[MUSIC] It looks like the government is going to run another big budget deficit this year. >> So how come the government can spend more than it earns every year, and we can't? >> Maybe it is because the government can print its own money. >> That sure would be nice. >> In this lesson, we're going to enter the interesting realm of public finance, which is the study of the role of government in the macroeconomy. What we really want to do is drill down on the strategic consequences of chronic budget deficits for business executives and investors. And also, carefully assess the related dangers for the business and investment communities of an upward-spiralling government debt. Historically, the classical school of economics has argued that chronic budget deficits are bad and should be avoided, except in wartime. In contrast, Keynesians believe that, at least during recessions, temporary budget deficits are a necessary byproduct of an expansionary fiscal policy designed to fiscally stimulate an economy back to full employment output. One obvious problem with this Keynesian strategy, however, is that it implies federal expenditures and receipts will not always be equal. Indeed, when the government engages in physical stimulus, it typically is engaging in deficit spending, a situation in which the government borrows funds to pay for spending that exceeds tax revenues. [MUSIC] Here then are the three possible budget outcomes for a nation in any given year, deficit, surplus, or balance. With a balanced budget, government spending = tax revenues. With a budget surplus, government spending is less than tax revenues. And with a budget deficit, government spending exceeds tax revenues. Now, in the case of a budget deficit, the government must either raise taxes to bring the budget back into balance, or borrow funds from the public, or the government can print money. For example, with the borrowing option, the government can issue bonds and sell them, not just to its own citizens, but perhaps to foreign investors as well. [MUSIC] Now here's a very key definition. A nation's public debt, or national debt, is simply that nation's accumulated annual budget deficits minus its annual accumulated surpluses. And note that when a nation has a significant national debt, it is making equally significant interest payments on that debt. And that is indeed one of the hazards of a country that runs large budget deficits. It winds up paying out of portion of its tax revenues in interest payments to service the debt, when these tax revenues could otherwise be used to provide public services, like education, healthcare, new roads and bridges, and national defense. Now, at this point in our discussion, it should begin to become clear already why it is critical for both business executives and investors to pay very close attention to the public finances of the nations that it wants to do business with or invest in. Do you see what I'm getting at here? And I'd like you to think about this now. So take a minute now to jot down some ways businesses and investors might be affected by the size of a nation's public debt and the pattern of its budget deficits or surpluses. [MUSIC] Okay, why should business executives care about the public debt or budget deficits? Well, remember, when a government runs a budget deficit, it often either raises taxes or sells bonds to the public to finance the debt. Obviously, higher business taxes will hurt businesses directly by quite literally subtracting from their bottom line. However, even increasing taxes on consumers will harm business prospects indirectly. As for example, a hike in the personal income tax will take money out of the pockets of potential customers. If, on the other hand, a government that finds itself placed with a budget deficit chooses to sell bonds to the public, chief financial officers of companies in search of borrowing funds will soon find themselves competing with the government for limited capital, and facing higher interest rates. The likely result is a phenomenon called crowding out, as these higher interest rates drive down business investment, and GDP growth slows. [MUSIC] Investors think about budget deficits and public debt in the same ways, but for different reasons. For example, investment professionals know that the bonds of a country that runs chronic budget deficits will have a greater default risk than the bonds of fiscally sound and balanced nations. This is because an increasing share of that country's tax revenues must go to servicing the debt. And like companies, nations have been known to declare bankruptcy and not pay their debts. So bond traders may want to avoid the government bonds of chronic borrowers, or at least hedge their default risk. Investors also know that the higher interest rates that can result from deficit financing by nations will have a big impact on the structuring of any bond portfolios. For example, when interest rates go up, we know that bond prices will fall because of the inverse relationship between bond prices and bond yields. This means that those bond investors who can accurately forecast a rise in interest rates due to a rising national debt burden can avoid a nasty loss by buying bonds from other nations instead. [MUSIC] Okay, with that brief overview of some of the possible dangers of chronic budget deficits and a rising national debt for business executives and investors. Let's move on, in our next module, to a discussion of how to accurately measure the burden of any nation's public debt. And it's not simple as you may think. [MUSIC]
