Chapter 31: The Impacts of Government Borrowing
When a government persistently borrows, the consequences ripple through investment, trade, private saving, interest rates, exchange rates, and long-run growth. This chapter traces those connections using the national saving and investment identity — an accounting relationship that must always hold true — and examines real-world evidence for each channel.
Table of Contents
1. Government Borrowing, Investment, and the Trade Balance
1.1 The National Saving and Investment Identity
The supply of financial capital must always equal the demand for financial capital. This gives us the national saving and investment identity:
Supply of financial capital: Private savings (S) + Public savings (T − G) + Foreign capital inflow (M − X)
Demand for financial capital: Private investment (I)
When the government runs a deficit (G > T), public savings is negative. We can rewrite the identity as:
\[S + (M - X) = I + (G - T)\]National saving and investment identity — an accounting relationship stating that financial capital supplied (private savings + foreign inflows) must equal financial capital demanded (private investment + government borrowing). A change in any one part must be offset by changes in other parts.
1.2 Three Possible Adjustments to Higher Government Borrowing
When the government increases its borrowing (larger deficit), the identity demands at least one of these adjustments:
| Adjustment | Mechanism |
|---|---|
| 1. Private saving increases | Households anticipate future taxes and save more |
| 2. Private investment falls | Government borrowing “crowds out” private firms from financial capital markets |
| 3. Trade deficit increases | Foreign investment flows in to fund the deficit; imports rise relative to exports |
1.3 The Identity Under Different Scenarios
| Scenario | Supply Side | Demand Side |
|---|---|---|
| Budget deficit + trade deficit | S + (M − X) = | I + (G − T) |
| Budget surplus + trade deficit | S + (T − G) + (M − X) = | I |
| Budget deficit + trade surplus | S = | I + (G − T) + (X − M) |
The algebra is the same; what changes is which items appear as supply (savings) vs. demand (borrowing).
Key insight: The identity always holds by definition. You cannot change one variable without something else adjusting. This is not a theory — it is an accounting fact.
2. Fiscal Policy and the Trade Balance
2.1 Twin Deficits
Twin deficits — the situation where a large budget deficit and a large trade deficit occur simultaneously and move together.
The 1980s pattern:
- Federal budget deficit went from 2.6% of GDP (1981) to 5.1% (1985) — a drop of 2.5% of GDP.
- Trade deficit went from 0.5% (1981) to 2.9% (1985) — a drop of 2.4% of GDP.
- The match was almost perfect: foreign investment capital flowed in to fund the government deficit.
Worked Example — Twin Deficits Arithmetic (1981–1985):
Using the identity: $S + (M - X) = I + (G - T)$
| Variable | 1981 (% GDP) | 1985 (% GDP) | Change |
|---|---|---|---|
| Budget deficit $(G - T)$ | 2.6% | 5.1% | +2.5% |
| Trade deficit $(M - X)$ | 0.5% | 2.9% | +2.4% |
| Private saving $(S)$ | ≈ 18% | ≈ 18% | ≈0% |
| Private investment $(I)$ | ≈ 16% | ≈ 16% | ≈0% |
Verification: The budget deficit rose by 2.5% of GDP. Private saving and investment barely changed. Therefore, by the identity, the trade deficit had to absorb nearly all of the increase: $\Delta(M-X) \approx \Delta(G-T) = 2.4\%$.
Mechanism: Budget deficit ↑ → Treasury bond sales ↑ → foreign demand for USD ↑ → dollar appreciates (exchange rate rose ~50% from 1980–1985) → exports became expensive, imports became cheap → trade deficit widens.
But twin deficits don’t always hold:
- Late 1990s: budget surplus, but trade deficit grew (foreign capital funded a private investment boom).
- 2009: budget deficit surged, but trade deficit actually shrank.
- 2010s: budget deficit changed, trade deficit stayed relatively stable.
The budget and trade deficits are “more like cousins than twins.”
2.2 The Exchange Rate Mechanism
Budget deficits can cause trade deficits through exchange rates:
- Government borrows more → sells Treasury bonds
- Foreign investors demand more dollars to buy those bonds → demand for USD shifts right
- Foreign investors supply fewer dollars → supply of USD shifts left
- Dollar appreciates (e.g., from 0.9 to 1.05 euros per dollar)
- Stronger dollar → exports become more expensive, imports become cheaper → trade deficit widens
Interest Rate Channel: The same story can be told via interest rates. Budget deficit → higher demand for financial capital → interest rates rise → foreign investors attracted by higher returns → capital inflows → dollar appreciates → trade deficit widens. These are different ways of describing the same economic connection.
2.3 From Budget Deficits to International Crisis
When sustained large deficits are funded by short-term portfolio investment (rather than long-term FDI), the economy becomes vulnerable:
- Foreign investors grow concerned about inflation or default risk
- They rapidly withdraw funds
- This depreciates the exchange rate sharply
- Domestic banks that borrowed in dollars/euros cannot repay international loans
- Bank failures + collapsed investment + depreciated currency → deep recession
Countries that followed this pattern:
| Country | Year |
|---|---|
| Mexico | 1995 |
| Thailand & East Asia | 1997–1998 |
| Russia | 1998 |
| Turkey | 2002 |
| Argentina | 2002 |
Default history: Over the past 100–175 years: Turkey defaulted 4 times, Argentina 5 times, Brazil 7 times, Venezuela 9 times.
2.4 Risks of Chronic Large Deficits
Brookings Institution findings on sustained deficits:
- Reduced national savings → less financial capital for private investment
- Higher interest rates → rising cost of financing government debt → political pressure for painful spending cuts or tax increases
- Rising debt/GDP ratio → uncertainty → possible resort to inflationary tactics to erode the real value of debt (e.g., if government borrows at 5% fixed rate and lets inflation exceed 5%, it effectively repays at negative real interest)
- Negative relationship between high debt and long-term growth (though causality direction is debated)
2.5 Fiscal Policy to Address Trade Imbalances
- A trade deficit funded by long-term FDI is less worrying — it ties the economy into global production networks.
- A trade deficit funded by short-term portfolio investment in government bonds is dangerous — investors can flee at the first sign of trouble.
- Reducing the budget deficit doesn’t always reduce the trade deficit (private saving or investment may adjust instead).
3. Government Borrowing and Private Saving
3.1 Ricardian Equivalence
Ricardian equivalence — the theory (rooted in David Ricardo, 1772–1823) that rational households adjust their savings to offset government borrowing. When deficits rise, people save more (anticipating future tax increases); when surpluses appear, people save less (anticipating future tax cuts).
If Ricardian equivalence held perfectly: Every dollar of government borrowing would be offset by a dollar of private saving. Government deficits would have no effect on investment or trade balances.
3.2 Empirical Evidence
Ricardian equivalence holds only partially:
- U.S. studies: When government borrowing increases by $1, private saving rises by about $0.30 (30 cents on the dollar).
- World Bank study: Found a similar partial offset across countries worldwide.
- The offset varies by country, time period, and whether the horizon is short or long term.
Historical patterns (U.S.):
- Mid-1980s: Large deficits, but no corresponding surge in private saving.
- Late 1990s: Surpluses appeared → private saving declined simultaneously.
- 2008–09: Very large deficits → private saving did rise.
- 2020: Deficit surged → saving jumped up as well (partly due to lockdown reducing spending opportunities).
Bottom line: Private saving does partially increase when deficits grow, but the offset is much less than one-to-one. Changes in government borrowing still affect investment and trade balances — Ricardian equivalence is a theoretical benchmark, not a complete description of reality.
4. Fiscal Policy, Investment, and Economic Growth
4.1 Crowding Out Physical Capital Investment
Crowding out — when government borrowing absorbs available financial capital and leaves less for private investment in physical capital.
Numbers to understand the scale (U.S.):
- Private investment has hovered at 14–18% of GDP in recent decades.
- About half just replaces worn-out or obsolete capital.
- New physical capital investment is only about 7–9% of GDP.
- A budget deficit of even 3% of GDP can potentially crowd out a substantial share of new investment.
Evidence:
- 1995–2000: Budget went from −2.2% to +2.4% of GDP (swing of 4.6%). Private investment rose from 15% to 18% of GDP.
- Early 2000s: Deficits returned → investment fell back to ~15% of GDP by 2003.
- Post-2009: The Fed’s dramatic interest rate cuts (3.94% → near 0%) largely suspended the crowding-out effect.
4.2 The Interest Rate Connection
Government borrowing shifts the demand for financial capital rightward → interest rates rise → private investment is discouraged.
Consensus estimate: A 1% of GDP increase in the budget deficit raises interest rates by 0.5–1.0 percentage points.
Interaction with monetary policy:
| Economic Situation | Central Bank Response | Effect on Crowding Out |
|---|---|---|
| Economy near potential GDP (inflation threat) | Contractionary monetary policy | Crowding out is amplified (rates rise even more) |
| Economy well below potential GDP | Expansionary monetary policy | Crowding out is offset (rates stay low) |
Even the central bank cannot escape the identity. If government borrowing rises, then either private investment must fall, or private saving must rise, or the trade deficit must increase. The central bank can only influence which of these adjustments occurs — it cannot prevent all of them.
4.3 Public Investment in Physical Capital
Government can also invest directly in productive physical capital:
| Category | Federal Outlays 2014 ($ millions) | Federal Outlays 2021 ($ millions) |
|---|---|---|
| Transportation | $91,915 | $146,156 |
| Community & regional development | $20,670 | $83,619 |
| Natural resources & environment | $36,171 | $40,691 |
| Education, training, employment | $90,615 | $236,723 |
| Other | $37,282 | $41,227 |
| Total | $276,653 | $548,416 |
Public capital (roads, bridges, water systems, airports, electricity) increases productivity. But government investment faces political incentives (spending in key districts, costly projects benefiting politically connected contractors) that private investment doesn’t.
4.4 Public Investment in Human Capital
- Government plays a large role through the education system.
- U.S. K–12 spending increased substantially in nominal dollars through 2020, but student achievement (SAT scores, international tests) has barely budged.
- This has led experts to question whether the problem is structural rather than a matter of resources.
Programs across the education spectrum:
- Head Start — early childhood education for families with limited resources
- K–12 public schools — the bulk of education spending
- Higher education — ~60% of U.S. students take at least some college classes (vs. ~50% in Germany/Japan, ~25% in Latin America, ~5% in sub-Saharan Africa)
The College Cost Crisis: Between 1980 and 2020, average tuition at a 4-year public university rose from $738 to $9,349 — a 12-fold increase. Median household income rose only 3.5-fold over the same period ($20,000 → $67,000). The Pell Grant program, initiated by President Johnson’s Higher Education Act of 1965, has not kept pace with tuition growth.
4.5 How Fiscal Policy Can Improve Technology
- Federal R&D outlays have averaged about 8.8% of GDP.
- About one-fifth goes to defense/space-oriented research (less likely to benefit the civilian economy directly).
- By 2014, federal R&D totaled $135.5 billion (~4% of total federal budget).
Two fiscal policy channels for R&D:
- Direct spending — government labs, grants to universities, nonprofits, and private firms.
- Tax incentives — allowing firms to reduce their tax bill based on R&D spending.
4.6 Summary: Sources of Long-Term Growth
| Physical Capital | Human Capital | New Technology | |
|---|---|---|---|
| Private Sector | New investment in property & equipment | On-the-job training | Research & development |
| Public Sector | Public infrastructure (roads, bridges, utilities) | Public education, job training (Head Start) | R&D encouraged through incentives and direct spending |
Growth policy insight: A market-oriented economy should avoid outsized sustained budget deficits that crowd out private investment. But government spending on infrastructure, education, and R&D can also boost growth. The effects of growth-oriented policies unfold very gradually over time — there are no quick fixes.
Key Takeaways
- The national saving and investment identity must always hold: S + (M − X) = I + (G − T).
- Higher government borrowing must be offset by ↑ private saving, ↓ private investment, or ↑ trade deficit.
- Twin deficits (budget + trade) occurred in the 1980s but the relationship is inconsistent — they’re “cousins, not twins.”
- Budget deficits can cause trade deficits via exchange rate appreciation (foreign capital inflows → stronger dollar → cheaper imports).
- Sustained large deficits funded by short-term portfolio flows risk international financial crises (capital flight → currency collapse → bank failures → deep recession).
- Ricardian equivalence predicts private saving offsets government borrowing, but evidence shows only a 30% offset — far from complete.
- Crowding out reduces private investment: a 1% GDP deficit increase raises interest rates by 0.5–1.0 percentage points.
- The central bank can influence which adjustment occurs but cannot escape the identity.
- Government can invest in physical capital, human capital, and R&D to support long-term growth, but these investments face political pressures and structural challenges.
- Higher education costs have risen 12-fold since 1980 while incomes rose only 3.5-fold — a growing fiscal challenge.
Practice Questions
Q1. In a country, private savings = 600, government budget surplus = 200, and trade surplus = 100. What is the level of private investment?
Answer
With a budget surplus, government is a supplier of financial capital. With a trade surplus, capital flows out. Identity: S + (T − G) = I + (X − M). So: 600 + 200 = I + 100 → **I = 700**.Q2. Explain the “twin deficits” hypothesis and why the relationship between budget and trade deficits is not always one-to-one.
Answer
The twin deficits hypothesis says that a budget deficit leads to a trade deficit because government borrowing attracts foreign capital, appreciates the exchange rate, and makes imports cheaper/exports more expensive. However, the relationship isn't one-to-one because the other parts of the identity — private saving and private investment — also change. In the late 1990s, the U.S. had budget surpluses but a growing trade deficit because foreign capital was funding a private investment boom, not government borrowing.Q3. Describe the chain of events by which large budget deficits can lead to an international financial crisis.
Answer
(1) Large deficits attract short-term foreign portfolio investment. (2) Foreign investors become concerned about inflation or default risk. (3) They rapidly withdraw funds, increasing supply of the domestic currency and reducing demand. (4) The exchange rate depreciates sharply. (5) Domestic banks that borrowed in dollars/euros cannot repay because loans are now much more expensive in local currency. (6) Widespread bank failures + collapsed investment + depreciated currency cause a deep recession. This pattern occurred in Mexico (1995), East Asia (1997-98), Russia (1998), Turkey (2002), and Argentina (2002).Q4. What is Ricardian equivalence? Does empirical evidence support it fully?
Answer
Ricardian equivalence (named after David Ricardo) holds that rational households offset government borrowing by saving more (anticipating future taxes) and offset government surpluses by saving less. If fully true, deficits would have zero effect on investment or trade. **Empirically, it holds only partially:** U.S. studies show private saving rises by about $0.30 for every $1 increase in government borrowing — far short of the full $1 offset the theory predicts.Q5. How does crowding out work, and why does it matter for long-term growth?
Answer
Government borrowing increases demand for financial capital, raising interest rates. Higher rates discourage private firms from investing in new physical capital. Since new investment in physical capital (about 7–9% of GDP) is the foundation of long-term growth, even a 3% GDP deficit can crowd out a substantial share of it. Less physical capital accumulation means lower productivity and slower economic growth over time.Q6. If the economy is in a deep recession, should we worry less about crowding out? Why?
Answer
Yes. During a deep recession, the central bank typically pursues expansionary monetary policy, keeping interest rates low. This offsets the upward pressure on rates from government borrowing, largely neutralizing crowding out. Also, during recessions, private firms lack both the funds and the incentive to invest anyway, so government borrowing is filling a gap rather than displacing private investment. After the Great Recession, the Fed cut rates from 3.94% to near zero, and crowding out appeared to be suspended.Q7. Why might increased government spending on education not automatically improve economic outcomes?
Answer
U.S. K–12 spending increased substantially in nominal dollars, but standardized test scores (SAT) barely changed and U.S. students lag many countries on international tests. This suggests the problem may be **structural** — related to how schools are organized, incentives for teachers and students, and curriculum design — rather than simply a lack of resources. More money through the same system may not produce better results without institutional reform.Q8. An economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000. (a) What is the trade balance? (b) If the surplus becomes a deficit of 1,000, with savings and investment unchanged, what is the new trade balance?
Answer
**(a)** Identity with surplus: S + (T − G) = I + (X − M). So: 4,000 + 1,000 = 5,000 + (X − M) → X − M = 0. Trade is balanced. **(b)** Now with deficit: S + (M − X) = I + (G − T). So: 4,000 + (M − X) = 5,000 + 1,000 → M − X = 2,000. The country now has a **trade deficit of 2,000**, funded by foreign capital inflows.Q9. Between 1980 and 2020, public university tuition rose 12-fold while median household income rose only 3.5-fold. What fiscal policy tools could address this growing gap?
Answer
Options include: (1) Expanding Pell Grants and other financial aid (as proposed in Biden's Build Back Better plan). (2) Increasing direct state funding to universities to reduce tuition. (3) Subsidizing student loan interest rates or forgiving debt. (4) Tax incentives for education savings (e.g., 529 plans). (5) Making community college free or heavily subsidized. Each option has trade-offs regarding the budget deficit, moral hazard (colleges raising tuition further), and equity.Q10. A nation’s government debt-to-GDP ratio is rising. In what two ways might the government use inflationary tactics to address this, and why is this approach dangerous?
Answer
(1) The government can borrow at a fixed interest rate (say 5%) and then allow inflation to exceed that rate, effectively repaying debt at a **negative real interest rate**. (2) Inflation erodes the real value of outstanding nominal debt. **Dangers:** This destroys confidence in the currency, damages real wealth, discourages foreign investment, may trigger capital flight, and can spiral into hyperinflation. It is essentially a stealth tax on creditors and savers.Q11. An economy has private saving $S = 2{,}500$, private investment $I = 3{,}000$, and a government budget deficit $(G - T) = 800$.
(a) Calculate the trade balance $(X - M)$.
(b) If the government reduces the deficit to 200 (and private saving/investment stay the same), what is the new trade balance?
(c) Calculate: by how much does the trade deficit change per dollar of deficit reduction?
Answer
**(a)** Identity: $S + (M - X) = I + (G - T)$ $2{,}500 + (M - X) = 3{,}000 + 800$ $(M - X) = 3{,}800 - 2{,}500 = 1{,}300$ Trade deficit = 1,300. (Equivalently, $X - M = -1{,}300$.) **(b)** $2{,}500 + (M - X) = 3{,}000 + 200$ $(M - X) = 3{,}200 - 2{,}500 = 700$ New trade deficit = 700. **(c)** Deficit reduction = $800 - 200 = 600$. Trade deficit reduction = $1{,}300 - 700 = 600$. Ratio: $\frac{600}{600} = 1.0$ — a **one-for-one** relationship (perfect twin deficits). This is consistent with the 1980s experience but is the extreme case. In practice, private saving and investment also adjust, so the ratio is typically less than 1:1.Q12. The consensus estimate is that a 1% of GDP increase in the budget deficit raises interest rates by 0.5–1.0 percentage points. An economy has GDP of $25 trillion and new private investment of 8% of GDP ($2 trillion).
(a) If the budget deficit increases by 2% of GDP, what is the expected interest rate increase?
(b) Suppose each percentage point of interest rate increase reduces investment by $120 billion. How much investment is crowded out?
(c) Express the crowded-out investment as a percentage of new investment.
Answer
**(a)** Using the midpoint estimate (0.75 pp per 1% GDP): $2\% \times 0.75 = 1.5$ percentage points. **(b)** Crowded-out investment = $1.5 \times \$120B = \$180B$. **(c)** As a share of new investment: $\frac{180}{2{,}000} \times 100 = 9\%$. A 2% of GDP deficit increase crowds out **9% of new private investment** — a meaningful drag on long-term growth, since it's this new investment that builds future productive capacity.Q13. Case Study — The 1997–98 Thai Financial Crisis:
Thailand maintained a soft peg to the U.S. dollar throughout the 1990s. Thai banks borrowed in dollars (low interest rates) and lent in baht (higher rates), earning the spread. By 1996, Thailand’s current account deficit reached 8% of GDP, and 10–15% of bank loans had gone bad.
(a) Use the national saving and investment identity to explain how Thailand’s large current account deficit was sustained.
(b) When foreign investors pulled out in mid-1997, the baht fell from 25 to 56 per dollar. A Thai bank had borrowed $1 million USD when the rate was 25 baht/$. Calculate the bank’s loss in baht from the currency depreciation alone.
(c) Why did the crisis spread to Indonesia, South Korea, and Malaysia (contagion)?
Answer
**(a)** Thailand had a large gap between domestic investment and domestic saving: $I > S + (T - G)$. The identity required $(M - X)$ to fill the gap — massive capital inflows from foreign investors funded the current account deficit. This foreign capital was largely short-term portfolio investment and bank lending, not stable FDI. **(b)** At 25 baht/$: loan = $1M \times 25 = 25M$ baht. At 56 baht/$: repayment = $1M \times 56 = 56M$ baht. **Loss from depreciation alone = 56M − 25M = 31 million baht** — a 124% increase in the local-currency cost of the debt, rendering the bank insolvent even if all domestic loans were repaid. **(c)** Contagion spread because: (1) Foreign investors reassessed all similar economies (“wake-up call” effect); (2) Same structural vulnerabilities existed: pegged currencies, dollar-denominated bank borrowing, current account deficits; (3) Trade linkages meant Thailand's recession reduced demand for neighbors' exports; (4) Panic selling — investors withdrew from the entire region, not just Thailand. Indonesia's rupiah fell from 2,400 to 17,000 per dollar; South Korea required a $57 billion IMF bailout.Glossary
| Term | Definition |
|---|---|
| Crowding out | Government borrowing absorbs financial capital, reducing private investment |
| Head Start program | Federal early childhood education program for families with limited resources |
| National saving and investment identity | Accounting identity: financial capital supplied = financial capital demanded |
| Ricardian equivalence | Theory that private households adjust saving to offset government borrowing/saving |
| Twin deficits | Simultaneous budget deficit and trade deficit moving together |