Budget Deficits and Surpluses

The Government Budget

As we’ve seen, one important tool of government fiscal policy is government spending. But where does the government get the money to spend? The government collects its revenues from taxes of various kinds. The most important taxes (in terms of providing revenue for the government) are personal income taxes and corporate income taxes. The government budget represents the relationship between the government’s spending and the revenues it collects.

There are three possibilities. A balanced budget is when the government spends an amount equal to the amount it collects in taxes. A budget deficit is when the government spends more than it collects in taxes. A budget surplus is when the government collects more in taxes than it spends. Although in the past couple of years, the government had a much-publicized budget surplus, for most of the past 40 years the government has run a budget deficit.

The graph below shows the U.S. budget deficit or surplus in each year since 1940.

There were relatively large budget deficits during the 1940s, as a result of U.S. involvement in World War II. The budget was more or less in balance each year during the 1950s. There were fairly small deficits during the 1960s and 1970s. During the 1980s, budget deficits got much larger. These large budget deficits were primarily the result of the policies of President Ronald Reagan, which involved cutting personal income taxes and business income taxes, and at the same time increasing government spending (primarily for military purposes). Increased government spending at a time when income taxes are cut creates budget deficits. Budget deficits existed into the 1990s, although they got smaller (but still the government was spending more than it took in from taxes). By 1998, however, the government was actually collecting more in taxes than it was spending. Budget surpluses continued for several years, largely because the economy was growing rapidly: as incomes rose, people paid more income taxes, and the government’s tax revenues increased. Deficits emerged again in 2002.

How big were government budget deficits? The most useful way to measure the size of a budget deficit or surplus is to compare it to the size of the economy (that is, GDP). The graph below shows budget deficits and surpluses as a percentage of GDP.

Measuring the budget deficit or surplus as a percentage of GDP clearly shows how large the budget deficits were during World War II. The budget deficits of 2005 and 2006, though the largest in history in dollar terms, are much smaller compared to the size of the economy than were the budget deficits of the 1940s and the deficits of the Reagan-Bush years.

Are Budget Deficits Bad?

The question that arises is this: Are budget deficits bad? Are budget surpluses good?

Here’s a piece of the answer. Remember that the government uses spending and taxes to conduct fiscal policy. Fiscal policy is a way to bring down unemployment or inflation. For example, we know that if the economy is in a recession, the appropriate fiscal policy is to either increase government spending or decrease taxes. But what does increased government spending do to the government’s budget? What does a cut in taxes do to the government’s budget? Both increased spending and decreased taxes will tend to make the government’s budget deficit bigger.

The point is that a budget deficit is exactly what we need during a recession. The government should have a budget deficit to bring us out of a recession.

Likewise, during a period of inflation, the government should have a budget surplus: during inflation, the government should reduce Aggregate Demand, by cutting its spending or by raising taxes. Both a cut in government spending and a raise in taxes will tend to make a government budget surplus bigger. A surplus is exactly what we need during inflation.

So in one sense budget deficits and surpluses are neither inherently Good nor Bad. Good or bad depends on the state of the economy. Deficits are what we need during a recession; surpluses are what we need during inflation.

Unfortunately, there is a little more to it.

Budget Deficits and Interest Rates

A government budget deficit means that the government is spending more than it is collecting in taxes. How is that possible? How can the government spend more money than it has? The same way you can: when people buy a house or a car or some other expensive item, they don’t usually plunk down the whole purchase price in cash. Usually what people do is borrow the money they need. And that’s what the government does: if the government has a budget deficit, the government has to borrow the extra money it needs.

Who does the government borrow from? It borrows from banks, from businesses, and from individual people. The borrowing takes the form of government bonds, which are just government IOUs. If you have a government bond, that means that you have loaned money to the government.

The government borrowing can have an important effect. When the government goes to borrow money, it joins all those other people and businesses who are trying to borrow money to buy cars or houses or take vacations or build new factories. That is, the demand for borrowing increases. Now we know that when the demand for anything increases, the result will be a higher price. So when the demand for borrowing increases, the price of borrowing goes up. The price of borrowing is the interest rate that lenders charge. So: when the government has a budget deficit, and borrows to cover that deficit, the interest rate will be pushed up.

Crowding Out

OK, so a government budget deficit causes interest rates to rise. So what? What happens when the interest rate goes up?

As interest rates rise, consumers will be less willing and able to borrow money to buy cars or houses. As interest rates rise, businesses will be less willing and able to borrow money to build new factories. So as interest rate rises, consumer spending will go down and business investment spending will go down.

The reduction in spending by consumers and businesses when government borrowing pushes up the interest rate is called crowding-out.

What’s so important about crowding out? There is both a short-run effect and a long-run effect.

In the short run, when government increases its spending or decreases taxes, it is trying to increase Aggregate Demand. When the government increases spending or cuts taxes, so that it has a budget deficit, the government will have to borrow. That borrowing pushes up interest rates. Higher interest rates reduce spending by consumers and businesses. Reduced spending by consumers and businesses reduces Aggregate Demand. So the government’s attempts to increase Aggregate Demand are offset to some extent by the crowding-out effect.

Because of crowding-out, government fiscal policy may not be as effective at bringing down unemployment or bringing down inflation as we would expect. The bigger is the crowding-out effect, the less effective is fiscal policy.

There is also a long-run crowding-out effect. If businesses borrow less today because of the higher interest rates, then they will not invest as much today in building new factories or buying the latest technologies. As a result, businesses will not be able to produce as much in the future as they otherwise would. And if businesses don’t invest in new technologies, then our standard of living in the future will be lower than it would other wise be.

How big is the crowding-out effect?

Recent evidence suggests that it is not very big. It’s not very big because government borrowing does not lead to much of an increase in the interest rate. And the reason that government borrowing does not lead to much of an increase in the interest rate is that as soon as the interest rate starts to rise, people in other countries decide to lend their money in the U.S. to earn those higher interest rates. And that increased supply of money for lending keeps the interest rate from rising very much.

Of course, there are those who think that an increased supply of lending from people in other countries is not a good thing.

Summary

So: are budget deficits Bad? It’s not a simple issue. It really depends on whether we’re concerned with the short run or the long run. In the short run, budget deficits are A Good Thing if the economy is in a recession. A budget deficit helps lift us out of recession. But in the long run, budget deficits are A Bad Thing. Budget deficits push up interest rates, which causes businesses to invest less today, reducing our standard of living in the future.