Understanding the Effects of Fiscal Deficits on an Economy

Fiscal deficits are negative balances that arise whenever a government spends more money than it brings in during the fiscal year. This imbalance—sometimes called the current accounts deficit or the budget deficit—is common among contemporary governments all over the world. Since 1970, the U.S. government has had higher expenditures than revenues for all but four years with recent years each year showing a fiscal deficit in the U.S. of more than $1 trillion.

Key Takeaways

  • A government experiences a fiscal deficit when it spends more money than it takes in from taxes and other revenues excluding debt over some time period.
  • This gap between income and spending is subsequently closed by government borrowing, increasing the national debt.
  • An increase in the fiscal deficit, in theory, can boost a sluggish economy by giving more money to people who can then buy and invest more.
  • Long-term deficits, however, can be detrimental for economic growth and stability.
  • The U.S. has consistently run deficits over the past decade.

Fiscal Deficit Impact on the Economy

Economists and policy analysts disagree about the impact of fiscal deficits on the economy. Some, such as Nobel laureate Paul Krugman, suggest that the government does not spend enough money and that the sluggish recovery from the Great Recession of 2007 to 2009 was attributable to the reluctance of Congress to run larger deficits to boost aggregate demand. Others argue that budget deficits crowd out private borrowing, manipulate capital structures and interest rates, decrease net exports, and lead to either higher taxes, higher inflation or both.

Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. The Keynesian revolution and the rise of demand-driven macroeconomics made it politically feasible for governments to spend more than they brought in. Governments could borrow money and increase spending as part of a targeted fiscal policy. Keynes rejected the idea that the economy would return to a natural state of equilibrium. Instead, he argued that once an economic downturn sets in, for whatever reason, the fear and gloom that it engenders among businesses and investors will tend to become self-fulfilling and can lead to a sustained period of depressed economic activity and unemployment.

In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand.

Note that a fiscal deficit is fundamentally different from a trade deficit, which occurs when a country imports relatively more value of goods than it exports abroad.

The U.S. Fiscal Deficit

The U.S. federal shortfall for fiscal year 2020 was to be $3.1 trillion (due in large part to the coronavirus pandemic). Such a deficit occurs because the U.S. government currently spends way more than it earns. The fiscal year 2019 budget deficit came in at $984 billion.

The deficit in the United States is the result of three factors. The so-called "War on Terror" following the events of 9/11 has added $2.02 trillion to the debt since 2001. Annual military spending has doubled. Tax cuts are another cause of the burgeoning deficit because they reduce revenue for each dollar cut.

The Trump tax cuts will reduce revenue and increase the deficit; tax cuts total $1.5 trillion over the next 10 years. While the Joint Committee on Taxation expects that the cuts should stimulate growth by 0.7% annually offsetting some of the lost income, the deficit will increase $1 trillion over the next decade. Lastly, Social Security is another contributor to the deficit. According to the Henry J. Kaiser Family Foundation, Medicare spending accounted for 15% of total federal spending in 2018 and is expected to reach 18% by 2029.

The next few years should see an even larger deficit, as the 2020 global coronavirus pandemic caused a spike in unemployment and business closures, which reduces tax revenues for the government. At the same time, Congress passed a $2.2 trillion spending and stimulus package to blunt the economic blow of the public health crisis. This package greatly increased the fiscal budget gap. These effects on the deficit are likely to be long-lasting.

Impact in the Shorter-Term

Even though the long-term macroeconomic impact of fiscal deficits is subject to debate, there is far less debate about certain immediate, short-term consequences. However, these consequences depend on the nature of the deficit.

If the deficit arises because the government has engaged in extra spending projects—for example, infrastructure spending or grants to businesses—then those sectors chosen to receive the money receive a short-term boost in operations and profitability. If the deficit arises because receipts to the government have fallen, either through tax cuts or a decline in business activity, then no such stimulus takes place. Whether stimulus spending is desirable is also a subject of debate, but there can be no doubt that certain sectors benefit from it in the short run.

Financing a Deficit

All deficits need to be financed. This is initially done through the sale of government securities, such as Treasury bonds (T-bonds). Individuals, businesses, and other governments purchase Treasury bonds and lend money to the government with the promise of future payment. The clear, initial impact of government borrowing is that it reduces the pool of available funds to be lent to or invested in other businesses. This is necessarily true: an individual who lends $5,000 to the government cannot use that same $5,000 to purchase the stocks or bonds of a private company. Thus, all deficits have the effect of reducing the potential capital stock in the economy. This would differ if the Federal Reserve monetized the debt entirely; the danger would be inflation rather than capital reduction.

Additionally, the sale of government securities used to finance the deficit has a direct impact on interest rates. Government bonds are considered to be extremely safe investments, so the interest rate paid on loans to the government represent risk-free investments against which nearly all other financial instruments must compete. If the government bonds are paying 2% interest, other types of financial assets must pay a high enough rate to entice buyers away from government bonds. This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy.

Federal Limits on Deficits

Even though deficits seem to grow with abandon and the total debt liabilities on the federal ledger have risen to astronomical proportions, there are practical, legal, theoretical and political limitations on just how far into the red the government's balance sheet can run, even if those limits aren't nearly as low as many would like.

As a practical matter, the U.S. government cannot fund its deficits without attracting borrowers. Backed only by the full faith and credit of the federal government, U.S. bonds and Treasury bills (T-bills) are purchased by individuals, businesses, and other governments on the market, all of whom are agreeing to lend money to the government. The Federal Reserve also purchases bonds as part of its monetary policy procedures. Should the government ever run out of willing borrowers, there is a genuine sense that deficits would be limited and default would become a possibility.

Total government debt has real and negative long-term consequences. If interest payments on the debt ever become untenable through normal tax-and-borrow revenue streams, the government faces three options. They can cut spending and sell assets to make payments, they can print money to cover the shortfall, or the country can default on loan obligations. The second of these options, an overly aggressive expansion of the money supply, could lead to high levels of inflation, effectively (though inexactly) capping the use of this strategy.

A Historical Perspective

There is any number of economists, policy analysts, bureaucrats, politicians, and commentators who support the concept of government running fiscal deficits, albeit to varying degrees and under varying circumstances. Deficit spending is also one of the most important tools of Keynesian macroeconomics, named after British economist John Maynard Keynes, who believed that spending drove economic activity and the government could stimulate a slumping economy by running large deficits.

The first true American deficit plan was conceived and executed in 1789 by Alexander Hamilton, then Secretary of the Treasury. Hamilton saw deficits as a means of asserting government influence similar to how war bonds helped Great Britain out-finance France during their 18th-century conflicts. This practice continued, and throughout history, governments have elected to borrow funds to finance their wars when raising taxes would have been insufficient or impractical.

Upside of Deficits

Politicians and policymakers rely on fiscal deficits to expand popular policies, such as welfare programs and public works, without having to raise taxes or cut spending elsewhere in the budget. In this way, fiscal deficits also encourage rent-seeking and politically motivated appropriations. Many businesses implicitly support fiscal deficits if it means receiving public benefits.

Not all see large-scale government debt is negative. Some pundits have even gone so far as to declare that fiscal deficits are wholly irrelevant since the money is "owed to ourselves." This is a dubious claim even at face value because foreign creditors often purchase government debt instruments, and it ignores many of the macroeconomic arguments against deficit spending.

Government-run deficits have wide theoretical support among certain economic schools and near-unanimous support among elected officials. Both conservative and liberal administrations tend to run heavy deficits in the name of tax cuts, stimulus spending, welfare, public good, infrastructure, war financing, and environmental protection.

Ultimately, voters think fiscal deficits are a good idea, whether or not that belief is made explicit, based on their propensity to ask for expensive government services and low taxes simultaneously.

Downside of Deficits

On the other hand, government budget deficits have been attacked by numerous economic thinkers throughout time for their role in crowding out private borrowing, distorting interest rates, propping up non-competitive firms, and expanding the influence of nonmarket actors. Nevertheless, fiscal deficits have remained popular among government economists ever since Keynes legitimized them in the 1930s.

So-called expansionary fiscal policy not only forms the basis of Keynesian anti-recession techniques but also provides an economic justification for what elected representatives are naturally inclined to do: spend money with reduced short-term consequences.

Keynes originally called for deficits to be run during recessions and for budget shortfalls to be corrected once the economy recovered. This rarely occurs, since raising taxes and cutting government programs is rarely popular even in times of plenty. The tendency has been for governments to run deficits year after year, resulting in massive public debt.

The Bottom Line

Deficits are seen in a largely negative light. While macroeconomic proposals under the Keynesian school argue that deficits are sometimes necessary to stimulate aggregate demand after a monetary policy has proven ineffective, other economists argue that deficits crowd out private borrowing and distort the marketplace.

Still, other economists suggest that borrowing money today necessitates higher taxes in the future, which unfairly punishes future generations of taxpayers to service the needs of (or purchase the votes of) current beneficiaries. If it becomes politically unprofitable to run higher deficits, there is a sense that the democratic process might enforce a limit on current account deficits.

Article Sources

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  2. Paul Krugman. "End This Depression Now!," Page xi. W.W. Norton & Company, 2012.

  3. International Monetary Fund. "What Is Keynesian Economics?" Accessed Jan. 9, 2021.

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  6. U.S. Department of Defense. "FY 2019 Defense Budget," DoD Topline: FY 2001-2019. Accessed Jan. 9, 2021.

  7. Joint Committee on Taxation. "Macroeconomic Analysis of the Conference Agreement for H.R. 1, The Tax Cut and Jobs Act," Page 3. Download "JCX-69-17." Accessed Jan. 9, 2021.

  8. Kaiser Family Foundation. "The Facts on Medicare Spending and Financing." Accessed Jan. 9, 2021.

  9. The White House. "Remarks by President Trump, Vice President Pence, and Members of the Coronavirus Task Force in Press Briefing." Accessed Jan. 9, 2021.

  10. Board of Governors of the Federal Reserve System. "Open Market Operations." Accessed Jan. 9, 2021.

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