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CHAPTER
2
The
Financial System and the Economy
TEACHING OBJECTIVES
Goals of Part 1: Money
and the Financial System
A. Introduce basic ideas
behind bond, stock and other financial markets (Chapter 2), money and the
payments system (Chapter 3), the present-value formula (Chapter 4), the
structure of interest rates (Chapter 5), real interest rates (Chapter 6), and
stocks and other assets (Chapter 7).
Goals of Chapter 2
A.
Show how the financial system matches borrowers and lenders.
B.
Investigate the role of financial securities.
C.
Describe the basic workings of financial intermediaries.
D.
Show how supply and demand determine the financial system.
E.
Discuss the consequences of failures of the financial system.
F.
Describe the major attributes of financial securities that investors care
about.
TEACHING NOTES
A.
Introduction
1. Borrowing and lending is
valuable to an individual and to the society as a whole
2. The financial system consists of
securities, intermediaries, and markets that exist to match savers and
borrowers
3. Figure 2.1 illustrates the components of financial system
4. This chapter introduces
the financial system and explains why it is an essential part of a
well-functioning economy
B.
Financial Securities
Definition of Financial Securities
1. Debt and Equity
a) Define a debt
security and an equity security (stock)
b) How much debt and equity exist in the U.S.? Use
Figure 2.2
c) Who issues debt and equity? Use Figure 2.3
d) Who owns debt and equity? Define investor and use Figure 2.4
2. Differences Between Debt and Equity
a) Maturity;
define principal
b) Type of payment being made (interest versus dividends)
c) Bankruptcy
d) Use Table
2.1 for the differences between debt and equity
e) Differences exist because borrowers and
lenders have different needs
C.
Matching Borrowers with Lenders
1. Direct versus
Indirect Finance
a) Definitions
b) Example; use Figure 2.5 for the differences between direct and indirect finance
2. Financial
Intermediaries
a) Different types
b) How average people use them
3. Functions of Financial Intermediaries
a) Help savers through diversification
b) Pool funds of many people
c) Take short-term deposits and make long-term
loans
d) Gather information
e) Reduce the costs of financial transactions
D.
Financial Markets
1. The Structure of Financial Markets
a) What is a financial
market?
b) Do financial markets have a physical location?
c) Markets for new
securities (primary market) and
existing securities (secondary market);
use Figure 2.6
2. How Financial Markets Determine Prices of
Securities
a) Supply and demand determine prices
b) Examples of determining equilibrium; use Figure 2.7
c) Prices of securities affected by changes in
supply and demand; use Figure 2.8
E.
The Financial System
1. The Financial System and Economic Growth
a) Firms need to borrow to grow
b) A country with an efficient financial system
makes loans available to firms, so they can grow
c) The strength of a country’s financial system
is correlated with its growth rate
2. What Happens When the Financial System Works
Poorly?
a) The Asian Crisis
(1) The poor performance
of Asian economies, beginning in 1997, was caused by a number of problems and exacerbated
by weak accounting systems
(2) Good accounting
standards are needed so investors can assess the value of their securities
b) The Savings and Loan Crisis
(1) U.S. savings and loan
(S&L) institutions began failing in large numbers in the 1980s
(2) S&L losses were
magnified when the government failed to close bankrupt S&Ls
c) Mortgages and Housing
(1) Home ownership is
easy to obtain in the United States because the financial system is well
developed
(2) In countries with
less developed financial systems, homeownership is more difficult, requiring
greater savings, so people do not own homes until later in their lives
(3) Since 2008, it has
become difficult for prospective home buyers to obtain a mortgage loan.
d) The Financial Crisis of 2008
(1) The expectation of
constantly rising housing prices was caused in part by subprime lending
(2) When home prices
dropped in 2007, the market for mortgage-backed securities crashed
(3) A global financial
crisis required governments and central banks to provide bailouts
(4) Unregulated financial
firms need to be prevented from growing so large that they are too big to fail;
government regulators need to respond more quickly to risky financial practices
(5) Dodd-Frankly Act gave
more power to government regulators
F.
Application to Everyday Life: What Do Investors Care About?
1. Five Determinants of Investors’ Decisions
a) Expected Return
(1) Definition of expected return
(2) Define return
(3) Return equals current
yield plus capital-gains yield; define current
yield, capital gain, and capital-gains
yield
(4) Numerical examples of
return, current yield, and capital-gains yield
(5) General formula for
expected return
b) Risk
(1) Causes of uncertainty
about return
(a) Default
by issuer of debt security; use Data Bank: Default Risk on Debt
(b) Unexpected change in dividend paid on equity
(c) Change in the price of the security
(d) Unexpected change in
the inflation rate; use Data Bank: How Much Risk Do Investors Face from
Inflation?
(2) Quantify risk by standard deviation
(a) General formula for standard deviation
(b) Numerical examples
c) Liquidity
(1) Definition: ease of
buying or selling securities at low transaction cost
(2) Marketable versus nonmarketable
securities
d) Taxes
(1) Define after-tax expected return
(2) Investors seek to
reduce tax burden
e) Maturity
(1) Many investors favor
securities with shorter times to maturity
(2) Long-term securities
must usually offer a higher expected return than short-term securities
2. Choosing a Financial Investment Portfolio
a) Definition of portfolio
b) Need to examine risk of entire portfolio,
taken together, not just individual security
c) Idiosyncratic
risk (unsystematic risk): risk
that can be eliminated by diversification
d) Market
risk (systematic risk): risk
that cannot be eliminated by diversification
e) No portfolio is right
for everyone; a person who is less risk-averse should hold a riskier portfolio
than someone who is very risk-averse
G.
Data Bank: Default Risk on Debt
1. Debt ratings indicate the riskiness of
different debt securities
2. Lower rated debt pays higher interest rates in
the market; use Figure 2.A
3. The difference in
interest rates between debts with different ratings gets larger in recessions;
use Figure 2.B
H.
Data Bank: How Much Risk Do Investors Face from Inflation?
1. Inflation is sometimes
difficult to predict
2. Data on economists’
expectations of inflation shows that their forecasts are often far from the forecasted
mark, especially when inflation rises or falls sharply; use Figure 2.C
3. For the past decade,
the forecasts have been fairly accurate
ADDITIONAL ISSUES FOR
CLASSROOM DISCUSSION
1. Add a more detailed
discussion of diversification. You could start by asking this question: Why is
it usually better for an investor to own 100 different stocks rather than one?
Then you could cite research that suggests that having about twenty stocks from
different industries reduces most of the idiosyncratic risk to a portfolio.
2. To expand on the
discussion of risk and return, you can draw bell-shaped curves that describe
the distribution of returns to a stock. After drawing the basic curve, you can
illustrate a variety of concepts. Show a mean-preserving spread by drawing two distributions
with the same expected return but different risks, and ask which one an
investor would prefer. Then show that if the security with more risk has a
higher expected return; some investors will prefer one and other investors will
prefer the other.
3. You can introduce the idea of a
portfolio-possibilities line by drawing a diagram showing risk on the
horizontal axis and expected return on the vertical axis. The upward sloping
portfolio-possibilities line shows the trade-off that investors face between
risk and expected return. Some investors will prefer to be on the left side of
the line, with low risk and low expected return; other investors will prefer to
be further to the right on the line, accepting greater risk in return for
increased expected return. No spot on the line is correct for everyone; a
person’s preference towards risk determines her or his optimal position.
SOLUTIONS TO TEXTBOOK
NUMERICAL
EXERCISES AND ANALYTICAL
PROBLEMS
Numerical Exercises
11.
a. The expected return to Uninvest is
E = p1X1 + p2X2
= (0.10 × 0.20) + (0.90 × 0.07)
= 0.02 + 0.063
= 0.083
= 8.3%.
The expected return to Speculate is
E = p1X1
+ p2X2
= (0.50 × 0.00) + (0.50 × 0.50)
= 0.00 + 0.25
= 0.25
= 25%
b. The standard deviation of the return to
Uninvest is
S = [p1(X1
− E)2 + p2(X2 − E)2]1/2
= {[0.10 × (0.20 − 0.083)2]
+ [0.90 × (0.07 − 0.083)2]}1/2
= (0.001369 + 0.000152)1/2
= 0.0015211/2
= 0.039
= 3.9%
The standard deviation of the return to Speculate
is
S = [p1(X1
− E)2 + p2(X2 − E)2]1/2
= {[0.50 × (0.00 − 0.25)2] + [0.50 ×
(0.50 − 0.25)2]}1/2
= (0.03125 + 0.03125)1/2
= 0.06251/2
= 0.25
= 25%
Thus, Speculate has a much higher expected return
but also much higher risk.
c. If Julia is very
risk-averse, she will not want to buy Speculate because it is too risky; she
will buy Uninvest.
d. If Julia is
risk-neutral, she will buy the stock with the highest expected return, which is
Speculate in this case.
12.
BD = 250 − 0.15b − 20Wt − 10Wt+1
BS = 50 + 0.05b + 40Wt + 20Wt+1
a. Recession today and next year:
BD = 250 − 0.15b
BS = 50 + 0.05b
BD = BS: 250 − 0.15b
= 50 + 0.05b, so 200 = 0.2b, so b = 1000
Then BD = 250 − 0.15b
= 250 − (0.15 × 1000) = 250 − 150 = 100
Check using other
equation: BS = 50 + 0.05b = 50 + (0.05 × 1000) = 50 + 50 = 100
b. Expansion today; recession next year:
BD = 250 − 0.15b − 20 = 230 − 0.15b
BS = 50 + 0.05b + 40 = 90 + 0.05b
BD = BS: 230 − 0.15b
= 90 + 0.05b, so 140 = 0.2b, so b = 700
Then BD
= 230 − 0.15b = 230 − (0.15 × 700) =
230 − 105 = 125
Check: BS
= 90 + 0.05b = 90 + (0.05 × 700) = 90
+ 35 = 125
c. Recession today; expansion next year:
BD = 250 − 0.15b − 10 = 240 − 0.15b
BS = 50 + 0.05b + 20 = 70 + 0.05b
BD
= BS: 240 − 0.15b = 70 + 0.05b, so 170 = 0.2b, so b = 850
Then BD
= 240 − 0.15b = 240 − (0.15 × 850) =
240 − 127.5 = 112.5
Check: BS
= 70 + 0.05b = 70 + (0.05 × 850) = 70
+ 42.5 = 112.5
d. Expansion today; expansion next year:
BD = 250 − 0.15b − 20 − 10 = 220 − 0.15b
BS = 50 + 0.05b + 40 + 20 = 110 + 0.05b
BD = BS: 220 − 0.15b
= 110 + 0.05b, so 110 = 0.2b, so b = 550
Then BD
= 220 − 0.15b = 220 − (0.15 × 550) =
220 − 82.5 = 137.5
Check: BS
=110 + 0.05b = 110 + (0.05 × 550) =
110 + 27.5 = 137.5
13.
a.
b. E = p1X1 + p2X2 + p3X3
+ p4X4
= [0.25 × (−0.333)] +
(0.25 × 0) + (0.25 × 0.333) + (0.25 × 0.667)
= −0.083 + 0.0 + 0.083 +
0.167
= 0.167
= 16.7%
c. S =
[p1(X1 − E)2
+ p2(X2 − E)2
+ p3(X3 − E)2
+ p4(X4 − E)2]1/2
= {[0.25 × (−0.333 −
0.167)2] + [0.25 × (0.0 − 0.167)2] + [0.25 × (0.333 –
0.167)2] + [0.25 × (0.667 − 0.167)2]}1/2
= (0.0625 + 0.00697 +
0.00689 + 0.0625)1/2
= 0.1391/2
= 0.373
= 37.3%
14.
a.
b. E = p1X1 + p2X2 + . . . + pNXN
= (0.1 × 0.00) + (0.2 ×
0.10) + (0.3 × 0.20) + (0.2 × 0.30) + (0.2 × 0.40)
= 0 + 0.02 + 0.06 + 0.06
+ 0.08
= 0.22
= 22%
c. S =
[p1(X1 − E)2
+ p2(X2 − E)2
+ . . . + pN(XN − E)2]1/2
= {[0.1 × (0.00 − 0.22)2]
+ [0.2 × (0.10 − 0.22)2] + [0.3 × (0.20 − 0.22)2] + [0.2
× (0.30 − 0.22)2] + [0.2 × (0.40 − 0.22)2]}1/2
= (0.00484 + 0.00288 +
0.00012 + 0.00128 + 0.00648)1/2
= 0.01561/2
= 0.125
= 12.5%
d. The alternative security has a return (which
equals its expected return) of
This security is riskless, so S = 0. This compares with a 22 percent
expected return with a standard deviation of 12.5 percent on the risky
security. If a person is extremely risk-averse, he will accept the lower return
on the riskless security. Someone who is not too risk-averse will choose the
riskier security. Note that there is only a 10 percent chance that the risky
security would have a lower payoff than the riskless security.
15.
a. Buy security A because its expected return is higher and there is no other
difference between the two securities.
b. Buy security D because
it gives a higher return after taxes. After-tax return to C is 10% − (10% ×
0.4) = 6%, which is less than the 7%, that an investor gets from security D.
c. Buy security F because it has a lower chance
of default, everything else being the same.
d. Buy security H because
it has no transactions cost, and its return is higher. If you buy security G,
your return is:
= 0.03 = 3 %
which is less than the return of 5% that you get from
security H.
Analytical Problems
16. a. Ford bonds would
have a higher interest rate than U.S. government bonds because Ford’s bond market
is not as liquid as the government bonds.
b. IBM bonds would have a
higher interest rate than U.S. government bonds because bond owners must pay
more taxes on IBM bonds.
c. Microsmart bonds would
have a higher interest rate than Microsoft bonds because Microsmart has higher
risk of default.
d. Thirty-year bonds
would have a higher interest rate than three-month government bonds because
investors must be compensated more for holding long-term bonds as they prefer
short-term bonds.
17. If the risk to all
your securities increases, you are now holding securities that are too risky
for you relative to their return. Therefore, you should sell some of your
securities to obtain some that are less risky, thus rebalancing your portfolio.
18. Investors pay
attention to economic data releases because the data tell investors about the
overall state of the economy. A strong economy helps most industries grow and
become more profitable; a weak economy reduces the profits of most companies.
If investors think that the probability of recession has risen, they will
reduce their demand for stocks because firms’ profits will be low and thus
stock prices will decline.
ADDITIONAL TEACHING NOTES
Current Yield versus
Dividend Yield
Some
people use the term current yield when they are referring to a debt security
and they use the term dividend yield when they are referring to an equity
security. In both cases, the definition is the same— income divided by initial
value. We will use the term current yield for both debt and equity.
Additional Example of
Calculating Expected Return
To
illustrate how to calculate the expected return, we look at two examples.
First, consider a bond (debt security) issued by Safetyco, which pays $600 in interest
in one year on a $10,000 bond. If the bond pays the promised interest and
repays the principal amount of $10,000 so there is no capital gain, it has a
return of:
But,
suppose there is a one percent chance that Safetyco will go bankrupt during the
year. When a company declares bankruptcy, the debt holders often get back some
portion, but not all, of their principal and the interest that is owed to them.
In this case, suppose an investor in a $10,000 Safetyco bond gets only $3,000
of her principal back and loses the rest of her principal and the interest due.
The return to the investor is negative:
So,
if an investor buys a $10,000 Safetyco bond, there is a 99 percent chance she
will have a return of 0.06 (or 6 percent) during the year, and a 1 percent
chance she will have a return of −0.70 (or −70 percent). The expected return to
an investment in the Safetyco bond can be found by multiplying each return by
its probability and adding up the results. (Note that the return and the
probability should both be expressed in decimal form.) The expected return to a
Safetyco bond is:
Because
there is a 1 percent chance that Safetyco will not pay the interest and
principal on its bonds, the expected return is below the 6 percent promised
return by about three quarters of one percentage point.
For
the second example, consider stock (an equity security) issued by Riskco.
Suppose that the Riskco stock pays no dividend (so, its current yield is zero)
and its stock price is $100 per share today. Consider an investor who purchases
100 shares at $100 per share, for a total investment of $10,000. If Riskco’s
main product is successful over the coming year, which has a probability of
0.75 (75 percent), Riskco’s stock price will rise to $140 per share. In this
case, the return to 100 shares of Riskco’s stock is:
If
Riskco’s main project is unsuccessful, which has a probability of 0.25 (or 25
percent), the stock price falls to $10 per share, a loss of $90 per share. The
return to a share of Riskco’s stock is then:
The
expected return on a Riskco stock can be calculated as before:
Expected return =
(probability of high return × high return) + (probability of low return × low
return)
=
(0.75 × 0.40) + (0.25 × −0.90)
=
0.300 − 0.225
=
0.075
=
7.5 percent.
Because
the expected return on a Safetyco bond is 5.24 percent and the expected return
on a Riskco stock is 7.5 percent, an investor might prefer to invest in Riskco.
Profiting from a Change
in the Price of a Security
Suppose
Sue buys a security today from Bill that promises to pay her $1,500 in one year
and costs her $1,200 today. Sue made the transaction because she thought that
the equilibrium between supply and demand in the market for such debt would
occur at a price of $1,200. But suppose business firms turn suddenly
pessimistic because they fear that the economy will weaken. As a result, the
supply of debt securities declines. This change drives up the price of the
security today, and the bond price rises to $1,400.
In
this example, Sue is very happy that she bought the security when she did. She
bought it for $1,200, but had she waited to buy it, the price would have been
$1,400. Now, if Sue wanted to, she could sell her security in the market to
make a quick profit of $200.
Additional Example of
Calculating Standard Deviation
Let’s
return to our example of the Safetyco bond to calculate the standard deviation
of its return. There was a 99 percent chance (0.99) that a Safetyco bond would
return 6 percent (0.06), and a 1 percent chance (0.01) that it would return −70
percent (−0.70), and we calculated that the expected return was 5.24 percent
(0.0524). The standard deviation of the return to a Safetyco bond is:
Standard deviation
=
{[probability of outcome 1 × (deviation of outcome 1)2] + [probability of outcome 2 × (deviation of outcome 2)2]}1/2
=
{[0.99 × (0.06 − 0.0524)2] + [0.01 × (−0.70 − 0.0524)2]}1/2
=
0.0756
=
7.56 percent.
For
a stock in Riskco, we calculate the standard deviation in the same manner. In
this case, the probability of a poor return is higher and the poor return is
worse than with the Safetyco bond, so we would expect our measure of risk to be
higher. Let’s see if that is true. There is a 0.75 percent chance of a return
of 0.40, and a 0.25 percent chance of a return of −0.90, so the expected return
is 0.075, as we calculated earlier. So, the standard deviation of the return to
the Riskco stock is:
Standard deviation
=
{[probability of outcome 1 × (deviation of outcome 1)2] + [probability of outcome 2 × (deviation of outcome 2)2]}1/2
=
{[0.75 × (0.40 − 0.075)2] + [0.25 × (−0.90 − 0.075)2]}1/2
=
0.5629
=
56.29 percent.
As
expected, the standard deviation for a Riskco stock is significantly higher
than the standard deviation for a Safetyco bond.
The
standard deviation of the return to a security is a useful measure of risk.
When the standard deviation of one security’s return is higher than the standard
deviation of another, the first security is riskier. Thus, a Riskco stock is a
riskier investment than a Safetyco debt.
Investors’ Decisions
Affect Supply and Demand
These
portfolio decisions are not one-time choices because the return, risk,
liquidity, taxation, and maturity of securities change over time. So, an
investor may have decided to buy a particular stock in 1999, thus adding to the
market demand for that stock. Then the investor may decide to sell the stock in
2003, thus adding to the market supply of the stock. So, investors’ decisions
affect both demand and supply in financial markets.
ADDITIONAL POLICY ISSUE:
SHOULD GOVERNMENT
DEBTS EXIST TO PROVIDE A
LIQUID SECURITY?
“It
is a well known fact, that in countries in which the national debt is properly
funded, and an object of established confidence, it answers most of the
purposes of money.”
—Alexander Hamilton, U.S.
Secretary of the Treasury, 1790
In
the late 1990s, the U.S. government began running budget surpluses and
projected large future surpluses totaling trillions of dollars. In 2000, the
government began buying back some of its debt in financial markets, reducing
the amount available to the public. The ratio of U.S. government debt to the
economy’s output (GDP), which measures a country’s debt relative to its ability
to repay the debt, fell sharply and was projected to fall even more. Investors
in financial markets had been using U.S. government bonds for two decades as a
benchmark security, which is a security whose returns are used for comparison
to other financial securities. But, in 2000, as the supply of U.S. government
bonds in the secondary market became smaller and smaller, investors began
looking for other securities to use as their benchmark.
Is
there value to society of the government having some debt? Alexander Hamilton
thought so, as suggested by the quote above. In the late 1700s, Hamilton, then
U.S. Secretary of the Treasury, argued that government debt was not a sign of
financial weakness, but rather was beneficial because it provided a convenient
financial security that paid interest, in the same way that currency was a
convenient financial security that paid no interest. Hamilton thought that
government debt enhanced international trade by providing interest on a
merchant’s money balances and reduced the interest rate because it provided
liquidity. That is why Hamilton suggested that government debt “answers most of
the purposes of money” in the opening quote. In Chapter 3, “Money and Payments,”
we will learn much more about the role of money in the economy.
Hamilton’s
ideas were noteworthy, but the U.S. government has run up such a big debt over
time that his argument was not debated seriously. But in the early 2000s, it was
worth thinking about, because government debt was shrinking and could have even
disappeared.
The
government debt increases the most during wartime, when large expenditures must
be financed and the government usually does not want to raise tax rates dramatically.
The ratio of government debt to GDP rose sharply in the 1940s as a result of
World War II. After that, the debt-GDP ratio declined fairly steadily until the
1970s. Government debt rose a bit in the 1970s, then increased sharply in the
early 1980s as tax rates were reduced but government spending was not reduced
as much as taxes. But the mid- to late-1990s brought faster economic growth and
the amount of debt began to decline relative to the size of the economy. And in
1999 and 2000, the debt shrank dramatically.
Is
there an optimal size of government debt? And is that optimal size positive? To
answer these questions, consider four reasons why government debt may be good
or bad. First, government debt may be good because the government provides a safe,
liquid security to investors. Second, government debt may be good when the
government borrows in bad times, which, as we will see shortly, may help to
stabilize the economy. Third, government debt may be bad because it allows the
government to be financially irresponsible. Fourth, government debt may be bad
because its existence might reduce the economy’s long-term growth rate.
The
first argument in favor of government debt is that it gives people a liquid
security that is free from default risk, thus making it a natural benchmark
security. In countries where the government debt is not very safe because the
government may default on its debt, investors tend to use a benchmark security
from another country (often U.S. government bonds). In every country, something
becomes the benchmark. In the Asian crisis in 1997 and the worldwide financial
crisis in 1998 (when first Russia defaulted on its debt and later financial
markets in many securities failed to operate when a large hedge fund failed),
as investors throughout the world sought a safe haven for their wealth, the
demand for U.S. government bonds grew tremendously and the interest rates on
such bonds fell sharply. Suppose, however, that U.S. government debt ceased to
exist. What would people do? They would probably try some alternative, but no
other bond in existence is quite as useful for this purpose as U.S. government
bonds. Bonds issued by private firms always have some default risk, more so if
the worldwide economy is in a recession. Bonds issued by the governments of
other industrialized countries might be good substitutes, but most people
perceive that those governments might default on such loans or that exchange
rates might change, causing the value of the bonds to change. Thus, alternative
benchmarks are risky.
The
second argument in favor of government debt is that it allows the government to
borrow in bad times. Suppose, for example, that the United States is in a
recession but other countries are having an economic boom. It makes sense for
the U.S. government and U.S. citizens to borrow from abroad, so that their
spending will not decline, which would make the recession worse. Then, when
economic conditions improve, people in the United States could repay the loans.
Thus, debt really is not bad; it is just a way to transfer funds between people
and countries over time to reduce the severity of recessions. A country
generally benefits by running a large government budget deficit in a time of
recession.
The
first argument against government debt is that politicians will use the debt to
pay for projects that are not worthwhile, rather than having to pay for them
from current taxes. When taxes must cover the costs of government spending,
taxpayers feel the costs of such spending directly and thus may oppose
politicians’ attempts to spend too much. But, if politicians finance the
expenditures by borrowing, and if taxpayers do not understand the future
ramifications of the debt (which include higher future taxes), then politicians
find it easier to increase government spending. Some economists believe that
this was the main cause of the large increase in U.S. government debt in the
1970s and 1980s. It was not until strict financing laws were enacted in the
late 1980s that the growth of government spending was finally curtailed.
The
second argument against government debt is that government debt causes economic
growth to decline. This happens because if the government borrows, interest
rates may rise, so business firms will not borrow as much. Consequently, they
do not invest in as much plant and equipment. As a result, the economy does not
produce as much and economic growth is lower. This notion has been debated
fiercely by economists, and they remain split on whether it is true or not.
There continues to be much dispute over how important government debt is for
economic growth.
Historically,
there have been many negative views of government debt. For example, over 200
years ago, Adam Smith argued that debt has “. . . gradually enfeebled every state
which has adopted it” (p. 881). Smith noted that many nations had been ruined
financially when they ran up debt: “. . . the enormous debts which . . . oppress,
and will in the long-run probably ruin all the great nations of Europe . . .”
(p. 863). And when it comes to debt, as David Ricardo put it “That which is
wise in an individual is wise also in a nation” (p. 163), so governments should
be no more willing to take on debt than are individuals.
One
other argument that is important to consider, concerns the social-security
system. The social-security system is set up to provide retirement income to
everyone in the country. Wage taxes on those who work are used to provide
benefits to retirees. The system works well if there is a balance of worker and
retirees, but because of the baby-boom generation, that balance is being
tilted. For the first few decades of this century, there will be many more
workers than retirees, and the amount of money entering the social-security
system will far exceed the outflow. In fact, the extra funds coming into the
social-security system are the main source of the government’s overall surplus.
But, what will happen later this century when the number of retirees begins to
grow dramatically as the baby boomers retire? No one knows for sure, but some
groups are certain to bear a high cost—either retirees or taxpayers, perhaps
both. Either, the retirement age will be increased or benefits to retirees will
be reduced, so that outflows from the social-security fund will be reduced, or
taxes on young people will be increased sharply, so the inflows to the funds
can keep up with the outflows. Even then, we could have a problem in a few
years because the social-security fund invests in—you guessed it—U.S.
government bonds. If those shrink in supply, the social-security system may be
forced to invest in the bonds issued by corporations, which raises a new
danger.
The
danger from the social-security system and hence the government investing in
financial securities issued by private corporations arises from politics. If
the government invested in corporations, there would be tremendous political
gamesmanship about choosing the companies the government would invest in.
Indeed, when you look at privately run pension funds and compare them to those
run by the government, the private funds have much higher returns, because the
government-run funds invest inefficiently. This argument is important because
it makes a large government surplus undesirable. Taxpayers would be better off
investing for themselves rather than through the government.
So,
we could face a dilemma. We would be happy if the U.S. government, after thirty
years of continuous budget deficits, would finally stop borrowing so much. But
the magnitude of the surpluses could be so great that it would cause problems
by making the government debt disappear. Is there a solution? Two possibilities
seem promising. First, if the debt is disappearing because economic growth is
permanently higher, then it may be best to reduce tax rates permanently. That
is the approach that led to the cuts in tax rates beginning in 2001. The
problem with this solution, of course, is that if the higher economic growth we
have had in recent years is just temporary, then we will face higher tax rates
in the future. An alternative solution is for the government to mimic what
people do in their personal lives—buy durable goods. When people become
wealthier, they usually buy durable goods such as houses and cars. When the
government becomes wealthier, rather than pay down its debt, it might be better
off spending the money on improving the nation’s infrastructure—buildings,
highways, schools, sewer systems, and airports. Such expenditures would create
benefits for future generations and would offset the payments they would have
make on the government debt they inherit.
Recap
1.
The existence of government debt has some value to the private sector.
2. Although balancing the
government budget may seem desirable, it may be better for the government to
keep some amount of debt and adjust its budget in other ways.
Additional Question
If
you were a member of Congress, and you believed forecasts that suggest that
government surpluses will be large and rising in the future, would you vote to:
(a) increase government spending to use up the surpluses; (b) issue tax cuts to
reduce government revenues; or (c) pay down the existing government debt?
Defend your choice and explain the main arguments in favor of the other
choices.
Answer
Many
answers are possible. If government spending has been underfunded in the past
because of financial constraints, then option (a) might be appropriate. If
government spending has been at the right level from a cost-benefit standpoint,
then option (b) would be sensible. If the ratio of government debt to GDP is
high, and there are enough government bonds outstanding to provide for
efficiency in financial markets (Hamilton’s argument), then paying down some of
the debt may be wise.
References
Hamilton,
Alexander. Report on Public Credit,
1790. Published on the Web at presspubs. uchicago.edu/founders/documents/a1_8_2s5.html.
Ricardo,
David. The Principles of Political
Economy. London: J.M. Dent and Sons, Ltd., 1911; originally published in
1817.
Smith,
Adam. The Wealth of Nations. New
York: Modern Library, 1937; originally published in 1776.
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