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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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