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Deficit spending?qsrc=3044

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.

Table of Contents

1	Government deficits
	1.1	Keynesian Effect
	1.2	Loanable funds
	1.3	"Crowding out"
2	Government deficits: good or bad?
	2.1	Unintentional deficits
	2.2	Automatic vs. active deficit policies
3	References
4	See also

Government deficits

When the outlay of a government (its purchases of goods and services, plus its transfers (grants) to individuals and corporations, in addition to its net interest payments) exceed its tax revenues, the government budget is said to be in deficit; government spending in excess of tax receipts is known as deficit spending. A deficit requires the government to borrow capital from the 'world market', increasing the level of (i) public debt, (ii) private sector net worth, (iii) debt service (interest payments) and (iv) interest rates (See: "crowding out" below). Deficit spending may, however, be consistent with public debt remaining stable as a proportion of GDP, depending on the level of GDP growth.

The opposite of a budget deficit is a budget surplus; in this case, tax revenues exceed government purchases and transfer payments.

For the public sector to be in deficit implies that the private sector (domestic and foreign) is in surplus. An increase in public indebtedness must necessarily therefore correspond to an equal decrease in private sector net indebtedness. In other words, deficit spending permits the private sector to accumulate net worth.

On average, through the economic cycle, most governments have traditionally tended to run budget deficits, as can be seen from the large debt balances accumulated by governments across the world.

Keynesian Effect

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 which method has a better stimulative economic effect is a matter of debate.^{[citation needed]}

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. Increase in government payroll has been shown to depress the economy in the long run.

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.

Loanable funds

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.

"Crowding out"

Main article: Crowding out (economics)

Usually when economists use the term "crowding out" they are referring to the government spending using up financial and other resources that would otherwise be used by private enterprise. However, some commentators use "crowding out" to refer to government providing a service or good that would otherwise be a business opportunity for private industry.

Government deficits: good or bad?

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.

Unintentional deficits

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.

By contrast, other sources of tax revenue such as wealth taxes, notably property taxes, are not subject to recessions, though they are subject to asset price bubbles.

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.

Automatic vs. active deficit policies

Further information: Automatic stabilizer

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.

References

This article needs additional citations for verification.
Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (February 2010)

William J. Baumol, Alan S. Blinder (2005). Economics: Principles and Policy. Thomson South-Western. ISBN 0324221134.
Mitchell, Bill: Deficit spending 101 – Part 1, Part 2, Part 3; Neo-Chartalist (Modern Monetary Theory) perspective on deficit spending
Vickrey, William (October 5th, 1996), Fifteen Fatal Fallacies of Financial Fundamentalism: A Disquisition on Demand Side Economics, http://www.columbia.edu/dlc/wp/econ/vickrey.html. Paper was written one week before the author's death, three days before he received the Nobel Memorial Prize in Economics.