Curiosity 12.2 Why Did the Natural Rate of Unemployment Fall in the Late 1990s?

		Foreign Borrowing

		The great advantage of borrowing from foreigners is that crowding out can be avoided. The foreign exchange obtained by the borrowing can be used to import more goods and services, allowing the economy to have extra output to distribute to its citizens. In this case, however, future generations must pay interest and principal to foreigners, so it looks as though they are being burdened. Once again, though, this conclusion depends on the nature of the deficit spending. If the government has borrowed to invest in social infrastructure that increases the economy's productivity by enough to create additional annual income sufficient to pay off the interest and principal of the debt, then the deficit cannot be said to burden future generations.

		A good example of "investment borrowing" is the foreign borrowing done by the United States that allowed it to build railroads and steel mills during the nineteenth century. If the deficit arises because the government has borrowed to spend on overly generous social security or Medicare, or unnecessary military hardware, future generations will be asked to reduce their consumption to repay the principal and interest. In this case a burden is placed on future generations.

		Media Illustrations

		Example 1

		Prices in all areas of the bond market traded in a narrow range for most of the week, but jumped sharply yesterday morning in reaction to the news that the U.S. Senate voted to approve specific deficit reduction measures.

		Why would bond prices jump in reaction to this news?

		If the deficit is reduced, the government will not be selling so many bonds, implying that the interest rate should fall. A fall in the interest rate will push up the price of bonds. Anticipating this increase, bond traders buy bonds, bidding up their price.

		Example 2

		The damaging effect to the marketplace created by the persistence of heavy government borrowings is an ever-present concern for bond investors. A fear is that the solution to the government's seemingly insatiable appetite for funds will be debt monetization. As a result, most observers expect interest rates to remain historically high.

		What is debt monetization, and why is it feared?

		Debt monetization is printing money to finance a deficit (i.e., selling bonds to the central bank). Doing this would increase the money supply and lead to inflation, raising the nominal interest rate and lowering the price of bonds. This fall in bond prices is why it is feared by bond investors.