So we have to make a decision on what are we spending this money on, and how will the effects be felt most broadly and efficiently. Likewise, we  might want to distinguish between government consumption, such as wages of  employees at the Department of Motor Vehicles, from government investment,  such as spending on cancer research. We could then argue that it makes more  sense to borrow to finance government investment rather than government.  Consumption. We want the government to be able to use the cash wisely, and  we would rather them invest back into the social fabric than have them continue  to consume our tax dollars, bloating the bureaucracy inside the government.  Although a very nice idea and principle. This approach to the government  accounts often founders on the practicalities of the politics of implementation.  First, it is not at all clear how to classify many government expenditures. Was a  launch of the space shuttle consumption or investment? What about the wages  of teachers in the public schools? What about the money spent on national  parks? Second, politicians would have a strong incentive to classify  expenditures as investment rather than consumption, just to defer the payment.  Another benefit of deficits is that they can play a role in economic stabilization.  In the short run, the level of economic activity can deviate from the potential  GDP. As a consequence, aggregate expenditures play a role in determining the  level of output. Fiscal policy influences the level of aggregate expenditures.  Changes in government purchases directly affect aggregate expenditures  because they are a component of spending, and changes in taxes indirectly  affect aggregate demand throughout the effect of consumption; therefore, deficit  spending can help stabilize the economy. The more we have, the more cash we  have out there, the more that they run a deficit and able to redistribute that  revenue back into the economy can potentially give individual households the  capacity to consume more, and therefore through a deficit, they are able to spur  the economy and make it make it grow that way too. So there's varying policies  and principles on how to run government deficits, and it's basically on the  opinion of. In summary, there are several arguments for allowing governments to run deficits. We would foresee these benefits if we were able to adopt a  balanced budget amendment. One of the arguments for deficits is funding wars. 

This is an explicit exception, and the only such exception written in the bill that  we discussed earlier, but we conclude by noting that there is a further, much  less benign reason for government deficits. They may benefit politicians even if  they do not benefit the country as a whole. Deficits allow politicians to provide  benefits to constituents today and leave the bill to future generations. If  politicians and voters care more about current benefits than future costs, then  they have a strong incentive to incur large deficits and let future generations  worry about the consequences. To me, that seems unfair, but that's how  governments at times choose to run their finances, so we're kind of subjected to  the policies of whoever is controlling the purse at the time inside the  government.