In this module, we're going to drill down on the three possible ways to finance a budget deficit and the various problems associated with each. These three methods include, raising taxes, borrowing money, or printing money. Here's a fun saying, from one of the most colorful politicians in American history, Louisiana Senator Russell Long: "Don't tax you, don't tax me, tax that fellow behind the tree". It's a script that speaks to a fundamental truth. It's very difficult politically to raise taxes to balance government budgets. And this is true, whether the country in question is a rich democracy, like the United States, France, or South Korea, or an authoritarian country like China, Russia, or Iran. This precisely because, taxes are so difficult to implement politically. Nations often have to resort option two to finance their budget deficits, borrowing from the public. With "The Borrow Money" option, the National Government sells IOUs in the form of bonds or Treasury bills, directly to the private capital markets, and then uses the proceeds of the sales to finance the deficit. Know, that in this case, the nation's central bank is completely out of the borrowing loop and the borrowing is left to that Nation's Treasury department, which is usually separate from the central bank. Note also, that when the government sells bonds to finance the deficit, it is competing directly in the capital markets with private corporations, which may also be seeking to sell bonds to raise capital, to invest in new plant and equipment. So what do you think is going to happen to the bond market interest rates, when the government borrows additional funds to finance its deficits? And how might that affect businesses trying to borrow funds? Take a minute to write down your answer before moving on. Yep, that's right. When the government borrows additional funds to finance its deficits, the most likely result is upward pressure on interest rates. And that in turn, will raise the cost of borrowing for companies in the private sector and business investment then falls. In fact, this phenomenon has its own name and it's called crowding out. As we have discussed, crowding out is the offsetting effect on business investment caused by the sale of government bonds to finance increased public expenditures. This crowding out effect, which is one of the most important concepts in micro economics is illustrated by these two figures: On the left hand figure, the increase in investment demand by the government shifts the demand curve from i_d1 to i_d2. This raises the interest rate and reduces private investment. In the right hand figure, we see that if the economy starts at point A and moves to point B, crowding out will be equal to h1-h2. Now let's use the Keynesian model to more fully illustrate how the crowding out effect might reduce the actual effectiveness of fiscal policy. In this figure, the initial equilibrium is at y, where the aggregate expenditure curve AE crosses the aggregate production curve AP. However, expansionary fiscal policy shifts the aggregate expenditure curve up to AE_1, and this leads to a new equilibrium of Y_1. However, because the government has had to borrow money from the private capital markets to finance these expenditures, interest rates rise, this reduces investment and the resulting contractionary effect shifts the aggregate expenditure curve back down from AE_1 to AE_2. And the final equilibrium at Y_2, the net economic expansion equals Y_2-Y. The same time the partial crowding out of private business investment may be measured by Y_1-Y_2 and is precisely on the basis of this kind of analysis that critics of discretionary Keynesian fiscal policy have argued that it is a very weak policy tool. In fact the minor tourist school of economics tends to take the view that crowding out is almost complete, so fiscal policy is completely ineffective. Keynesians on the other hand, typically argue that crowding out is minimal. And here's a very key point. At least in theory it's possible to avoid crowding out altogether, with this third possible deficit financing option. This involves the printing of money by the central bank. And it is that option, along with a phenomenon known as the Balanced Budget Multiplier. We will examine in the next module.
