[MUSIC] Now that we know the difference between the cyclical and structural components of the budget deficit, let's delve more deeply into why this distinction is so important. As we have learned the two basic policy guidelines when dealing with budget deficits are these. To reduce the structural budget deficit the government should either raise taxes and or cut government spending. In contrast, to reduce a cyclical budget deficit, the government can stimulate the economy through expansionary fiscal, and or monetary policies. Now here's an interesting question for you. What do you think might happen to the economy, and business environment, if the government mistakes a cyclical budget deficit for structural budget deficit and it attempts to reduce that deficit? Take a minute now ,think about this and jot down your answer. [MUSIC]. So what is likely to happen if the government mistakes a cyclical budget deficit for a structural budget deficit, and attempts to reduce that deficit? [SOUND] Well, the likely policy response will be a fiscally conservative one, using some combination of higher taxes and reduced government spending. And that policy response is likely to only further exacerbate the cyclical budget deficit by further slowing the economy, reducing tax revenues and increasing automatic stabilizer payments like unemployment compensation. Of course, the even slower economy will harm both businesses trying to sell more products and investors trying to earn returns in stock market, which is almost certainly to fall with even slower economic growth. So is what I'm sharing with you now simply hypothetical? Not at all. Do you see how these kinds of policy mistakes actually do happen and thereby harm the business and investing climate. Well, lets jump into our time machine and go back to one of the most famous cases of mistaken budget deficit identity in history. The presidential race in America, in 1960, between Republican Richard Nixon and Democrat John F Kennedy. [MUSIC] This curious case begins in 1958, when Dwight D Eisenhower was president, the US economy was in a nagging recession. And here's the critical point, America was running a budget deficit that was totally cyclical in nature of $10 billion. That is the budget deficit had no structural component at all. Now at the time, Vice President Richard Nixon was deeply concerned that a stagnating economy Would make you vulnerable during his run for president in the 1960 election. So like any good Keynesian, Nixon, vigorously, advocated, and expansionary tax cuts to stimulate the economy. However, President Eisenhower one now park Of Nixon's Keynesian stimulus for fear it might worsen the budget deficit and violate his fiscally conservative principles. So, who do you think was right, Nixon or Eisenhower? And what do you think happened? Take a minute to jot down your answers before moving on. [MUSIC] Well, since Eisenhower was the President, it was his call to make. So he spurned Nixon's Keynesian tax cut advice and absent any Nixon tax cut stimulus,the US economy limped into the presidential election season. John F Kennedy ceased on the slogan, let's get the country moving again and Kennedy squeaked by Nixon in one of the tightest presidential races in history. Of course, here's the irony. If President Eisenhower had simply listened to Vice-President Nixon's Keynesian advice and cut taxes, the result would not only have been strong economic growth, Eisenhower would have left office basking in the glow of a budget surplus of about $5 billion. Which would have been more than enough to have paid for Nixon's tax cut. This is because the additional economic growth would have generated billions of dollars of additional tax revenues. By the way, Nixon, not Kennedy, probably would've won that election, changing history entirely, in so many ways. [MUSIC] So what's the really key point of this historical example? Simply that one must know thy deficit in order to fix it. And this key point is not just useful to policy makers debating tax hikes or tax cuts. It can also be quite important for business executives and investors. [MUSIC] For example, suppose a business executive team observes that the government is about to engage in large fiscal stimulus in the presence of a large cyclical budget deficit. Should that team anticipate higher growth or simply high inflation? And how might is forecast effective production plans? Take a minute now to jot down your answer before moving on, [MUSIC] Well, in this case, a large cyclical deficit clearly implies a slow to recessionary economy in possible need of a Keynesian stimulus. In this case, the likely result may well be increased growth and the savvy business executive team will plan for increase production in anticipation of such growth. [MUSIC] Now suppose a team of bond traders observes that the government is about to engage in a massive fiscal stimulus in the form of increased government expenditures in the presence of a large structural budget deficit. Will this team be more likely to buy long term bonds, or sell them, in anticipation of how this fiscal stimulus will affect interest rates? Take a minute now to jot down your answer before moving on. [MUSIC] Well in this case, increased government expenditures in the presence of a large structural budget deficit, is likely to merely further increase the structural deficit. And thereby increase the need to finance that deficit. The likely result would be an increase in interest rates if the government borrows additional funds to finance the deficit. In that case, the bond traders will be selling long term bonds because as interest rates go up, bond prices will be falling. By selling bonds now These bond traders will thereby avoid any lawsuits due to increase interest rates. [SOUND] Okay, nice job. Feel free to take a rest and when you're ready, let's move on to the next module and the discussion of how budget deficits maybe financed. And the pros and cons of each of these three methods, raising taxes, borrowing money, or printing money. [MUSIC]
