Running a Budget Deficit and Increasing the National Debt

Key Terminology

• Budget Deficit (Fiscal Deficit): When government spending is greater than tax revenue in a year.
• Structural Budget Deficit: Budget deficit when the economy is at full employment; tax revenue does not cover government spending despite optimal economic performance.
• Cyclical Budget Deficit: Budget deficit occurring in a recession due to increased government spending on benefits and reduced tax revenues.
• National Debt: Total stock of government debt over time (a stock concept), as opposed to budget deficits which are a flow concept.

How Budget Deficits and National Debt Rise

• Increases in government spending
• Reductions in taxation
• Expansionary Fiscal Policy: Leads to higher aggregate demand, higher growth, and lower unemployment.

Pros of Running a Budget Deficit

1. Higher Aggregate Demand:

   • Higher growth and lower unemployment.
   • Helps close the negative output gap and return the economy to full employment.

2. Improves Long-Term Growth:

   • Investment in education, healthcare, infrastructure, and public services increases the productive capacity of the economy (boosts LRAS).

3. Solves Market Failures:

   • Positive externalities from education and health.
   • Public goods like infrastructure.

4. Boosts Living Standards:

   • Improves quality of life through better public services, education, and health.

5. Reduces Income Inequality:

   • Redistribution of income through increased benefits and lower regressive tax.

6. Encourages Private Sector Investment:

   • Government spending crowds in private investment due to increased output and demand in the economy.

Cons of Running a Budget Deficit

1. Deterioration of Government Finances:

   • Lower credit ratings lead to higher interest rates on government bonds.
   • Increased borrowing costs for the government.

2. Burden on Future Generations:

   • Future tax rises or cuts to government spending to pay back debt.
   • Opportunity cost of debt interest payments, constraining future government spending.

3. Reduced Foreign Direct Investment:

   • Lower confidence in government finances can deter foreign investment.

4. Conflicts with Macro Objectives:

   • Demand-pull inflation and worsening current account deficits.
   • Higher incomes lead to increased spending on imports.
   • Reduced international competitiveness of exports.

5. Crowding Out of Private Sector:

   • Increased demand for loanable funds raises interest rates, making it more expensive for private firms to borrow.

6. Unbalanced Growth:

   • Over-reliance on public sector for growth.

7. Government Inefficiency:

   • Lack of profit motivation and expertise can lead to wasteful spending.

Evaluating the Pros and Cons

1. Current State of Government Finances:

   • If finances are already strained, the cons of worsening them may outweigh the pros.
   • If finances are strong, the pros may outweigh the cons.

2. Short Run vs. Long Run Impacts:

   • Consideration of long-term returns from either increased government spending or direct tax cuts.

3. Stage of the Economic Cycle:

   • In a recession: budget deficits could be desirable to boost aggregate demand and return to full employment.
   • In a boom: budget deficits could be inflationary and not necessary, a time to mend finances instead.

4. Specific Policy Used:

   • Direct tax cuts rely on strong consumer and business confidence.

5. Role of Automatic Stabilizers:

   • Strong automatic stabilizers reduce the need for discretionary expansionary fiscal policy.

Conclusion

Understanding the balance between the pros and cons of budget deficits and national debt is essential. The context of current government finances, economic conditions, and specific policies matter critically in evaluating their impact. Stay tuned for the next video discussing the implications of running a budget surplus.