AP Econ Module 30 Deficits Debt - Sunny Hills High School

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Future Demands on the Federal Budget Il s flgure shows Congressional Budget office projsc- tions of spending on soclal insurance Uoorams as a share of GDP hrtiy as a resuft of an aging populadon, but mainty because ot rislng hsalth care cos{s, tiese programs ars ex- pected to become much more expensiw over time, posing ffoblems lor the lederal budgst &urDa Congr€ssional Budget offico. f Medicorc and Medicoid J Social Secuity the system. By 2030, according to rhe Social Securiry Administration, that number will rise to 46; by 2050, it will rise to 48; and by 2080 that number will be 51. This will raise benefit payments relarive to rhe size ofrhe economy. of the baby boomers, by .The-aging itsef poses only a moderately sized long-run fis_ cal problen. The projected rise in Medicare and Medicaid spending is a much more serious concern. The main story behind projections of higher Me&care and Medicaid spending is the long-run tendency of health care spending to rise fasrer than overall spending both for government-funded and for private-funded health care. . To some extent, the implicit liabilities ofthe U.S. government are already reflected in debt statistics. We mentioned eadier that the govirnment had a total debt of $12 trillion at the end offiscal 2009, but that only $7.6 trillion ofthat toral was owed to the public The main explanation for thar discrepaacy is that both Social Security and part ofMedicare (the hospital insurance program) are suppo rred.by dedirated. taxis: theii expenses are paid out ofspecial taxes on wages, At times, these dedicated taxes yield more revenue than is needed to pay current benefits. In particular, since rhe mid-lggOs the Social Security system has been taking in more revenue tharr it currently needs in ord.er to prepare for the retirement ofthe baby boomers. This surplus in the Social Security system has been used to accurnulate a Social Secait! trustfaf which was g2.5 trillion at the end offiscal2009. The rnoney in the trust fund is held in the form of U.S. government bonds, which are included in the $12 trillion in rotal debt. you could say that rhere,s somerhing funny about counting bonds in the Social Security trust fund as p".t of gorr"rrrrn"rri debt. After all, these bonds are owed by one part of the govemment (the govemment outside the Social Securiry system) to another part ofrhe government (the Social Security system irsel$. But the debt corresponds to a real if implicit, liability: promises by the govemment to pay future retirement benefits. So many economists argue that the gross debt of$12 trillion, the sum ofpublic debt and government debt held by Socia.l Security and ocher trust funds, is a more accurate indication ofthe governmenCs fiscal health than the smaller amount owed co the public alone 304 section 6 lnflation, Unemployment, and Stabilization policies Year
ffiffirywffimk Argentina's Creditors Take a Haircut As we mentioned earlier, the ldea ftat a govern- A4enline ofiicials tied to reassure lenders by ment's debt can reach a level at which the government can't pay ib creditors can seem tar-fetched. ln the United Shtes, government debt is usually regarded as the safest asset there is. But c0untries do default 0n their debts-they lail to repay the money they bon0wed. ln 1998, Bussia delaulted on its bonds, triggering a worldwide panic in financial markets.ln 2001, in the biggest default 0l modern times, be govemment olArgentina stopped making payments on $81 billion in debt. How did theArgentine delault happen? During much olthe 1990s, the country was experiencing an economic b00m and the govemm€ntwas easily able to bonow money from abroad.Although delicit spending led b rising government debt, few considered this a problem.ln 1998, however, the country slid into an economic slump that reduced tax rev- enues, leading to much larger deficits. Foreign lenders, increasingly nervous aboutthe country's abilityto repay, became unwilling h lend more except at very high interest rates. By 2001, fte counfy was caught in a vicious circle:to cover its deficib and pay otf old loans as they came due, it was forced to bonow at much higher interest rates, and the escalating interest rabs on new bofiowing made the deficits even bigger. Sol.tttiont dppear dt the bdck ofthe book- Check Your Understanding raising taxes and cutting govemment spending. But hey were never able to balance he budget due to the continuing recession and fie nega0ve multiplier impact 0f their contractionary fiscal policies. Th€se strongly contractionary fiscal policies drove the country deeper into recession. Late in 2001, facing popular protesh, the Argen- tine govemment collaps€d, and fie country de- faulted on its debt. Creditors can take individuals who lail to pay debts io court. Ihe court, in turn, can seize the debtors' assets and torce them to pay part of tuture earnings totheir ffedihrs. But when a c0untry defaults, it's different. lts creditors can't send in fie police to seize the country's assets. They must negotiate a deal with the counfry for partial repayment. The only leverage creditors have in these negotiations is the defaulting govemment's lear that il it talls to reach a settlement, its reputation will sufier and it will be unable h bonow in the future. (A report by 1. 'ffhy is the cyclically adjusted budget balance a better measure ofthe long-run suscainabilicy ofgovernmenc policies than the accua.l budget bdance? Reuters, fie ne\,vs agency, on Argentina's debt negotiations was headlined "Argentina to un- happy bondholders:so sue.") lt took three years lor Argentina to reach an agreement with its creditors because the new Argentine government was determined to strike a hard bargain. And it did. Here's how Reuters described the settlement reached in March 2005:"The deal, which exchanged new paper valued at around 32 cents for every dollar in default, was the biggest 'haircut,' or loss on principal,lor in- vestors of any sovereign bond restructudng in modern times.'Let's put this inb English:AF gentina forced its creditors to trade their "sovereign bonds"-debts ot a sovereign nation, that is, Argentina-for new bonds worth only 32% as much. Such a reduction in the value 0l debt is known as a "hakcut." It's imporhnt to avold two misconceptions aboutthis "haircut." Flrst, you might be tempted h think that becaus€ kgentina ended up pay- ing only a fraction of he sums it owed, it paid a small price for default.ln lact, Argentina's default accompanied one 0f the worst economic slumps 0f modern times, a period of mass unemployment, soaring poverty, and widespread unrest. Second, it's tempting to dismiss theAF gentine shry as being ot little relevance to countries like the United States. After all, aren't we more responsible han tha? ButArqentina wouldn't have been able t0 borrow so much in the lirst place if ib government hadn't been well regarded by international lenders. ln fact, as late as 1998 Argentina was lvidely admired for ih economic management. What Argentina's sllde into default sh0ws is that concerns about fie long-run effects 0I budget delicits are not at all academic. Due to its large and growing debt-GDP ratio, one recession pushed Argentina over the edge inh economic collapse. 2. Explaio why states required by their consti[ucions to ba.lance rheir budgecs are likely ro experience more severe economic fluctuations than states not held to that requirement. module 30 Long-run lmplications of Fiscal Policy; Deficits and the Public Debt 305
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AP Econ Module 30 Deficits Debt - Sunny Hills High School

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