Deficit spending

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Deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit; the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual.

Government deficit spending is a central point of controversy in economics, as discussed below. Much of the discussion is an obsolete argument between two schools of thought, those of Keynes and Hayek based on their theories and policies for the economy of the UK as it existed in the 1930s and those of the classical economists such as the Austrians who preceded them. The theories and ideas of both in their application to the United States and the US dollar were superseded in the 1960s by those of John Lindauer (The General Theories of Inflation, Unemployment, and Government Deficits) and George Stigler[citation needed].

Old Controversy[edit]

Government deficit spending is a central point of controversy in economics, with prominent economists holding differing views.[1]

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 (i.e., permanent deficit): The government should run deficits during recessions to compensate for the shortfall in aggregate demand, but should run surpluses in boom times so that there is no net deficit over an economic cycle (i.e., only run cyclical deficits and not structural deficits). This is derived from Keynesian economics, and gained acceptance (especially in the Anglo-Saxon world) during the period between the Great Depression in the 1930s and post-WWII in the 1950s.[citation needed]

This position is attacked from both sides: Advocates of sound finance argue that deficit spending is always bad policy, while some post-Keynesian economists—— particularly post-Keynesian Chartalists——argue that deficit spending is necessary, and not only for fiscal stimulus.[citation needed]

Fiscal conservatism[edit]

Advocates of fiscal conservatism reject Keynesianism by arguing 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.[citation needed]

Fiscal conservatism has academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all of the United States except Vermont having a balanced budget amendment to their state constitution, and the Stability and Growth Pact of the European Monetary Union punishing government deficits of 3% of GDP or greater. Proponents of fiscal conservatism date back to Adam Smith, founder of modern economics. Fiscal conservatism was the dominant position until the Great Depression, associated with the gold standard and expressed in the now outdated Treasury View that government fiscal policy is ineffective.[citation needed]

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. Modern economists consider that this does not apply to governments that have central banks or the ability to create currency. They can always pay their debts.[citation needed]

A similar argument is that deficit spending today will require increased taxation in the future, thus burdening future generations. (See generational accounting for discussion.) Others argue that because debt is both owed by and owed to private individuals, there is no net debt burden of government debt, just wealth transfer (redistribution) from those who owe debt (government, backed by tax payers) to those who hold debt (holders of government bonds).[2]

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 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.[citation needed]

Post-Keynesian economics[edit]

Some Post-Keynesian economists argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.[citation needed]

Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: fiat money cannot be collected in taxes before it is issued and spent; 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 which only have debt in their own currency can issue other liabilities, their fiat money, to pay off their interest bearing bond debt. They cannot go bankrupt involuntarily because this fiat money is what is used in their economy to settle debts, while household liabilities are not so used. This view is summarized as:

But it is hard to understand how the concept of "budget busting" applies to a government which, as a sovereign issuer of its own currency, can always create dollars to spend. There is, in other words, no budget to "bust". A national "budget" is merely an account of national spending priorities, and does not represent an external constraint in the manner of a household budget.[3]

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. Private sector savings are equal to government sector deficits, to the penny. In the absence of sufficient deficit spending, money supply can increase by increasing financial leverage in the economy——the amount of bank money 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.[citation needed]

Chartalism is a small minority view in economics; while it has had advocates over the years, and influenced Keynes, who specifically credited it,[4] it is categorically rejected or ignored by virtually all contemporary mainstream economists.[citation needed] 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.

Chartalists, like other Keynesians, accept 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.[citation needed]

An alternative argument for the necessity of deficits was given by U.S. economist William Vickrey, who argued that deficits were necessary to satisfy demand for savings in excess of what can be satisfied by private investment.

Larger deficits, sufficient to recycle savings out of a growing gross domestic product (GDP) in excess of what can be recycled by profit-seeking private investment, are not an economic sin but an economic necessity.[5]

Government deficits[edit]

When the outlay of a government (i.e., the total of its purchases of goods and services, transfers in grants to individuals and corporations, and its net interest payments) exceeds its tax revenues, the government budget is said to be in deficit; government spending in excess of tax receipts is known as deficit spending. Governments usually issue bonds to match their deficits. They can be bought by its Central Bank through open market operations. Otherwise the debt issuance can increase 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.[citation needed]

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 tended to run budget deficits, as can be seen from the large debt balances accumulated by governments across the world.

Keynesian Effect[edit]

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.)

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.[citation needed]

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.

Deficit spending may create inflation, or encourage existing inflation to persist. For example, in the United States Vietnam-war era deficits encouraged inflation. This is especially true at low unemployment rates. 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 (e.g., 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.[citation needed]

Loanable funds[edit]

Many economists believe government deficits influence the economy through the loanable funds market, whose existence Chartalists and other Post-Keynesians dispute. Government borrowing in this market increases the demand for loanable funds and thus (ignoring other changes) pushes up interest rates. Rising interest rates can crowd out, or 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.[citation needed]

A government deficit increases government debt. In many countries the government borrows by selling bonds rather than borrowing 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[edit]

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.[citation needed]

Unintentional deficits[edit]

National government deficits may be intentional, a result of policy decisions, or unintentional. When an economy goes into a recession, deficits usually rise in the more affluent countries. Revenue from progressive taxes based on economic activity (income, expenditure, or transactions) falls. 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. Transfer payments due to increased unemployment and reduced household income rise.

Automatic vs. active deficit policies[edit]

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.[citation needed]

See also[edit]

References[edit]

  1. ^ In "Britain’s Deficit", February 16, 2010, Paul Krugman cites two opposing groups of economists, one arguing that Britain should cut its deficit immediately, the other arguing that the deficit provides useful or necessary fiscal stimulus.
  2. ^ Mankiw Promulgates Confusion on the Debt at the NYT, Dean Baker
  3. ^ Spain and the EU: Deficit Terrorism in Action, 01/8/2010, New Deal 2.0, Marshall Auerback
  4. ^ See references at Chartalism for the influence on Keynes.
  5. ^ (Vickrey 1996, Fallacy 1)

Further reading[edit]