What is Deficit Spending

Deficit spending happens when a government's expenditures are higher than the revenues it collects during a fiscal period and thus causes or worsens a government debt balance. Usually, government deficits are financed by the sale of public securities, especially government bonds. A number of economists, especially those in the Keynesian tradition, believe government deficits can be used as a tool of stimulative fiscal policy.

BREAKING DOWN Deficit Spending

Deficit spending is an accounting phenomenon. The only way to participate in deficit spending occurs when revenues fall shy of expenditures. Nevertheless, most academic and political debate regarding deficit spending centers on economic theory, not accounting. According to demand-side economic theory, a government can commence deficit spending after the economy enters recession. The concept of deficit spending as fiscal policy is typically credited to British economist John Maynard Keynes. However, many his ideas were re-interpretations or adaptations of older mercantilist contentions.

In fact, many of Keynes’ spending ideas had already been tried prior to the 1936 publication of his “The General Theory of Employment, Interest and Employment,” Keynes seminal tome on economics. For instance, Herbert Hoover battled the Great Depression with a 50 percent-plus increase in government and immense public works projects during his four years as President from 1928 and 1932.

Keynes' 1936 book gave academic and intellectual legitimacy to deficit spending programs. He contended that a decline in consumer spending could be balanced by a corresponding increase in government deficit spending, which would therefore maintain the correct balance of demand to avoid high unemployment. Once full employment was reached, Keynes believed, the market could return to a more relaxed approach and the deficit could be repaid. In the event that extra government spending caused inflation, Keynes argued that the government could simply raise taxes and drain extra capital out of the economy.

Deficit Spending and Economic Growth

Deficit spending is often misconstrued as a pro-growth economic policy apparatus, possibly because, over time, the tactic has been positively correlated with gross domestic product (GDP). However, since government spending is a component of GDP, it is not an empirical fact that the two to rise and fall together.

Keynes felt the main role of deficit spending is to prevent or reverse rising unemployment during a recession. He also believed there was a second benefit of government spending, something know “the multiplier effect.” This theory suggests that $1 dollar of government spending could increase total economic output by more than $1. There are many theoretical and empirical challenges to the Keynesian multiplier, with various and inconclusive results.

Many economists believe that the effects of deficit spending, if left unchecked, could threaten economic growth. Too much debt, augmented by consistent deficits, could cause a government to raise taxes, seek ways to increase inflation, and default on its debt. What's more, the sale of government bonds could crowd out corporate and other private issuers, which might distort prices and interest rates in capital markets.