[MUSIC] In thinking about the size of our national debt, the first thing we want to do is to establish a benchmark of comparison. In this regard, economists like to compare the debt to the size of the nation's gross domestic product or GDP. The reason is simple. In the abstract, a five trillion dollar national debt is a very large number. However, such a debt would pose a far more crushing burden to a small nation such as Thailand than it does to the United States. Accordingly, comparing the debt to the GDP, gives us a measure of a nation's ability to produce and therefore its ability to pay off its debt. Now, a second important way to think about the size of the national debt is to distinguish between the real and nominal budget deficits. This distinction is important because it allows us to measure how inflation in any given year reduces the effective burden of the debt. To see this, let's define our terms and then do an example. The real deficit in any given year is the actual or nominal deficit adjusted for inflation's effect on the debt. In particular the real deficit equals the nominal deficit minus the inflation rate time the total debt. So, if the nominal deficit is $100 billion, inflation is 10%, and the total debt is $5 trillion. What's the real deficit? If you said minus $400 billion you're right. Here's the math. Inflation rate of 10% times the existing debt of $5 trillion is $500 billion. Subtract this from the nominal deficit of $100 billion. And you get a real deficit of minus $400 billion. Now here's the point. Even though there is a nominal deficit inflation has eroded the actual burden of the total debt. This suggests that one way the government can lower the burden of the national debt is by increasing the inflation rate. Perhaps needless to say, this is a controversial strategy to reduce the debt. And one must hasten to add, that such a strategy can only work if the inflation is unanticipated. Otherwise bond holders will demand a higher interest rate to compensate for the anticipated inflation and thereby drive up the nominal deficit through higher interest payments. A third, indeed a very crucial distinction to make in thinking about budget deficits. Is between the structural deficit and the cyclical or passive deficit. The structural deficit is that part of the actual budget deficit that would exist even if the economy were at full employment. It is due to the existing structure of tax and spending programs. Accordingly, the structural part of the budget is thought of as active. It is determined by discretionary fiscal policies, such as those covering tax rates, public works projects, and education and defense spending. In contrast, the cyclical or passive deficit is that part of the actual budget deficit attributable to a recessionary economy. It results, at least partly, from the government's automatic stabilizers. Those increased income transfers that kick in during a recession, on such things as unemployment compensation, food stamps, and other welfare benefits. However, the cyclical deficit results primarily from the shortfall of tax revenues that arises when the government's resources are underutilized. Such as in the downward portion of the business cycle. Hence, the cyclical deficit. You better understand the nature of the cyclical deficit. Let's digress fora moment and talk a little more about automatic stabilizers and income transfers. Income transfers are payments to the individuals by the government for which no current goods or services are exchanged. They include payments for entitlement programs like Social Security, welfare, and unemployment benefits. At least some of these income transfers, particularly, welfare and unemployment, are part of the government's automatic stabilizer system. Where, automatic stabilizers are defined as federal revenues or expenditures that automatically respond to changes in the GDP in a counter-cyclical way. Take a look at this table to better understand how income transfers can affect the economy. Here we see that when the unemployment rate increases by a percentage point the budget deficit increases. This is because even as government spending for items such as food stamps and unemployment benefits are rising. Government tax revenues are falling. In this case, government spending is acting counter-cyclically, helping to offset the recession. But the table also shows that an increase in inflation can also widen the budget deficit. This is at least partly because some income transfer programs like Social Security are indexed to inflation. The broader point is that neither the president nor the congress has complete control over the federal deficit. And that's one major reason why the distinction between the structural and cyclical deficits is so important.
