Deficit

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DEFINITION of 'Deficit'

The amount by which a resource falls short of a mark, most often used to describe a difference between cash inflows and outflows. Deficit is the opposite of surplus and is synonymous with shortfall or loss.

 

BREAKING DOWN 'Deficit'

The term deficit is generally prefixed by another term to refer to a specific situation, a trade deficit or budget deficit, for example.

A trade deficit exists when a nation has exports of $2 billion and imports of $3 billion in a given year. The country’s deficit is at $1 billion for that year. 

A budget deficit occurs when a government has revenues lower than its expenditures. Lets say a small country has $10 billion worth of revenue for a year and its expenditures were at $12 billion for that same year, it would be running a deficit of $2 billion.

An income deficit isn’t quite the same as a budget or trade deficit. A measurement used by the U.S. Census, an income deficit is the dollar amount by which a family’s income falls short of being at or above the poverty line. If the poverty line is $17,000 a year for a family of three, and the family income is at $15,000, then the family’s income deficit is $2,000. 

Primary and Total Deficits

While there are different types of deficits depending on context, even within a specific context there are different ways to measure deficit. When measuring a government deficit, there are two different ways to measure.

Primary deficit refers to the deficit without including interest payments on loans taken out to finance the operation of the government.

Total deficit measures the deficit while including interest payments on loans taken out to finance the operation of the government as well as the interest on the loans. 

The size of these deficits can vary depending on the economic and political climate. If a country economy is expanding, increased tax receipts and other inflows of government income will reduce or eliminate government deficits and may lead to government surpluses. Specific goods can be taxed at higher rates, like in OPEC nations or Norway and Russia where oil and gas play important roles in the funding of public spending. 

Intentionally Running a Deficit

It’s not uncommon that in a recession, a government will intentionally run a deficit. The theory behind running a deficit is that by reducing taxes and increasing spending on infrastructure while maintaining government programs and expenditures, the public’s purchasing power will be increased and can then stimulate the economy. While running a deficit, a government can finance its expenditures with bonds, or from loans from foreign countries.

This tactic is by no means universally agreed upon. The Ricardian equivalence hypothesis, originally brought up by member of Parliament and economist David Ricardo, argues that households, anticipating a rise in taxes in the future necessary to pay current government deficits will keep money saved instead of spending it. However, for Ricardian equivalence to apply, the deficit spending would have to be permanent as opposed to a one time stimulus through deficit spending.  

Another hypothesis, called crowding out says that when a government borrows to offset the deficit they’re running, interest rates rise as a response to increased demand, decreasing the incentive for private investment.

The experience of governments that have run persistent deficits in the 20th and 21st centuries have complicated the Ricardian and neo-classical analyses of the effect of government debt on economic activity. The Great Recession, which drove up government deficits across the world from 2008 to 2013, led many neo-classical economists to speculate that government budgets would collapse under the weight of persistent spending deficits. In a particularly famous case, the Harvard economists Carmen Reinhart and Kenneth Rogoff predicted in 2010 that government debt above 90% of GDP would actively retard economic growth. Researchers at the University of Massachusetts discovered a coding error in the Excel spreadsheet Reinhart and Rogoff used that invalidated their original conclusion.

Deficit and Risk

It used to be that government budget deficits were financed exclusively by loans from private investors and foreign countries. These loans were often seen as holding a lot of risk for the lender seeing that they were often both large and long-term. When governments began to issue bonds, which could be payable to bearer, it enabled the original lender could sell the debt - reducing risk and interest rates.

If a deficit is large enough, it can over a number of years can wipe out equity for an individual or a company's shareholders, eventually leaving bankruptcy as the only option. Although sovereign governments have a much greater capacity to sustain deficits, negative effects in such cases include lower economic growth rates (in case of budget deficits) or a devaluation of the domestic currency (in case of trade deficits).

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