The Economics of Deficits

Governments run deficits for several reasons. By running short-run deficits, governments can

avoid raising taxes during economic downturns, which helps households smooth consumption

over time. Running deficits can stimulate aggregate demand in the economy, thus giving

policymakers a valuable fiscal policy tool to help support macroeconomic stability. In particular,

short-run deficits may help boost economic activity when monetary policy loses its potency.

When interest rates fall to low levels during an economic downturn, banks can become reluctant

to lend when they perceive the risks of lending outweigh the gains, while fewer firms and

consumers demand new loans. In such a situation, known as a liquidity trap, a monetary authority

such as the Federal Reserve can do little to expand the money supply. Thus, while the monetary

authority can cut short-term interest rates to nearly zero—or even to zero—lower interest rates or

other monetary policy initiatives may do little to encourage new consumer spending or business

investment. During a liquidity trap situation, fiscal policy tools such as increased government

spending or tax cuts, which increase deficits, may be an important complement to monetary

policy. So-called “fresh-water” economists have questioned the logic of these fiscal policies.

So-called “salt-water” economists, who have sought to put Keynesian fiscal theories on a more

modern foundation, contend that government interventions can mitigate economic downturns.

Most professional economic forecasters find that deficits and fiscal policy measures can stimulate

economic activity when the economy operates well below its potential.

 

In better economic times, deficits may crowd out private investment or worsen trade deficits. But

long-run deficits may transfer economic resources from younger to older generations, allowing

older generations to enjoy anticipated benefits of future economic growth—long-run deficits may

also impose large burdens on future generations. Some have argued this allows politicians to act

opportunistically by providing benefits to current constituents while leaving future generations,

an unrepresented constituency, with substantial fiscal burdens.

 

Between 2007 and 2009, federal tax revenues fell by 18.0% and corporate tax revenues fell

62.7%. Government outlays rose during the recession due to “automatic stabilizer” programs such

as unemployment insurance and income support programs; federal support provided to Fannie

Mae, Freddie Mac, AIG, and other companies; and economic stimulus legislation such as the

American Recovery and Reinvestment Act of 2009 (ARRA; H.R. 1, P.L. 111-5).

 

Anticipation of changes in partisan control of government can motivate deficits, as current policy

makers may wish to restrict their successors’ options. Research on state and foreign governments

suggests that balanced-budget rules force governments to adjust spending and taxes sharply

during economic downturns. Budget enforcement legislation, such as the 1990 Budget

Enforcement Act (P.L. 101-508), may have helped preserve budgetary compromises between

parties, which may have contributed to a reduction in federal deficits.

 

Deficits can seriously harm national economies. In the short run, fiscal overstimulation leads to

inflation. In the long term, deficits either reduce capital investment, which retards economic

growth, or increase foreign borrowing, which swells the share of national income going abroad.

Governments can spend more than they collect in revenues by printing money, which causes

inflation, or by borrowing. In the long run, governments risk default and bankruptcy if they fail to

repay borrowers, at least to the extent of stabilizing the ratio of government debt to gross

domestic product.