In this chapter we examined the roles played by governments in the financial markets when they borrow money, levy taxes, and spend the funds they raise. We explored the fiscal policy and debt management practices of governments at all levels—federal or national, state, and local. Among the key points made in the chapter are the following:

• The chief fiscal agency of the United States is the U.S. Treasury Department. Other governments around the world have similar governmental departments which generally engage in two principal activities: (a) financing government expenditures through taxation, borrowing, and accessing other funds sources; and (b) managing the government’s outstanding debt.



• The government affects the financial system and the economy through its taxing and spending activities, or fiscal policy. The government also can set in motion changes in the financial system and the economy through its debt management policy. This policy strategy involves changing the mix or composition of the government’s debt (e.g., changes in the ratio of short-term to long-term government securities outstanding).



• If the government runs a budget deficit, with expenditures outstripping revenues, it will most likely be forced to borrow, issuing new debt. Market interest rates may tend to rise, while total income and spending may tend to move higher unless the central bank offsets the government’s fiscal policy action or private borrowing and spending decline.



• On the other hand, the government may run a budget surplus, with revenues outpacing expenditures, and therefore may need to borrow less money. If the budget surplus is relatively large, a substantial portion of that surplus may be used to retire outstanding government debt. Income and market interest rates may tend to fall unless the central bank acts to offset the impact of the government’s debt retirement program.



• The government also can use debt management policy to change conditions in the financial markets and the economy. For example, if the U.S. Treasury refunds maturing short-term securities by issuing new long-term securities, this action will tend to reduce the liquidity of the public’s security holdings as the average maturity of the U.S. public debt increases. Short-term interest rates may tend to rise, while income (spending and production) may fall. In contrast, a government policy that emphasizes short-term borrowing may lead to more rapid economic growth and less unemployment, but possibly at the cost of greater inflation.



• The United States government carries one of the largest public debts in the world and, recently, due to a sluggish economy, record defense spending to fight terrorism, and costly social programs, that debt has been rising rapidly. With such a large and complex debt structure, U.S. Treasury debt managers must work to refund maturing government securities every week (in the case of short-term securities) and every quarter (in the case of longer-term securities) of the year. Their principal focus is on managing the marketable debt of the United States, represented by Treasury bills, notes, and bonds, which is sold to the public through security dealers. Today U.S. government agencies, the Federal Reserve System, and foreign investors hold a majority of the public debt of the United States.



• Fiscal policy and debt management policy, like monetary policy by the central bank, focus upon promoting maximum employment and sustainable economic growth and keeping inflation under control. But these different forms of public policy must be coordinated for maximum effectiveness; otherwise, the possible positive benefits of one policy may offset those of another.



• In addition to heavy borrowing by the U.S. Treasury Department, state and local governments in the United States also borrow billions of dollars each year to fund the construction of public facilities and to supply themselves with working capital to cover daily operations in providing government services to their citizens.



• The borrowings of these units of government are specially privileged under the U.S. Constitution and U.S. Treasury Department regulations. Their interest earnings are exempt from federal income taxation and many states also exempt the interest earnings on their own debt from state and local taxes. The taxexemption feature makes these financial instruments (called municipals) uniquely attractive to investors occupying the highest tax brackets.



• Major factors driving state and local government borrowing have included rapid population and income growth, the upgrading of citizen expectations for publicly providing services, and a shifting of responsibility for funding many local services from the federal government to state and local units of government



• Key revenue sources for state and local governments include sales and income taxes, property taxes, user fees, and funds transfers among governmental units. The largest categories of state and local government expenditures include education, social services, transportation services, health services, and construction spending.



• Many different types of securities are issued by states and local governments to borrow money. Short-term municipals include tax-anticipation notes (TANs), revenue-anticipation notes (RANs), and bond-anticipation notes (BANs). Each of these instruments is issued in the expectation that revenues to pay them off will subsequently appear.



• Long-term security issues include general obligation (GO) bonds and revenue bonds. The latter depend for their repayment on revenues generated by specific municipal projects, such as toll roads, toll bridges, and other revenuegenerating ventures. There has been a tendency in recent years to develop many new types of state and local government securities such as securitized bonds and lottery bonds.



• Among the many significant features of municipal securities are their taxexempt feature and their subsidization of high-tax-bracket investors—both of which tend to create a relatively volatile market. State and local obligations are also usually serialized or broken up into a range of maturities in order to appeal to a wider variety of potential buyers and minimize the risk of misusing public funds.



• State and local government securities are generally of high credit quality with low perceived default risk. However, in recent years a few notable failures have appeared, causing investors to rapidly move their funds to investments of higher quality. Recent failures also have spurred the expanded use of municipal bond insurance, even though it slightly lowers a municipal investor’s expected yield.



• Municipals are generally marketed through security dealers under competitive bidding. However, there are some signs of taxpayer resistance to the continuing issuance of state and local debt obligations and the higher taxes that usually follow their sale in the money and capital markets.