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Policy Debates

Budget Deficit



Balanced budget debate

The budget deficit is often in the media spotlight. The budget deficit is defined as the difference between what the government spends and what the government collects. Government spending takes the form of salaries, defense spending, aid programs, and other cash outflows. Government collection predominately take the form of taxes. When the government spends more than it collects, a budget deficit exists. When the government collects more than it spends, a budget surplus exists.

There are three basic sides to the balanced budget debate. The traditionalists argue for a reduction of the budget deficit on the grounds that it harms the economy. Another group holds the Ricardian view of government debt in believing that there is no real harm done to the economy by the national debt. A third group exists on the fringe with the opinion that the budget deficit is not an adequate measure of fiscal policy.

Traditionalists argue that a reduction in the budget deficit will significantly help the economy in the long run. This theory is based on the following logic. When the government runs a budget deficit, it is spending more than it is taking in. In this way, national savings decreases. When national savings decreases, investment--the primary store of national savings--also decreases. Lower investment leads to lower long-term economic growth. Similarly, lower investment is accompanied by higher domestic interest rates, which decreases net exports. Based on this logic, a budget deficit is a drain on the long-term economy.

But the Ricardian view of the budget deficit takes a much less negative position on this issue. Supporters of this view believe that a budget deficit represents trading taxes in the future for taxes today. That is, if the government spends more than it taxes today, then it must tax more than it spends tomorrow. Given that the public intrinsically understands this, a questionable premise, then the public will spend and save accordingly. Since the public is adjusting its spending and savings schedules to account for the necessary future increases in taxes, the budget deficit should have little long-term effect on economic growth.

The third position, a bit on the fringe, claims that the budget deficit is not a reasonable measure of fiscal policy. While these economists do believe that the government can affect spending, savings, and investment, they also believe that the budget deficit is simply an incomplete measure of these variables. Based on this position, the budget deficit should not be a focal issue in the economic policy debate.

Which of these views is most reasonable? There is likely a bit of truth in all of them. The best view of the budget deficit comes from understanding the major positions on the issue and creating some sort of compromise between the traditional, Ricardian, and fringe viewpoints.

Burden of the national debt

Each time a budget deficit is run, money is added to the national debt. Similarly, each time a budget surplus is run, money can be, but is not necessarily, taken away from the national debt. In this context, the national debt is the total amount of money owed by the government for goods and services delivered but never paid for. Interestingly, deficit spending tends to increase both real GDP and the price level. The desirability of these effects of the budget deficit is mixed in the short run.

As with the budget deficit, there are a number of different views regarding the national debt. Some believe that the national debt is a significant strain on economic growth, while others minimize the possible effects of the national debt. With the national debt in the United States in the many trillions of dollars, the effects of a significantly reduced national debt seem far off and theoretical, yet in reality they can serve as very important goals for policy decisions.

Instead of analyzing the many views regarding the national debt, we will focus on the truths about the national debt and let the relative merits of the positions fall into place. The most important effects of a national debt are on the supply side of the economy. That is, because a large national debt increases the interest rate, investment falls as the national debt increases. That is, a large national debt today will result in less capital, especially physical, being passed on to future generations. In this way, future generations are burdened by a lower capacity for productivity as a result of decreased investment created by the national debt.

The problems created by the national debt can be attacked from another angle. If the government runs a budget deficit, then it spends more than it receives. In order to fund this spending, the government must take out loans. This is usually done by selling government bonds. In order for the government to sell its bonds, it must offer an interest rate that is attractive to investors. When the government sells bonds, money is diverted away from bonds being sold by private companies. Thus, the money that private companies would have received and used as investment funds is instead funneled to the government to fund a budget deficit. This is called crowding out because the government takes investment funds away from the private sector.

However, there is a force that works in the opposite direction of crowding out. This force is called crowding in. According to the theory of crowding in, as the government spends money, private industry must be prepared to provide the output demanded by the government. In order to do this businesses must invest in capital to increase their productivity. This is an effect of government spending wherein the government actually stimulates investment, thus "crowding in."

It is generally accepted that the crowding out effect of government spending increases is stronger than the crowding in effect. But, given the presence of both effects, it is not unreasonable to expect that in some situations, like extreme slowdowns in the economy, crowding in might be stronger than crowding out. In these situations a budget deficit is a positive policy, as it spurs on economic activity in a time where activity might otherwise be extremely sluggish.

It is important to remember that while crowding out is usually stronger than crowding in, it is not strong enough to completely cancel out all of the effects of increased government spending. In this way, national debt and budget deficits may be beneficial to the US economy, especially when the debt is owed domestically, because it represents economic activity that would otherwise be absent. While it is true that future generations will be burdened with greater interest payments on a large national debt, because all of this economic activity--including the interest payments--is predominately between agents in the US, the harmful effects of the national debt and the budget deficits are minimized.

There is a fringe party in the national debt debate who believes in debt neutrality. That is, they believe that the national debt has little or no effect on the economic wellbeing of the public because the public saves and spends in accordance with long-term economic goals. According to this position, if the national debt is high, citizens will save more to allow this debt to be attacked in the future. While this view is theoretically important, its practical importance is questionable as it relies on a fully informed populace. It is much more reasonable to accept the views that acknowledge some effect of the national debt on the economy.

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