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Deficits and Debt in the Short and Long Run

  • Benjamin M. Friedman
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    This paper begins by examining the persistence of movements in the U.S. Government%u2019s budget posture. Deficits display considerable persistence, and debt levels (relative to GDP) even more so. Further, the degree of persistence depends on what gives rise to budget deficits in the first place. Deficits resulting from shocks to defense spending exhibit the greatest persistence and those from shocks to nondefense spending the least; deficits resulting from shocks to revenues fall in the middle. The paper next reviews recent evidence on the impact of changes in government debt levels (again, relative to GDP) on interest rates. The recent literature, focusing on expected future debt levels and expected real interest rates, indicates impacts that are large in the context of actual movements in debt levels: for example, an increase of 94 basis points due to the rise in the debt-to-GDP ratio during 1981-93, and a decline of 65 basis point due to the decline in the debt-to-GDP ratio during 1993-2001. The paper next asks why deficits would exhibit the observed negative correlation with key elements of investment. One answer, following the analysis presented earlier, is that deficits are persistent and therefore lead to changes in expected future debt levels, which in turn affect real interest rates. A different reason, however, revolves around the need for markets to absorb the increased issuance of Government securities in a setting of costly portfolio adjustment. The paper concludes with some reflections on %u201Cthe Perverse Corollary of Stein%u2019s Law%u201D: that is, the view that in the presence of large government deficits nothing need be done because something will be done.

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    File URL: http://www.nber.org/papers/w11630.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11630.

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    Date of creation: Oct 2005
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    Publication status: published as Kopcke, Richard W., Geoffrey M.B. Tootell, and Robert K. Triest (eds.) The Macroeconomics of Fiscal Policy. Cambridge and London: MIT Press, 2006.
    Handle: RePEc:nbr:nberwo:11630
    Note: EFG ME PE
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    1. Jordi Galí & J. David López-Salido, 2003. "Understanding the Effects of Government Spending on Consumption," Working Papers 73, Barcelona Graduate School of Economics.
    2. R. Glenn Hubbard & Eric M. Engen, 2004. "Federal Government Debt and Interest Rates," Working Papers 50018, American Enterprise Institute.
    3. Poterba, James M., 1998. "The rate of return to corporate capital and factor shares: new estimates using revised national income accounts and capital stock data," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 211-246, June.
    4. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
    5. Thomas Laubach, 2009. "New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Journal of the European Economic Association, MIT Press, vol. 7(4), pages 858-885, 06.
    6. Galí, Jordi & Vallés, Javier & Wolman, Alexander L., 2003. "Understanding the effects of government spending on consumption," CFS Working Paper Series 2004/23, Center for Financial Studies (CFS).
    7. Seater, John J, 1993. "Ricardian Equivalence," Journal of Economic Literature, American Economic Association, vol. 31(1), pages 142-90, March.
    8. B. Douglas Bernheim, 1987. "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Chapters, in: NBER Macroeconomics Annual 1987, Volume 2, pages 263-316 National Bureau of Economic Research, Inc.
    9. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
    10. Olivier Blanchard & Roberto Perotti, 1999. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," NBER Working Papers 7269, National Bureau of Economic Research, Inc.
    11. Fama, Eugene F. & Schwert, G. William, 1977. "Human capital and capital market equilibrium," Journal of Financial Economics, Elsevier, vol. 4(1), pages 95-125, January.
    12. Roberto Perotti, 2004. "Estimating the effects of fiscal policy in OECD countries," Working Papers 276, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    13. Elmendorf, Douglas W. & Reifschneider, David L., 2002. "Short-Run Effects of Fiscal Policy with Forward-Looking Financial Markets," National Tax Journal, National Tax Association, vol. 55(3), pages 357-86, September.
    14. Eric M. Engen & R. Glenn Hubbard, 2004. "Federal Government Debt and Interest Rates," NBER Working Papers 10681, National Bureau of Economic Research, Inc.
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