Understanding the Effects of Fiscal Deficits on an Economy

Fiscal deficits arise whenever a government spends more money than it brings in during the fiscal year. This imbalance, sometimes called the current accounts deficit or the budget deficit, is common among contemporary governments all over the world. Since 1970, the U.S. government has had greater expenditures than revenues for all but four years. The four largest budget deficits in American history occurred between 2009 and 2012, each year showing a deficit of more than $1 trillion.

Economists and policy analysts disagree about the impact of fiscal deficits on the economy. Some, such as Nobel laureate Paul Krugman, suggest that the government does not spend enough money and that the sluggish recovery from the Great Recession of 2007-09 was attributable to the reluctance of Congress to run larger deficits to boost aggregate demand. Others argue that budget deficits crowd out private borrowing, manipulate capital structures and interest rates, decrease net exports, and lead to either higher taxes, higher inflation or both.

Even though the long-term macroeconomic impact of fiscal deficits are subject to debate, there is far less debate about certain immediate, short-term consequences. However, these consequences depend on the nature of the deficit. If the deficit arises because the government has engaged in extra spending projects – for example, infrastructure spending or grants to businesses – then those sectors chosen to receive the money receive a short-term boost in operations and profitability. If the deficit arises because receipts to the government have fallen, either through tax cuts or a decline in business activity, then no such stimulus takes place. Whether stimulus spending is desirable is also a subject of debate, but there can be no doubt that certain sectors benefit from it in the short run.

All government deficits need to be financed. This is initially done through the sale of government securities, such as Treasury bonds (T-bonds). Individuals, businesses and other governments purchase these bonds and lend money to the government with the promise of future payment. The clear, initial impact of government borrowing is that it reduces the pool of available funds to be lent to or invested in other businesses. This is necessarily true: an individual who lends $5,000 to the government cannot use that same $5,000 to purchase the stocks or bonds of a private company. Thus, all government deficits have the effect of reducing the potential capital stock in the economy. This would differ if the Federal Reserve monetized the debt entirely; the danger would be inflation rather than capital reduction.

Additionally, the sale of government securities used to finance the deficit has a direct impact on interest rates. Government bonds are considered to be extremely safe investments, so the interest rate paid on loans to the government represent risk-free investments against which nearly all other financial instruments must compete. If the government bonds are paying 2% interest, other types of financial assets must pay a high enough rate to entice buyers away from government bonds. This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy.

Even though federal deficits seem to grow with abandon and the total debt liabilities on the federal ledger have risen to astronomical proportions, there are practical, legal, theoretical and political limitations on just how far into the red the government's balance sheet can run, even if those limits aren't nearly as low as many would like.

As a practical matter, the U.S. government cannot fund its deficits without attracting borrowers. Backed only by the full faith and credit of the federal government, U.S. bonds and treasury bills (T-bills) are purchased by individuals, businesses and other governments on the market, all of whom are agreeing to lend money to the government. The Federal Reserve also purchases bonds as part of its monetary policy procedures. Should the government ever run out of willing borrowers, there is a very real sense that deficits would be limited and default would become a possibility.

Total government debt has real and negative long-term consequences. If interest payments on the debt ever become untenable through normal tax-and-borrow revenue streams, the government faces three options: cut spending and sell assets to make payments; print money to cover the shortfall; or default on loan obligations. An overly aggressive expansion of the money supply could lead to high levels of inflation, effectively (though inexactly) capping the use of the second strategy.

There are any number of economists, policy analysts, bureaucrats, politicians and commentators who support the concept of government running fiscal deficits, albeit to varying degrees and under varying circumstances. Government deficit spending is also one of the most important tools of Keynesian macroeconomics, named for British economist John Maynard Keynes, who believed that spending drove economic activity and the government could stimulate a slumping economy by running large deficits.

The first true American government deficit plan was conceived and executed in 1789 by Alexander Hamilton, then Secretary of the Treasury. Hamilton saw deficits as a means of asserting government influence similar to how war bonds helped Great Britain out-finance France during their 18th-century conflicts. This practice continued, and throughout history, governments have elected to borrow funds to finance their wars when raising taxes would have been insufficient or impractical.

Politicians and policymakers rely on fiscal deficits to expand popular policies, such as welfare programs and public works, without having to raise taxes or cut spending elsewhere in the budget. In this way, fiscal deficits also encourage rent-seeking and politically motivated appropriations. Many businesses implicitly support fiscal deficits if it means receiving public benefits.

Not all see large-scale government debt as a negative. Some pundits have even gone so far as to declare that fiscal deficits are wholly irrelevant, since the money is "owed to ourselves." This is a dubious claim even at face value because foreign creditors often purchase government debt instruments, and it ignores many of the macroeconomic arguments against deficit spending.

Government-run deficits have wide theoretical support among certain economic schools and near unanimous support among elected officials. Both conservative and liberal administrations tend to run heavy deficits in the name of tax cuts, stimulus spending, welfare, public good, infrastructure, war financing and environmental protection. Ultimately, voters think fiscal deficits are a good idea, whether or not that belief is made explicit, based on their propensity to ask for expensive government services and low taxes simultaneously.

On the other hand, government budget deficits have been attacked by numerous economic thinkers throughout time for their role in crowding out private borrowing, distorting interest rates, propping up noncompetitive firms and expanding the influence of nonmarket actors. Nevertheless, fiscal deficits have remained popular among government economists ever since they were legitimized by Keynes in the 1930s.

So-called expansionary fiscal policy not only forms the basis of Keynesian anti-recession techniques, but also provides an economic justification for what elected representatives are naturally inclined to do: spend money with reduced short-term consequences.

Keynes originally called for deficits to be run during recessions and for budget shortfalls to be corrected once the economy recovered. This rarely occurs, since raising taxes and cutting government programs is rarely popular even in times of plenty. The tendency has been for governments to run deficits year-after-year, resulting in massive public debt.

Government deficits are seen in a largely negative light. While macroeconomic proposals under the Keynesian school argue that deficits are sometimes necessary to stimulate aggregate demand after monetary policy has proven ineffective, other economists argue that government deficits crowd out private borrowing and distort the marketplace.

Still others suggest that borrowing money today necessitates higher taxes in the future, which unfairly punishes future generations of taxpayers to service the needs of (or purchase the votes of) current beneficiaries. If it becomes politically unprofitable to run higher deficits, there is a sense that the democratic process might enforce a limit on current account deficits.