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Government spending takes the form of salaries, defense spending, aid programs, and other cash outflows. Government collection predominantly takes 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.
Traditionally, budget deficits are considered bad, and a reduction in the budget deficit is expected to 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 expression 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.
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 trades 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), 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 National Debt
Whenever a budget is in deficit, money is added to the national debt. Similarly, whenever a budget is in surplus, money can be taken away from the national debt. The national debt is the cumulative result of all the annual deficits and the few annual surpluses.
When interest rates are low, even a large national debt may be carried without great difficulty. That is, the interest payments are not a crushing burden. But a nation’s debt is constantly being renewed, as bonds are retired and new bonds are sold. If interest rates go up and stay up for a sustained length of time, the government starts to pay a higher rate of interest on more and more of its debt. Now the interest payments are a greater burden. And because less money is available for government spending on investment, future productivity is threatened. In short, a large national debt today will result in less capital, especially physical capital, 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.
One way to lessen the damage caused by a large debt and high interest payments is for most of the debt to be domestically owned. About 20 percent of the U.S. government’s debt is in fact owned by government entities. (Notably, as the chapter on Monetary Policy explains, the Federal Reserve Bank owns a lot of Treasury bonds.) This is money the government owes to itself. Most of the rest of the U.S. federal debt is owned by American citizens, who are earning savings income from it. Only about one-third of the federal debt is owned by foreign governments and foreign private investors. This is a much better situation than if most of the federal debt were owed to foreign entities, since then most of the interest payments would be flowing out of the country and not contributing to national income.
