Deficit spending
Within the budgetary process, deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit, the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual. A central point of controversy in economics, government deficit spending was first identified as a necessary economic tool by John Maynard Keynes in the wake of the Great Depression.
Controversy
Government deficit spending is a central point of controversy in economics, with prominent economists holding differing views.The mainstream economics position is that deficit spending is desirable and necessary as part of countercyclical fiscal policy, but that there should not be a structural deficit : The government should run deficits during recessions to compensate for the shortfall in aggregate demand, but should run surpluses in boom times so that there is no net deficit over an economic cycle. This is derived from Keynesian economics, and gained acceptance during the period between the Great Depression in the 1930s and post-WWII in the 1950s.
This position is attacked from both sides: Advocates of federal-level fiscal conservatism argue that deficit spending is always bad policy, while some post-Keynesian economists—particularly neo-chartalists or proponents of Modern Monetary Theory—argue that deficit spending is necessary for the issuance of new money, and not only for fiscal stimulus. According to most economists, during recessions, the government can stimulate the economy by intentionally running a deficit.
The deficit spending requested by John Maynard Keynes for overcoming crises is the monetary side of his economy theory. As investment equates to real saving, money assets that build up are equivalent to debt capacity. Therefore, the excess saving of money in time of crisis should correspond to increased levels of borrowing, as this generally doesn't happen - the result is intensification of the crisis, as revenues from which money could be saved decline while a higher level of debt is needed to compensate for the collapsing revenues. The state's deficit enables a correspondent buildup of money assets for the private sector and prevents the breakdown of the economy, preventing private money savings to be run down by private debt.
The monetary mechanism describing how revenue surpluses enforce corresponding expense surpluses, and how these in turn lead to economic breakdown was explained by Wolfgang Stützel much later by the means of his Balances Mechanics.
William Vickrey, awarded the 1996 Nobel Memorial Prize in Economic Sciences, identified deficits being viewed as profligate spending as his #1 fallacy of Financial Fundamentalism when he commented:
Fiscal conservatism
Advocates of fiscal conservatism reject Keynesianism by arguing that government should always run a balanced budget, and that deficit spending is always bad policy. The neoclassical-inclined Chicago school of economics has supported fiscal conservative ideas. Numerous states of the United States have a balanced budget amendment to their state constitution, and the Stability and Growth Pact of the European Monetary Union punishes government deficits of 3% of GDP or greater.Proponents of fiscal conservatism date back to Adam Smith, founder of modern economics. Fiscal conservatism was the dominant position until the Great Depression, associated with the gold standard and expressed in the now outdated Treasury View that government fiscal policy is ineffective.
The usual argument against deficit spending is the Government-Household analogy: households should not run deficits—one should have money before one spends it, from prudence—and that what is correct for a household is correct for a nation and its government. A similar argument is that deficit spending today will require increased taxation in the future, thus burdening future generations.
Others argue that because debt is both owed by and owed to private individuals, there is no net debt burden of government debt, just wealth transfer from those who owe debt to those who hold debt.
A related line of argument, associated with the Austrian school of economics, is that government deficits are inflationary. Anything other than mild or moderate inflation is generally accepted in economics to be a bad thing. In practice this is argued to be because governments pay off debts by printing money, increasing the money supply and creating inflation, and is taken further by some as an argument against fiat money and in favor of hard money, especially the gold standard.
Post-Keynesian economics
Some Post-Keynesian economists argue that deficit spending is necessary, either to create the money supply or to satisfy demand for savings in excess of what can be satisfied by private investment.Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: fiat money cannot be collected in taxes before it is issued and spent; the amount of fiat money in circulation is exactly the government debt—money spent but not collected in taxes. In a quip, "fiat money governments are 'spend and tax', not 'tax and spend'"—deficit spending comes first.
Chartalists argue that nations are fundamentally different from households. Governments in a fiat money system which only have debt in their own currency can issue other liabilities, their fiat money, to pay off their interest bearing bond debt. They cannot go bankrupt involuntarily because this fiat money is what is used in their economy to settle debts, while household liabilities are not so used. This view is summarized as:
Continuing in this vein, Chartalists argue that a structural deficit is necessary for monetary expansion in an expanding economy: if the economy grows, the money supply should as well, which should be accomplished by government deficit spending. Private sector savings are equal to government sector deficits, to the penny. In the absence of sufficient deficit spending, money supply can increase by increasing financial leverage in the economy—the amount of bank money grows, while the base money supply remains unchanged or grows at a slower rate, and thus the ratio increases—which can lead to a credit bubble and a financial crisis.
Chartalism is a small minority view in economics; while it has had advocates over the years, and influenced Keynes, who specifically credited it, A notable proponent was Ukrainian-American economist Abba P. Lerner, who founded the school of Neo-Chartalism, and advocated deficit spending in his theory of functional finance. A contemporary center of Neo-Chartalism is the Kansas City School of economics.
Chartalists, like other Keynesians, accept the paradox of thrift, which argues that identifying behavior of individual households and the nation as a whole commits the fallacy of composition; while the paradox of thrift is widely accepted in economics, the Chartalist form is not.
An alternative argument for the necessity of deficits was given by U.S. economist William Vickrey, who argued that deficits were necessary to satisfy demand for savings in excess of what can be satisfied by private investment.
Government deficits
When the outlay of a government exceeds its tax revenues, the government budget is said to be in deficit; government spending in excess of tax receipts is known as deficit spending. For a government that uses accrual accounting the budget balance is calculated using only spending on current operations, with expenditure on new capital assets excluded.Governments usually issue bonds to match their deficits. They can be bought by its Central Bank through open market operations. Otherwise the debt issuance can increase the level of public debt, private sector net worth, debt service, and interest rates. Deficit spending may, however, be consistent with public debt remaining stable as a proportion of GDP, depending on the level of GDP growth.
The opposite of a budget deficit is a budget surplus; in this case, tax revenues exceed government purchases and transfer payments. For the public sector to be in deficit implies that the private sector is in surplus. An increase in public indebtedness must necessarily therefore correspond to an equal decrease in private sector net indebtedness. In other words, deficit spending permits the private sector to accumulate net worth.
On average, through the economic cycle, most governments have tended to run budget deficits, as can be seen from the large debt balances accumulated by governments across the world.
Keynesian effect
Following John Maynard Keynes, many economists recommend deficit spending to moderate or end a recession, especially a severe one. When the economy has high unemployment, an increase in government purchases creates a market for business output, creating income and encouraging increases in consumer spending, which creates further increases in the demand for business output. This raises the real gross domestic product and the employment of labour, and if all else is constant, lowers the unemployment rate.The increased size of the market, due to government deficits, can further stimulate the economy by raising business profitability and spurring optimism, which encourages private fixed investment in factories, machines, and the like to rise. This accelerator effect stimulates demand further and encourages rising employment.
Similarly, running a government surplus or reducing its deficit reduces consumer and business spending and raises unemployment. This can lower the inflation rate. Any use of the government deficit to steer the macro-economy is called fiscal policy.
A deficit does not simply stimulate demand. If private investment is stimulated, that increases the ability of the economy to supply output in the long run. Also, if the government's deficit is spent on such things as infrastructure, basic research, public health, and education, that can also increase potential output in the long run. Finally, the high demand that a government deficit provides may actually allow greater growth of potential supply, following Verdoorn's law.
Deficit spending may create inflation, or encourage existing inflation to persist. For example, in the United States Vietnam-war era deficits encouraged inflation. This is especially true at low unemployment rates. But government deficits are not the only cause of inflation: It can arise due to such supply-side shocks as the oil crises of the 1970s and inflation left over from the past.
If equilibrium is located on the classical range of the supply graph, an increase in government spending will lead to inflation without affecting unemployment. There must also be enough money circulating in the system to allow inflation to persist, so that inflation depends on monetary policy.