Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus.
Government deficit spending is a central point of controversy in economics, as discussed below.
Government deficit spending is a central point of controversy in economics, with prominent economists holding differing views. The mainstream economics position is that deficit spending is desirable and necessary as part of countercyclical fiscal policy, but that there should not be a structural deficit: in an economic slump, government should run deficits, to compensate for the shortfall in aggregate demand, but should run corresponding surpluses in boom times so that there is no net deficit over an economic cycle – a cyclical deficit only. This is derived from Keynesian economics, and has been the mainstream economics view (in the Anglo-Saxon world especially) since Keynesian economics was developed and largely accepted in the Great Depression in the 1930s.
The mainstream position is attacked from both sides – advocates of sound finance argue that deficit spending is always bad policy, while some Post-Keynesian economists, particularly Chartalists, argue that deficit spending is necessary, and not only for fiscal stimulus.
Advocates of sound finance (in the US known as fiscal conservatism) reject Keynesianism and, in the strongest form, argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt), and that deficit spending is always bad policy.
Sound finance has some academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all but one state of the United States (Vermont is the exception) having a balanced budget amendment to its state constitution, and the Stability and Growth Pact of the European Monetary Union punishing government deficits of 3% of GDP or greater. Proponents of sound finance date back to Adam Smith, founder of modern economics, and it was the dominant position until the Great Depression, associated with the gold standard and expressed in the Treasury View that government fiscal policy was ineffective.
The usual argument against deficit spending, dating to Adam Smith, is that households should not run deficits – one should have money before one spends it, from prudence – and that what is correct for a household is correct for a nation and its government. A further argument is that debts must be repaid, and thus it is burdening future generations to run deficits today, for little or no gain.
A similar argument is that deficit spending today will require increased taxation in future, thus burdening future generations – see generational accounting for discussion.
A related line of argument, associated with the Austrian school of economics, is that government deficits are inflationary. Anything other than mild or moderate inflation is generally accepted in economics to be a bad thing. In practice this is argued to be because governments pay off debts by printing fiat money, increasing the money supply and creating inflation, and is taken further by some as an argument against fiat money and in favor of hard money, especially the gold standard.
Conversely, some Post-Keynesian economists argue that deficit spending is necessary, either to grow the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
Chartalists argue that deficit spending is necessary because, in their view, fiat money is created by deficit spending: one cannot collect fiat money in taxes before one has issued it and spent it, and the amount of fiat money in circulation is exactly the government debt – money spent but not collected in taxes. In a quip, "fiat money governments are 'spend and tax', not 'tax and spend'," – deficit spending comes first. Chartalists argue that nations are fundamentally different from households – governments in a fiat money system can print money to pay off debt, and thus (assuming they only issue debt in their own currency, and print money to pay it) need not go bankrupt, unlike households, which cannot print money. This view is summarized as:
Continuing in this vein, Chartalists argue that a structural deficit is necessary for monetary expansion in an expanding economy: if the economy grows, the money supply should as well, which should be accomplished by government deficit spending. In the absence of sufficient deficit spending, money supply can increase by increasing financial leverage in the economy – the credit money supply grows, while the base money supply remains unchanged or grows at a slower rate, and thus the ratio (leverage = credit/base) increases, which can lead to a credit bubble and a financial crisis.
Chartalism is a small minority view in economics; while it has had advocates over the years, and influenced Keynes, who specifically credited it, it is categorically rejected or ignored by virtually all contemporary mainstream economists. A notable proponent was Ukrainian American economist Abba P. Lerner, who founded the school of Neo-Chartalism, and advocated deficit spending in his theory of functional finance. A contemporary center of Neo-Chartalism is the Kansas City School of economics.
The Chartalist position is a monetarist form of Keynesian economics, notably the paradox of thrift, which argues that identifying behavior of individual households and the nation as a whole commits the fallacy of composition; while the paradox of thrift (and thus deficit spending for fiscal stimulus) is widely accepted in economics, the Chartalist form is not.
An alternative argument for the necessity of deficits was given by celebrated American economist William Vickrey, who argued that deficits were necessary to satisfy demand for savings in excess of what can be satisfied by private investment.
When the expenditures of a government (its purchases of goods and services, plus its transfers (grants) to individuals and corporations) are greater than its tax revenues, it creates a deficit in the government budget; such a deficit is known as deficit spending. This causes the government to borrow capital from the 'world market', increasing further debt, debt service (interest) and interest rates (See: "crowding out" below).
The opposite of a budget deficit is a budget surplus; in this case, tax revenues exceed government purchases and transfer payments.
Following John Maynard Keynes, many economists recommend deficit spending to moderate or end a recession, especially a severe one. When the economy has high unemployment, an increase in government purchases creates 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 labour, and if all else is constant, lowers 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. 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. 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 encourage 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). If equilibrium is located on the classical range of the supply graph, an increase in government spending will lead to inflation without affecting unemployment. There must also be enough money circulating in the system to allow inflation to persist—so that inflation depends on monetary policy.
A government deficit also has an impact on 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, canceling 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). Despite a government debt that exceeded GDP in 1945, the U.S. saw the long prosperity of the 1950s and 1960s. The growth of the "supply side", it seems, was not hurt by the large deficits and debts.
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.
When a government borrows, generally it accepts bids, which are measured in terms of their interest rate. When a government borrows, it captures as bids exactly as much funds as it needs.
To other borrowers, be they corporate, state or smaller, after the central government borrows at the bid interest rate, that interest rate has become the base for the prevailing interest rate.
When a government borrows, it must borrow. To the corporate borrower who must see the possibility of profit from borrowing, the interest rate becomes a limbo stick, and a time comes when they can no longer afford to borrow. They are then said to be "crowded out".
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), to help self-defense, or spends on public investment (in infrastructure, education, basic research, or public health), the vast majority of economists would agree that the deficit is bearable, beneficial, and even necessary. If, on the other hand, the deficit finances wasteful expenditure or current consumption, most would recommend tax cuts to stimulate private investment, transfer cuts, and/or cuts in government purchases to balance the budget.
Not all national 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 based on economic activity (income, expenditure, or transactions) implies that tax revenues automatically fall. Similarly, transfer payments such as unemployment insurance benefits and food stamp grants rise.
The reliance of California on state income tax, rather than property tax, due to property taxes being limited by Proposition 13, has been cited as an example of the dangers of an income tax-reliant tax system and a cause of the 2008–10 California budget crisis.
Most economists favor the use of automatic stabilization over active or discretionary use of deficits to fight mild recessions (or surpluses to combat 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 the increased debt encouraged inflation, reinforcing the effect of Vietnam war deficit spending.