Introduction to Long-Run Fiscal Policy

1.

Introduction to Long-Run Fiscal
Policy
• Fiscal policy isn't just about managing shortterm recessions and inflation.
• This lecture explores how fiscal choices—
particularly deficits and surpluses—affect
long-run outcomes.
• Key focus: How government borrowing
impacts national saving, investment, and
economic growth over time.

2.

National Saving and Investment
Identity
• Investment funds in an economy must come
from somewhere:
• - Private savings
• - Government savings (or borrowing)
• - Foreign capital (via trade deficits)
• When the government runs a deficit, it
reduces national saving. The gap must be
filled by:

3.

Ricardian Equivalence Theory
• This theory suggests that when the
government borrows, individuals save more in
anticipation of future taxes.
• Globally, evidence is mixed—some offsetting
behavior is observed.
• But in the U.S., this offset doesn’t seem to
occur. Historical deficits were not matched by
higher private savings.

4.

Crowding Out Effect on Investment
• Increased government borrowing competes
with the private sector for capital.
• Evidence from the U.S. shows that:
• - 1990s: Surpluses → rising private investment
• - 2000s: Deficits → falling private investment
• Less investment harms innovation and longterm economic growth.

5.

Crowding In Effect on Trade Deficit
• Government borrowing can draw in foreign
capital → Larger trade deficits.
• Historical patterns:
• - 1980s and 2000s: Twin deficits—budget and
trade deficits rose together.
• - However, budget surpluses in the 1990s
didn’t produce trade surpluses—investment
absorbed the funds instead.

6.

Short vs. Long-Term Impacts of
Deficits
• Short-term deficits during recessions can help
boost demand—this is often appropriate.
• Long-term, persistent deficits create structural
problems:
• - More borrowing = rising national debt
• - Less flexibility in future fiscal policy
• - Pressure on private investment and trade
balance

7.

U.S. Debt History and Trends
• Four major debt surges in the 20th century:
• - WWI, WWII, Great Depression, 1980s
• Debt-to-GDP peaked at ~100% in WWII.
• Dropped to 25% by the 1970s, then rose again
in the 2000s.
• Current debt levels aren’t record-breaking—
but trends point upward.

8.

Long-Term Fiscal Projections
• Tax revenue is projected to rise only slightly
(to 22% of GDP by 2075).
• Spending is the real issue:
• - Social Security: 4.2% → 6.4% of GDP
• - Medicare: 2.4% → 10.4% of GDP
• Result: Deficits and interest costs balloon,
pushing debt to 200% of GDP by 2070.

9.

The Real Threat—Healthcare
Spending
• Medicare and Medicaid are the biggest fiscal
pressures.
• Healthcare alone is set to outgrow all other
federal spending.
• Rising health costs will drive long-term deficits
more than Social Security.
• Interest on debt adds another layer of
compounding risk.

10.

Policy Solutions? Not Easy
• Cutting spending: Unlikely due to political
resistance and existing commitments.
• Raising taxes: Would require unprecedented
hikes—doubling federal tax revenue.
• Boosting private saving: Tax-favored accounts
like IRAs/401(k)s haven't worked.
• Most proposals only slow growth of deficits,
not reduce them.

11.

Radical Proposals for Private Saving
• New ideas propose mandatory or default
saving systems:
• - Conservative: Private retirement accounts
requiring contributions
• - Liberal: 'Liberal paternalism'—automatic
saving unless you opt out
• These ideas aim to boost saving without direct
tax hikes or spending cuts.

12.

A Grim but Honest Outlook
• None of the options look likely:
• - Spending cuts? Politically improbable.
• - Major tax hikes? Unpopular and extreme.
• - Private saving increase? Not enough.
• Without action, huge deficits and trade
imbalances loom.
• “As economist Herb Stein said: 'If something