Running Deficits: Positives and Pitfalls

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

Governments run deficits for several reasons. By running short-run deficits, governments can
avoid raising taxes during economic downturns, helping households to smooth consumption over
time. Running deficits can stimulate aggregate demand in the economy, giving policy makers a
valuable fiscal policy tool that can help support macroeconomic stability. Long-run deficits allow
transfers of economic resources from younger to older generations, enabling older generations to
enjoy anticipated benefits of future economic growth, but also may be used to impose large
burdens on future generations.
Anticipation of changes in partisan control of government, according to some economists,
provides a political motive for running deficits, as current policy makers may wish to restrict their
successors’ options. Research on state and foreign governments suggests that balanced-budget
rules force governments to adjust spending and taxes sharply during economic downturns.
Balanced-budget rules also appear to hold down taxes and spending, at least in the short run.
Deficits can seriously harm national economies. In the short run, fiscal overstimulation leads to
inflation. In the long term, deficits either reduce capital investment, which retards economic
growth, or increase foreign borrowing, which swells the share of national income going abroad.
Governments can spend more than they collect in revenues by printing money, which causes
inflation, or by borrowing. In the long run, governments that fail to repay borrowers, at least to
the extent of stabilizing the ratio of government debt to gross domestic product, risk default and
bankruptcy.
This report will be updated as events warrant.

Basic Public Finance Theory.....................................................................................................1
Benefits and Costs of Smoothing Consumption via Deficit Finance........................................2
Macroeconomic Demand Management..............................................................................2
Political Explanations................................................................................................................3
Intergenerational Transfers........................................................................................................4
Costs of Financing Deficits.......................................................................................................6
Conclusion ................................................................................................................................ 7
Author Contact Information............................................................................................................7

Public finance theory suggests three reasons for deficit financing by government. First,
governments can prevent sudden changes in taxes by borrowing. Second, debt finance gives
governments a powerful macroeconomic policy tool. Third, debt finance can redistribute
resources among generations.
If government borrowing can shift revenues and expenses into different time periods more easily
or more cheaply than can households, then government can make taxpayers better off by ¹
smoothing tax levels using deficits. The federal government can spread the cost of a major
capital investment over many years by issuing debt in the form of bonds or Treasury bills. Deficit
finance can spread an especially large cost such as a major war over several generations, or even ²
centuries. Debt financing also allows governments to keep taxes steady during temporary
economic downturns, thus smoothing consumption for households. Of course, governments must ³
eventually pay back what they borrow or go bankrupt.
Second, increased government spending financed by borrowing can stimulate economic activity,
giving government a fiscal policy tool to counteract recessions. A countercyclical fiscal policy, in
which taxes are cut or spending is increased, can dampen economic fluctuations and limit the
depth of economic downturns. Pro-cyclical fiscal policy, in which taxes are raised or spending is
cut during recessions, tends to amplify economic fluctuations. During economic downturns,
government revenues fall and expenditures rise as more people become eligible for
unemployment insurance and income support programs, causing deficits to increase or surpluses
to shrink. These programs are known as “automatic stabilizers” because deficit spending then
provides a countercyclical stimulus to economic activity in the short run without the need for new ⁴
legislative action.
Both of these rationales presume that governments run surpluses during economic expansions to
repay debt or accumulate reserves. Critics of deficit finance and active fiscal policy argue that
policy makers are more willing to increase government spending when economic growth slows ⁵
than to cut spending when growth accelerates. In addition, designing fiscal policy is a slow and
deliberative process, whereas economic downturns can emerge suddenly and are difficult to
predict. Because economic shocks affect spending patterns with substantial lags, economic
conditions may have changed significantly before new federal spending actually reaches the
public. Few economists believe that large changes in fiscal policy designed to counterbalance
short-term economic downturns can be timed precisely, although many economists believe fiscal
policy is an important tool during prolonged periods of slow or negative growth.

¹^So-^c^a^lle^{d “}^r^aⁱ^ny^da^y^”^f^unds^{, us}^e^d^by^m^aⁿ^y^s^t^a^t^e^g^o^v^e^rⁿ^m^e^nts^,^a^llow^sm^oothing^of^ta^x^le^v^e^ls^w^{ithout de}^fⁱ^c^{it f}ⁱ^na^nc^e^.
²^T^h^e^{British g}^o^v^e^rnm^e^{nt still pa}^y^s^inte^re^{st o}ⁿ^c^o^{nsol bo}^{nds issue}^d^d^u^ri^ng^t^h^e^Na^pole^o^nic^W^a^rs.
³^A^m^o^r^e^pr^e^cⁱ^s^e^de^fⁱ^{nition of}^fⁱ^s^c^a^l^s^u^s^t^aⁱ^na^bili^ty^is^tha^t^the^p^u^b^lic^de^bt^doe^sⁿ^o^{t g}^r^ow^w^ithout^bo^un^d.
⁴^T^h^{e Co}ⁿ^g^ressi^oⁿ^a^l^Bud^g^et^Offⁱ^c^e^{(CBO) co}^m^p^u^t^{es a}^m^easu^r^{e o}^f^t^h^{e d}^e^fⁱ^ci^t^t^h^at^ad^j^u^st^{s f}^o^{r bu}^siⁿ^e^{ss c}^y^cl^{e e}^f^f^e^ct^{s t}^o
^al^l^o^w^a^m^o^re^m^eanⁱⁿ^g^f^u^l^co^m^p^ari^s^oⁿ^o^f^sh^o^r^t^-^t^e^rm^fⁱ^s^cal^st^an^{ce acr}^o^{ss d}ⁱ^f^f^e^ren^t^y^e^ars.
⁵^Milt^on^Frie^dm^aⁿ^,^C^api^talis^m^an^d^Fr^e^e^dom^.⁽^C^hic^a^g^{o: U}ⁿ^iv^.^of^C^h^ic^a^g^o^P^r^e^s^s^,¹⁹⁶²⁾^{, p}^p^.^75-⁸⁴^.

Helping households smooth income is a primary justification for short-run deficits according to
standard public finance theory. If governments must balance their budgets in each fiscal year, so
that current spending is constrained by available cash reserves and incoming revenues, then
negative economic shocks require spending cuts or tax increases. Public spending tends to rise
during recessions due to the effect of automatic stabilizers, while revenues fall. Thus, strict
balanced-budget requirements force governments to run a pro-cyclical fiscal policy, which can
either strain household budgets via tax increases or force painful cuts in public programs.
Economists have studied balanced-budget requirements in U.S. states, as well as budgetary ⁶
restrictions used by other national governments. All states except Vermont have balanced-budget
requirements, though the strictness of those requirements varies. Many studies have found that
the strictness of the balanced-budget requirement affects fiscal performance. Inman and Bohn
found that tight balanced-budget rules cause states to reduce deficits by cutting spending, whereas ⁷
softer constraints have little short-term effect. Other researchers found that balanced-budget rules ⁸
force governments to adjust spending and taxes sharply during economic downturns. Fiscal
crises may put strains on states and their citizens but may also force policy makers to face tough
fiscal decisions that would otherwise be avoided. Balanced-budget rules also appear to hold down
taxes and spending, at least in the short run. Over the longer term, both spending and taxes adjust,
although state and local governments with tight budget-balance measures appear to spend less
than those with less stringent requirements.
According to Keynesian theory, fiscal and monetary policy are the two major instruments of ⁹
macroeconomic policy. Deficit spending can be used to increase aggregate demand in the
economy, causing output and prices to increase. When the economy is running below its potential
level of output, expansionary fiscal policies such as deficits stimulate economic activity, bringing
idle economic capacity back into use and pushing the economy back toward its full potential. On
the other hand, if the economy is running near its full potential, expansionary fiscal policies lead
to inflation. Running government surpluses reduces aggregate demand in the economy and helps
restrain inflation. Fiscal policy, in coordination with appropriate monetary policies, can bring an
economy closer to its potential while restraining inflation.
Economists associated with the New Classical Macroeconomics criticized the underlying
assumptions of standard Keynesian theory, arguing that market forces naturally lead to
equilibrium and economic efficiency. The concept of rational expectations, a central tenet of the

⁶^F^o^{r a revi}^ew^o^f^res^earch^u^sⁱⁿ^{g U.}^S^.^st^at^{e d}^a^t^a^,^{see Jam}^e^{s M}^.^P^o^t^e^r^b^a,^“Bu^d^g^et^In^stⁱ^t^u^tⁱ^oⁿ^s^and^Fⁱ^scal^P^o^lⁱ^c^yⁱⁿ^t^h^e
^U^.^{S. Sta}^t^e^s^,”^A^m^eri^c^aⁿ^E^c^oⁿ^o^mⁱ^c^R^evi^ew^{, v}^o^{l. 8}⁶^,^no^{. 2}⁽¹⁹⁸⁶⁾^,^pp.³⁹^5-⁴⁰⁰^.^F^o^r^a^r^e^vⁱ^e^w^o^f^Eur^ope^aⁿ^bu^dg^e^t^a^r^y
^rule^{s, se}^e^Gⁱ^aⁿ^c^a^r^{lo Corse}^{tti a}^nd^Nourie^{l R}^o^u^bⁱⁿⁱ^,^“^E^ur^op^e^aⁿ^v^e^rs^{us Am}^e^r^ic^aⁿ^P^e^rspe^c^tiv^e^s^on^Ba^l^a^nc^e^d^-Budg^e^t
^Ru^les,”^A^m^eri^c^aⁿ^E^c^on^o^mⁱ^c^R^evi^ew^{, v}^o^{l. 8}⁶^,^no^{. 2}⁽¹⁹⁸⁶⁾^,^pp.⁴^08-⁴¹³^.
⁷^Henⁿⁱⁿ^g^B^o^hn^and^Rob^e^rt^P^.^Inman^.^“Bal^an^ced^Bu^d^g^et^Ru^l^e^{s and}^P^u^b^lⁱ^c^Defⁱ^ci^t^s^:^E^vⁱ^d^en^{ce F}^r^o^m^t^h^{e U.}^S^.^S^t^at^es,^”
^N^B^ER^W^o^r^k^ing^P^a^pe^r^N^o^.⁵⁵^33,^A^p^r^{il 199}^6.
⁸^Ja^m^e^{s M. Pote}^rba^,^“^S^ta^te^Re^spon^se^{s to Fisc}^a^l^Cris^e^s^{: T}^h^e^Eff^e^c^t^{s o}^f^Budg^e^t^a^r^y^Institutio^{ns a}ⁿ^d^Politi^c^s^,”^J^our^nal^of
^Politic^{al Ec}^o^nomy^{, v}^o^l^.¹⁰^{2, n}^o^.^{4 (}^A^ug^us^{t 19}⁹⁴⁾^{, p}^p^.⁷⁹^9-⁸²¹^.
⁹^T^r^a^d^itiona^{l K}^e^yⁿ^e^s^ia^{n the}^o^r^y^{in unde}^r^g^r^a^dua^te^te^x^t^b^ook^s^de^rⁱ^v^e^s^f^r^om^J^{ohn R}^.^Hⁱ^c^k^s^,^“^M^r^.^K^e^yⁿ^e^s^a^{nd t}^h^e^‘^C^la^s^sⁱ^c^s^’^:
^A^Sug^g^e^ste^d^Inte^rpre^ta^tio^n,”^E^c^on^o^m^et^ri^ca⁵⁽¹⁹³⁷⁾^{, pp}^.¹^47-⁵⁹^.

New Classical Macroeconomics, assumes that households and businesses are rational and
foresighted. Nevertheless, economic agents make mistakes because of changing circumstances
and uncertainty. The rational expectations approach presumes those mistakes are not
systematically wrong in any direction. The combination of neoclassical microfoundations for
macroeconomics and the assumption that economic agents are foresighted and rational, even
when faced with complex dynamic decisions, led economists associated with the New Classical
Macroeconomics to criticize Keynesian demand management policies.
For example, Robert Barro argued that deficit spending has no fiscal effect because households
save in anticipation of future tax increases, offsetting any short-term stimulative effects. This ¹⁰
concept is known as Ricardian equivalence. The theory of Ricardian equivalence implies that
only the net present value of government expenditures and taxes needed to pay for them matter, ¹¹
but that the timing of taxes does not. Empirical research has failed to find evidence of Ricardian
equivalence in its pure form, but some research has identified some Ricardian effects in savings ¹²
behavior.
Contrary to the predictions of Ricardian equivalence, the overwhelming evidence of economic
research and macroeconomic experience suggests that deficit spending creates a short-term fiscal
stimulus. Despite the imprint that New Classical Macroeconomics has left on macroeconomic
modeling, nearly all economists believe deficits affect prices and output in the short run and
recognize the usefulness of fiscal policy as a tool for macroeconomic management, at least in
some circumstances.
More recent research sets older Keynesian theories upon more modern foundations. This research
stresses that the structure of labor markets creates wage rigidities. For example, the price of
soybeans may change by the minute, but the wages of employees do not. These wage rigidities
lead to the appearance of involuntary unemployment or excess capacity during economic
downturns, and thus provide a role for traditional Keynesian demand management. New
Keynesian theories, like the New Classical Macroeconomics, treat economic expectations of the
future in a serious way, unlike traditional Keynesian theory. For example, if traders in bond
markets anticipate that deficits will cause inflation in the future, that will cause interest rates to
rise in the present. Rising interest rates will then change current decisions of firms and
households.
The political business cycle literature provides a theory of economic fluctuations based on
politicians’ desire to maximize their chances of reelection. Early versions of political business
cycle models presumed politicians could fool myopic voters by pumping up government spending

¹⁰^T^h^is^c^onc^e^p^{t is}^na^m^e^{d af}^te^r^D^a^vⁱ^{d R}ⁱ^c^a^r^do⁽¹⁷⁷^2-¹⁸²³⁾^,^a^L^oⁿ^d^oⁿ^fⁱ^na^nc^ie^r^a^{nd e}^c^oⁿ^o^mⁱ^s^t^eⁿ^g^a^g^e^dⁱⁿ^de^ba^te^s^a^b^o^u^t
^t^h^{e m}^aⁿ^a^g^e^m^eⁿ^t^o^f^d^e^b^t^{s accu}^m^u^l^a^t^e^d^d^u^riⁿ^g^t^h^{e Nap}^o^l^eonⁱ^{c W}^a^rs.^Ri^card^o^,^w^hⁱ^l^e^p^r^o^vⁱ^dⁱⁿ^{g exa}^m^p^l^{es p}^oⁱⁿ^tⁱⁿ^g^o^u^t
^tha^t^the^r^e^a^l^bur^deⁿ^of^a^s^t^r^e^am^of^inte^r^e^s^t^pa^y^m^eⁿ^ts^w^a^s^e^s^s^e^ntia^lly^the^s^a^m^e^a^s^the^bur^deⁿ^of^im^m^e^dia^t^e^pa^y^m^eⁿ^{t of}
^bor^r^o^wⁱ^ng^a^s^s^o^cⁱ^a^t^e^d^w^{ith thos}^e^pa^y^m^eⁿ^ts^{, w}^a^s^c^onc^e^r^ne^{d tha}^t^the^op^por^t^uⁿ^ity^{to c}^a^r^r^y^public^de^bt^c^ould^eⁿ^c^o^ur^a^g^e^rd
^“p^r^o^f^lⁱ^g^ac^{y” i}ⁿ^go^verⁿ^men^t^exp^eⁿ^dⁱ^tu^r^e^.^Davi^d^Rⁱ^car^do^,^T^h^e^Prⁱⁿ^cⁱ^ple^s^{of P}^o^lit^ic^{al Ec}^on^om^y^an^{d T}^a^x^a^ti^on^{, 3}^e^d^.,
⁽^L^ondo^{n: M}^u^r^r^a^y^,¹⁸²¹⁾^{, c}^h^{. 1}⁷^.
¹¹^R^obe^r^t^J^.^B^a^r^r^o^{, “}^A^r^e^G^ove^rⁿ^m^e^{nt B}^o^nds^N^e^{t W}^e^a^lth?^”^J^ourⁿ^a^{l o}^f^Poli^tic^{al Ec}^on^om^y^{, v}^o^l.⁸²^{, n}^o^.^{6. (}^N^ov^e^m^be^r^-
^D^e^c^e^m^b^e^r^{, 1974)}^{, p}^p^.¹⁰^95-¹¹¹⁷^.
¹²^{M. G}^a^brie^lla^Briotti^{, “}^E^c^oⁿ^o^mⁱ^c^Re^a^c^{tions to}^Pu^blic^Fi^naⁿ^{ce Con}^s^o^lⁱ^d^atⁱ^o^n:^A^S^u^rve^y^o^f^t^h^{e L}ⁱ^t^e^rat^u^re,^”^E^u^r^o^p^ean
^Cen^t^ral^Ban^k^Occasi^oⁿ^a^l^P^a^p^e^{r no}^.³⁸^,^Oct^o^b^e^r²⁰⁰⁵^.

before elections.¹³ More sophisticated versions assume voters are rational and not myopic, but are
unable to distinguish between sustainable prosperity based on policy and administrative ¹⁴
competence from temporary prosperity based on deficit spending. Drazen reviewed the
literature and found strong evidence that voters react to economic conditions, but weak evidence ¹⁵
that macroeconomic policy is manipulated to sway elections.
The alternation of partisan control of government may explain a persistent tendency towards
deficit spending. Several articles in the economics of politics literature, such as Alesina and
Tabellini or Persson and Svensson, contend the government of the day can constrain its ¹⁶
successors’ choices by running budget deficits. If a successor government has different spending
priorities, the current government may be tempted to influence future fiscal policies by using debt
to change the incentives and constraints facing future decision makers. Such policies are highly
unlikely to be as economically efficient as a more consistent fiscal policy.
One explanation of persistent deficits is that future generations do not vote, even if they will be
asked to pay for programs enacted by older generations. Generations now alive face a temptation
to pass on the costs of programs that benefit themselves to following generations that have no say.
Some shifting of resources to older generations, however, can be justified on the basis of equity.
To the extent that technological change leads to greater prosperity over time, future generations
will have access to higher standards of living. To the extent that population growth increases the
size of the economy, the burden of financing pay-as-you-go retirement systems is reduced. If
some of those gains are shifted from younger to older generations, then incomes and levels of
well-being would be more equal among generations. Furthermore, a fiscal policy that shifts some
resources from younger to older generations can raise living standards of all following
generations by transferring a portion of the benefits of future economic growth into the present.
A simple example illustrates this possibility.¹⁷ Consider an economy with a fixed population
divided among age-specific cohorts. For the sake of simplicity, suppose individuals live 75 years.
Also assume, for the sake of simplicity, that income of each cohort is the same, arrives from a
source outside the economy, and grows 3% per year. Consider a fiscal policy that causes each
age-specific cohort (except the oldest) to transfer 2% of its income to the one-year-older cohort.
All transfers, except for the oldest and youngest cohorts, cancel out. The youngest cohort gets
98% of its pre-transfer income, and the oldest gets 102% of its pre-transfer income. Although the
loss of the youngest cohort and gain of the oldest cohort balance out for each year, each

¹³^Nord^ha^{us, W}^illia^m^{D., “}^T^he^P^o^lⁱ^tic^a^l^Busine^{ss Cy}^c^l^e^,^”^Re^vⁱ^e^w^{of Ec}^onom^ic^Stu^d^ie^s^{, v}^o^l^.⁴²^,^no^{. 2}⁽^A^pr^{il 197}⁵⁾^,^pp^.
¹⁶⁹^-¹^90.
¹⁴^Ke^nne^{th R}^o^g^o^f^f^,^“^E^quilibri^um^Politic^a^l^Busi^ne^{ss Cy}^c^l^e^s^,”^Am^e^r^{ican Ec}^on^om^ic^Re^vⁱ^e^w^{, v}^o^l.^80,ⁿ^o^.¹⁽¹⁹⁹⁰⁾^,^pp^{. 2}¹^-
^36.
¹⁵^Drazen^{, A}^llan^,^“T^h^e^P^o^l^{itical Bu}^sin^e^{ss Cy}^cle^Af^{ter 2}⁵^Years,”^{NBER M}^a^c^r^oe^c^oⁿ^o^mic^s^Ann^u^a^l^{, v}^o^l^.¹⁵⁽²⁰⁰⁰⁾^,^pp.
^75-¹¹^7.
¹⁶^A^l^be^{rto A}^l^e^s^ina^a^{nd G}^u^{ido T}^a^be^{llini, “}^A^P^o^sitiv^e^T^h^e^o^ry^of^Fisc^a^l^De^fⁱ^c^{its a}^{nd G}^o^v^e^rn^m^e^{nt De}^bt,”^R^evi^{ew o}^f
^Ec^onom^ic^Stu^d^ie^s^{, v}^o^l^.⁵⁷^{, J}^u^ly¹⁹⁹⁰^{, p}^p^.⁴⁰^3-⁴¹⁴^;^T^o^r^s^teⁿ^P^e^r^s^s^o^{n a}ⁿ^d^L^a^r^s^{E. O}^.^Sv^eⁿ^s^s^oⁿ^,^“^W^hy^a^Stu^b^b^o^rⁿ
^Coⁿ^s^ervatⁱ^v^{e W}^o^u^l^d^Run^{a Def}ⁱ^ci^t^:^P^o^lⁱ^c^y^wⁱ^t^h^Tⁱ^m^e^-In^coⁿ^sⁱ^s^t^eⁿ^t^P^r^ef^eren^ces,^”^Q^uar^te^r^l^y^J^our^na^l^{of Ec}^o^nom^ic^s^{, v}^o^l^.
¹⁰⁴⁽^M^a^y¹⁹⁸⁹⁾^,^pp.³^25-³⁴^5.
¹⁷^T^h^is^e^x^am^ple^is^c^l^os^e^l^y^r^e^la^te^{d to the}^ov^e^r^la^ppi^ng^g^e^ne^r^a^tions^m^ode^{l. F}^o^r^a^c^o^m^p^r^e^he^ns^iv^e^e^x^pos^iti^{on a}ⁿ^{d a}ⁿ^a^l^y^s^is
^s^e^e^D^a^vⁱ^d^G^a^le^{, “}^P^ur^e^Ex^c^h^aⁿ^g^e^Equilⁱ^brⁱ^u^m^of^Dy^namⁱ^c^Ec^onom^ic^Mode^ls^,”^J^ourⁿ^a^l^{of Ec}^on^om^ic^The^o^r^y^{, v}^o^l.⁵
⁽¹⁹⁷³⁾^,^p^p^.^12-^36.

individual born after the start of the plan gains because of economic growth (so long as the
economy’s interest rate is below 3% per year). With a 3% growth rate over 74 years, income
increases by 891%. Therefore, the gain in buying power per dollar of income in present value
terms for a cohort born after the start of the policy is
⁷⁴1.03⎛⎞

1.02* - (.98) ⎜⎟

1+⎝⎠r
where r is the real interest rate. So long as the real interest rate is less than 3%, which is true for
long-term historical real rates of return for U.S. Treasury bills, the policy of shifting resources to ¹⁸
older generations makes all generations better off. This highly simplified example shares the
same basic structure as pay-as-you-go social insurance programs, in which young workers pay ¹⁹
contributions that are more or less immediately used to pay benefits to older retirees.
The possibility of raising standards of living by shifting resources from younger to older
generations has its limits. The example above relies on the assumption that the policy continues
indefinitely into the future. With a finite ending point this policy would be unsustainable because
some young cohorts near that end point would be made worse off and would be unwilling to give
up resources.
The current fiscal policies of the United States imply that large transfers will be made to the baby-²⁰
boom generation from younger generations. Computations by Auerbach, Gokhale, and Kotlikoff
indicate that future generations will pay much more in taxes than they will receive from the ²¹
government. In 2000, Gokhale and others estimated that a newborn male in 1998 would pay
$142,500 more in taxes than what he would receive from the government; the corresponding ²²
estimate for a newborn female was $71,300. Due to increased federal deficits and the
introduction of Medicare Part D, those estimates would be higher for current newborns. Despite
the projected magnitude of these intergenerational transfers, younger generations might not be
worse off than their parents if economic grows at a sufficiently swift pace.
These generational transfers are largely driven by the growth in the number of beneficiaries of
entitlement programs relative to the work force, as well as by rapid increases in health care costs.
The possibility that some future generation may eliminate fiscal policies that it perceives will
lower its standard of living introduces political risk into social insurance programs funded by a ²³
pay-as-you-go mechanism. If a generation anticipates that a younger generation will stop

¹⁸^G^o^e^t^zm^a^{nn a}^{nd Ib}^bots^{on f}^o^uⁿ^d^t^h^a^t^the^re^a^l^ra^te^of^re^turⁿ^oⁿ^U^.^S^.^T^r^e^a^s^u^r^y^bills^f^r^om^1924-²⁰^{04 w}^a^s^le^s^s^thaⁿ^1%
^pe^{r y}^e^a^r^{. Se}^e^T^a^ble^{II in W}^illia^m^{N. G}^o^e^t^z^m^a^{nn a}^{nd Rog}^e^{r G}^.^Ibb^o^t^{son, “}^H^ist^o^ry^a^{nd the}^E^quity^Risk^P^r^e^m^ium^,^”^Y^a^le
^Sc^hoo^{l of}^Ma^na^g^e^m^e^{nt w}^o^r^k^ing^pa^pe^r^,^O^c^to^be^r²⁰⁰⁵^{, a}^v^a^ila^ble^a^t^http:^//e^c^on.^uc^s^b^.e^d^u^/^c^onf^e^r^eⁿ^c^e^s^/^e^quity^05/^pa^pe^r^s^/
^G^o^et^z^m^anⁿ^.^pd^f^.
¹⁹^For^a^de^f^e^ns^e^of^pay^-^as^-^y^ou-^g^o^fⁱ^na^nc^ing^,^s^e^e^P^e^te^r^Dⁱ^a^m^{ond, “}^S^o^c^ia^{l Se}^c^u^r^ity^,”^Am^e^r^ic^{an Ec}^onom^ic^Re^vⁱ^e^w^{, v}^o^l.
⁹⁴^,ⁿ^o^.¹⁽^M^ar^ch²⁰⁰⁴⁾^,^p^p^.^1-²⁴^.
²⁰^L^a^ureⁿ^c^e^{J. Kotlik}^of^f^a^{nd Sc}^ott^Burns,^The^C^o^mⁱ^ng^G^e^ne^r^a^ti^on^al^Stor^m^{, (}^C^a^m^br^idg^e^{, Ma}^s^s^.^{: MI}^T^P^r^e^s^s^,²⁰⁰⁴⁾^.
²¹^A^l^aⁿ^J^.^A^u^e^r^ba^c^h^{, J}^a^g^a^de^es^{h G}^o^k^h^a^l^e^,^a^{nd L}^a^ureⁿ^c^e^J^.^K^o^tlik^of^f^,^“^T^he¹⁹⁹⁵^Bu^dg^e^t^a^{nd H}^e^a^{lth Ca}^re^Re^f^o^r^m^:^A
^G^e^ne^r^a^tiona^{l P}^e^rspe^c^tiv^e^,^”^E^c^o^nomi^c^R^evi^ew^{, Fe}^de^r^a^{l R}^e^s^e^r^v^e^B^aⁿ^k^of^C^l^e^v^e^l^a^{nd, is}^s^u^e^Q^I^,¹⁹⁹⁴^{, p}^p^{. 2}⁰^-^30.
²²^Jagad^eesh^G^o^kh^al^e,^Ben^j^amⁱⁿ^P^a^ge,^Jo^an^P^o^t^t^er,^and^Johⁿ^S^t^u^r^r^o^ck,^“^G^e^ne^r^a^tion^a^{l Ac}^c^o^unts^f^o^r^t^h^e^Uⁿ^ite^d^St^ate^s^:
^{An U}^p^date^,”^C^B^O^T^e^c^hnic^a^l^P^a^p^e^r^Se^rⁱ^e^s^{, 20}^00.
²³^Jo^hn^B.^S^h^o^v^en^an^d^Sⁱ^t^a^N.^S^l^avo^v^,^“P^o^lⁱ^tⁱ^cal^Ri^{sk versu}^s^M^a^rket^Ri^{sk i}ⁿ^S^o^ci^al^S^ecu^ri^t^y^{” (}^A^p^rⁱ^l²⁰⁰⁶⁾^.^NBE^R
^W^o^rkiⁿ^{g P}^a^p^e^{r No.}^W¹²¹³⁵^,^avai^l^a^b^l^{e at}^h^t^t^p^:^/^/^p^ap^ers.^ssrn^.^c^o^m^/^sol³^/^p^ap^ers.^cfm?ab^st^ract^_ⁱ^d⁼⁸⁹⁶²⁰⁸^.

contributing to a pay-as-you-go social insurance program, then it may decide to end the program
itself. A generation whose descendants are unwilling to finance its benefits would have little to ²⁴
gain, apart from altruistic impulses, by continuing its contributions.
A government that runs deficits and is unwilling to raise taxes or cut spending faces three choices.
First, domestic borrowing can be increased at the cost of crowding out domestic investment.
Second, a government can borrow from foreign investors and governments. Borrowing from the
rest of the world prevents deficits from crowding out investment. That is, foreign investors can
provide financial resources now in exchange for future interest payments and profits. As foreign
investors accumulate larger portfolios of stocks, bonds and other assets, the flow of interest
payments, dividends and repatriated profits abroad increases as well. Third, a central government
can print money to reduce the real value of debt denominated in domestic currency.
All three options have unpleasant consequences. Over time, each can seriously damage national
economies. Simple supply and demand theory implies that a smaller supply of savings for private
investment will lead to higher interest rates and lower growth in private capital stocks. Lower
stocks of private capital threaten economic growth, and slower economic growth translates into
lower average living standards in the future. Borrowing from the rest of the world permits higher
levels of investment and faster growth at the cost of sending a higher fraction of earnings abroad.
If foreigners lend capital by purchasing stocks and bonds rather than by building auto plants, for
example, they may decide suddenly someday to take their investments elsewhere. This could
strain domestic and international financial systems, thus constricting firms’ and households’
access to capital. Finally, inflation caused by printing money distorts the flow of information
generated by the price system and disrupts financial markets. Investors, if they wish to avoid
capital losses in real terms, demand higher interest rates when they see signs of inflation. A major
reduction in the real value of the federal debt would require a significant acceleration in inflation.
Few economists believe that the restrictive monetary policies needed to squeeze rapid inflation
out of an economy would not require substantial economic disruption, at least in the short run.
On the other hand, reducing government deficits can improve economic performance in at least
three ways. First, paying off government debt increases the supply of investment funds available
for domestic investment. Second, paying off government debt held by foreign governments or
investors reduces the amount of interest payments going abroad. Alternatively, paying off debt
held by domestic investors gives them the opportunity to rebalance their portfolios by buying
foreign assets, which offsets some of the flow of dividends and profits going abroad, or by buying
domestic assets that otherwise would have been bought by foreign investors. Third, scaling down
the federal debt decreases the temptation to reduce its real value by printing money, lessening the
possibility of a major acceleration in inflation. Finally, most economists believe reducing
government borrowing lowers interest rates, which in turn have positive effects on investment
and growth.

²⁴^A^ltr^uis^tic^im^puls^e^s^pla^y^aⁿⁱ^m^por^ta^{nt r}^o^le^{in m}^a^ny^que^s^tions^c^o^nc^e^r^ningⁱⁿ^te^r^g^eⁿ^e^r^a^tiona^{l tr}^aⁿ^s^f^e^r^s^.^For^aⁿ^ov^e^r^vⁱ^ew
^o^f^recen^t^research^oⁿ^t^h^{e sub}^j^ect^,^{see L}^.^-^A^.^G^é^rard^-V^aret^,^S^.^{- C.}^K^o^l^m^an^d^J.^M^e^rci^e^r-Yt^hⁱ^e^{r (ed}^s^.⁾^,^H^and^bo^ok^of^the
^Ec^onom^ic^s^{of G}ⁱ^vⁱⁿ^g^,^Re^cⁱ^pr^oc^ity^an^{d Altr}^uis^m^{, v}^o^l^.¹^,^(A^m^s^te^rda^m^{: N}^o^{rth H}^o^llaⁿ^d^,²⁰^06).

The ability of governments to run deficits can help avoid short-term fiscal crises caused by
adverse economic shocks. Long-term deficits can be used to allow older generations to enjoy
some of the anticipated fruits of future economic growth. A government can sustain a debt
indefinitely, so long as the size of the debt relative to the size of the economy does not grow
without bound. Maintaining a large debt requires large interest payments and can retard economic
growth. Thus deficits can serve as a useful tool of economic management, but also can cause
substantial economic damage to an economy.
^{D. An}^d^r^e^w^Au^s^tin
^An^al^y^s^{t i}ⁿ^Ecoⁿ^o^m^{ic P}^o^licy
^aau^s^tⁱⁿ^@^c^rs^.l^oc.g^ov^{, 7}^-⁶⁵⁵²