(a) There is practically no potential for using fiscal policy as a stabilization tool under an annually balanced budget. In an economic downturn tax revenues fall. To keep the budget in balance fiscal policy would require the government to reduce its spending or increase its tax rates adding to the deficiency in spending and accelerating the downturn. If the economy were booming and tax revenues were mounting to keep the budget balanced fiscal policy would have to increase government spending or reduce taxes thus adding to the already excessive demand and accelerating the inflationary pressures. An annually balanced budget would intensify cyclical ups and downs.

(b) A cyclically balanced budget would be countercyclical as it should be since it would bolster demand by lowering taxes and increasing government spending during a recession and restrain demand by raising taxes and reducing government spending during an inflationary boom. However because boom and bust are not always of equal intensity and duration budget surpluses during the upswing need not automatically match budget deficits during the downswing. Requiring the budget to be balanced over the cycle may necessitate inappropriate changes in tax rates or levels of government expenditures.

(c) Functional finance pays no attention to the balance of deficits and surpluses annually or over the cycle. What counts is the maintenance of a noninflationary full-employment level of spending. Balancing the economy is what counts not the budget.

Two ways of measuring the public debt: (1) measure its absolute size; (2) measure its size as a percentage of GDP.

An internally held debt is one in which the bondholders live in the nation having the debt; an externally held debt is one in which the bondholders are citizens of other nations. Paying off an internally held debt would involve boosting taxes or reducing other government spending and using the proceeds to buy the government bonds. This would present a problem of income distribution because holders of the government bonds generally have higher incomes than the average taxpayer. But paying off an internally held debt would not burden the economy as a whole -- the money used to pay off the debt would stay within the domestic economy.

In paying off an externally held debt people abroad would use the proceeds of the bonds sales to buy goods from the country paying off its external debt. That nation would have to send some of its output abroad to be consumed by others (with no imported goods in exchange).

Refinancing the public debt simply means rolling over outstanding debt -- selling "new" bonds to retire maturing bonds.

Economists do not in general view the large public debt as a burden for future generations. Future generations not only inherit the public debt they inherit the bonds which constitute the public debt. They also inherit public capital goods some of which were financed by the debt.

There is one way the debt can be a burden to future generations. Unlike tax financing debt financing may drive up interest rates since government must compete with private firms for funds in the bond market. Higher interest rates will crowd out some private investment resulting in a smaller stock of future capital goods and thus a less productive economy for future generations to inherit.

Cause and effect chain: Government borrowing to finance the debt competes with private borrowing and drives up the interest rate; the higher interest rate induces an inflow of foreign money to buy the now higher-return U.S. bonds; to buy the bonds the foreign financiers must first buy dollars; the demand for dollars rises and the dollar appreciates; U.S. exports fall and U.S. imports rise; a U.S. trade deficit results.

The U.S. public often blames the large trade deficits on the trade policies of other countries -- particularly Japan. But as noted in the scenario just described a substantial portion of the large U.S. trade deficits may have resulted from the U.S. policy of running large budget deficits for the past decade or more.