Let's turn now in this module to the pros and cons of budget deficits as set forth by the two major competing camps. On the one hand, deficit hawks view deficits and arising government debt as a serious threat. On the other hand, deficit doves take the position that such deficits and debt are relatively harmless. So, how do we square this circle? Before we lay out the debate, why not take a minute now and think about why budget deficits might be bad or good for a national economy. Just jot down a few ideas before moving on. Okay, let's start to work our way now through the deficit hawk versus deficit dove debate. And to begin, let's first distinguish between internal debt held by a country's citizenry and external debt held by foreigners. When most or all of the national debt is held internally by a country's citizens, the deficit doves will argue that since we owe it to ourselves, such a debt is not a problem. However, to the deficit hawks, if foreigners own a large share of a nation's debt, paying interest on that external debt acts like a tax on the nation's citizens by foreigners. Of course, the result of such a debtor's tax is reduce consumption, savings and investment so that over time, servicing interest payments on the debt effectively reduces the nation's economic growth. In addition, on the political front, if a foreign country holds a substantial amount of the nation's debt, that can expose the nation's economic and foreign public policies to undue political pressures from outside interests. Even if all of a nation's debt is held internally, the government must still make interest payments to bond holders. This can often mean higher taxes and as microeconomics teaches us, such taxes inevitably distort the allocation of a nation's resources and can lead to an efficiency loss. At the same time, paying interest on the internal debt also unfairly redistributes income from the poor and middle class to the rich. This typically happens because government bondholders, as a group, tend to be wealthier than taxpayers as a group. Deficit hawks insist that a large national debt can place an unreasonable burden on future generations that must pay off this debt. However, the deficit doves counter that any debt incurred now as a result of public investment will provide benefits, not just a burden to future generations. One of the most complex arguments against running large budget deficits has focused on the role of budget deficits stimulating the growth of trade deficits. With all the implications for negative GDP growth, higher trade deficits imply. Can you think of why a nation's budget deficit might also lead to an increase in that nation's trade deficit? Take a minute now to think about this and then describe in a step-by-step way how a budget deficit financed by selling bonds might increase the trade deficit. So, how might a budget deficit increase a nation's trade deficit? Here's the chain of logic. A nation runs a large budget deficit and finances that deficit by selling bonds in the private capital markets. To compete with private sector bonds, the government must raise the interest rate it is offering on its own bonds. Higher interest rates in turn attract more foreign investment into the nation. And as foreigners exchange their currencies for the domestic currencies so that they can make their investments, this drives the value of the domestic currency up. This appreciation or strengthening of the domestic currency then simultaneously reduces exports by raising their price and increases imports by lowering their price. This combination of increased imports and reduced exports, of course, leads to a larger trade deficit. And that's why the budget and trade deficits are often referred to as the twin deficits. Okay, that last little chain of logic involving the twin deficits was pretty fun and perhaps a bit of a brain twister. So, take a well-deserved rest now, and when you're ready, let's move on to our final lesson of this course in which we will explore the ins-and-outs and, quite literally, ups-and-downs of strategically managing companies and investments over the course of the business cycle. From the Merage School of Business, University of California, Irvine, I'm Peter Navarro.
