The Online Encyclopedia and Dictionary






Deficit spending

Like other institutions, governments operate on a budget -- or try to do so. When the expenditure s of a government (its purchases of goods and services, plus its tranfers (grants) to individuals and corporations) are greater than its tax revenues, it creates a deficit in the government budget. When tax revenues exceed government purchases and transfer payments, the government has a budget surplus (as in the late 1990s in the United States).

Following John Maynard Keynes, many economists recommend deficit spending in order to moderate or end a recession, especially a severe one. When the economy has high unemployment, an increase in government purchases create a market for business output, creating income and encouraging increases in consumer spending, which creates further increases in the demand for business output. (This is the multiplier effect). This raises the real gross domestic product (GDP) and the employment of labor, lowering the unemployment rate. (The connection between demand for GDP and unemployment is called Okun's Law.) Cutting personal taxes and/or raising transfer payments can have similar expansionary effects, though most economists would say that such policies have weaker effects on aggregate demand. On the other hand, if supply-side (non-Keynesian) effects are brought into consideration, which method has a better stimulative economic effect is a matter of debate.

The increased size of the market, due to government deficits, can further stimulate the economy by raising business profitability and spurring optimism, which encourages private fixed investment in factories, machines, and the like to rise. This accelerator effect stimulates demand further and encourages rising employment. (Similarly, running a government surplus or reducing its deficit reduces consumer and business spending and raises unemployment. This can lower the inflation rate. Any use of the government deficit to steer the macro-economy is called fiscal policy.)

A deficit does not simply stimulate demand. If private investment is stimulated, that increases the ability of the economy to supply output in the long run. Also, if the government's deficit is spent on such things as infrastructure, basic research, public health, and education, that can also increase potential output in the long run. (These are public goods which are very unlikely to be provided by private initiatives.) Finally, the high demand that a government deficit provides may actually allow greater growth of potential supply, following Verdoorn's Law.

There is, however, a danger that deficit spending may create inflation -- or encouraging existing inflation to persist. (In the United States, this is seen most clearly when Vietnam-war era deficits encouraged inflation.) This is especially true at low unemployment rates (say, below 4% unemployment in the U.S.). But government deficits are not the only cause of inflation: it can arise due to such supply-side shocks as the "oil crises" of the 1970s and inflation left over from the past (inflationary expectations and the price/wage spiral). There must also be enough money circulating in the system to allow inflation to persist. (Thus, inflation depends on monetary policy.)

A government deficit also impacts the economy through the loanable funds market. When there isn't enough tax money to cover outlays, the government must borrow. This increases the demand for loanable funds and thus (ignoring other changes) pushes up interest rates. Rising interest rates can "crowd out" (discourage) fixed private investment spending, cancelling out some or even all of the demand stimulus arising from the deficit -- and perhaps hurting long-term supply-side growth. But increased deficits also raise the amount of total income received, which raises the amount of saving done by individuals and corporations and thus the supply of loanable funds, lowering interest rates. Thus, crowding out is a problem only when the economy is already close to full employment (say, at about 4% unemployment) and the scope for increasing income and saving is blocked by resource constraints (potential output).

A government deficit leads to increased government debt (often confusingly called the "national debt" or the "public debt"). In the U.S., the government borrows by selling bonds (T-bills, etc.) rather than getting loans from banks. The most important burden of this debt is the interest that must be paid to bond-holders, which restricts a government's ability to raise its outlays or cut taxes to attain other goals. Further, most of the government debt is owned by rich people, so that a rising debt can encourage income inequality. Nonetheless, the U.S. saw the long prosperity of the 1950s and 1960s -- despite a government debt that exceeded GDP in 1945.

Whether government deficits are good or bad cannot be decided without examining the specifics. Just as with borrowing by individuals or businesses, it can be good or bad. If the government borrows (runs a deficit) to deal with a severe recession (or depression), win a war that's generally perceived as just and necessary, or is spent on public investment (in infrastructure, education, basic research, or public health), most economists would agree that the deficit is bearable and even beneficial. If, on the other hand, the deficit finances gambling, waste (pork-barrel projects), unnecessary wars, or current consumption, most would recommend tax hikes, transfer cuts, and/or cuts in government purchases to balance the budget. The decision about whether the deficits are good or bad can only be made democratically by an informed public. Most importantly, the details of the budget must be addressed in order to make sure that government outlays serve the democraticaly-decided public interest.

Not all government deficits are intentional, a result of policy decisions. When an economy goes into a recession (say, due to monetary policy), deficits usually rise, at least in the U.S. and other large, rich, countries: with less economic activity, a relatively progressive tax system implies that tax revenues automatically fall. Similarly, transfer payments such as unemployment insurance benefits and food stamp grants rise.

Most economists agree that raising taxes and/or cutting government outlays is a big mistake in this situation: President Herbert Hoover made the Great Depression greater by raising taxes (and cutting demand further) in the early 1930s. Instead, he should have relied on the increased deficit to moderate the recession. This is called automatic (or built-in) stabilization. (Similarly, a rise in GDP and employment automatically causes the government deficit to shrink in size, discouraging over-heating and inflation.)

Most economists favor the use of automatic stabilization over active or discretionary use of deficits to fight mild recessions (or surpluses to fight inflation). Active policy-making takes too long for politicians to institute and too long to affect the economy. Often, the medicine ends up affecting the economy only after its disease has been cured, leaving the economy with side-effects such as inflation. For example, President John F. Kennedy proposed tax cuts in response to the high unemployment of 1960, but these were instituted only in 1964 and impacted the economy only in 1965 or 1966 and encouraged inflation then, reinforcing the effect of war-time spending. Many or most economists now favor the use of monetary policy to replace active use of deficits or surpluses.

Last updated: 02-06-2005 07:00:03
Last updated: 05-06-2005 01:27:49