Hi everybody, before we dive into the pros and cons of running a budget deficit and increasing the national debt, let's ensure we're okay with some key terminology. Starting with a budget deficit, also known as a fiscal deficit. This is when government spending is greater than tax revenue in a year.
You can think of this as just government borrowing in a year, government debt in a year. A structural budget deficit is a budget deficit when the economy is at full employment. So even when the economy is performing as well as it possibly can, The government is not earning enough tax revenue to fully cover its government spending. Whereas a cyclical budget deficit is a budget deficit in a recession. Now in a recession we expect a budget deficit, we expect the worsening of government finances because government spending on benefits rises and tax revenues naturally come down.
So the budget deficit in a recession on top of the structural budget deficit is your cyclical budget deficit. This all differs from the national debt. The national debt is the total stock. of government debt over time.
So economists call the national debt a stock concept, it's the total, whereas budget deficits are a flow concept, they change every year. So at the end of the year, the budget deficit goes back to zero and that debt gets added to the national debt. So bearing all this in mind, it's clear, isn't it, that if the government is running a budget deficit or they're increasing the national debt, that increases in government spending must be taking place and or reductions in taxation. That's how Budget deficits go up or a run.
That's how national debt rises. Basically, this is expansionary fiscal policy, isn't it? Knowing that is going to help us identify the key pros and cons.
Let's go to the pros first. Well, given the link to expansionary fiscal policies, it's clear we can identify a major pro as higher aggregate demand, higher growth and lower unemployment that comes from that. Very desirable in a recession to close the negative output gap and try to return the economy to full employment, Keynesian economists would argue.
that a budget deficit in recession is a worthwhile policy to get the economy out of recession. But also if we specify higher government spending on education, on healthcare, on infrastructure, on public services, we can derive more unique benefits, especially long run benefits. All of these policies can increase the productive capacity of the economy. They can boost LRAS, which is great news for long term growth rates. It's great news for competitiveness.
It's great news for productivity. But also these policies in that sense, by boosting growth and activity over time, can actually generate long-run tax revenue returns back to the government. But also, more simply, these policies are solving market failures, aren't they?
Take education and health. We know there are positive excellencies there. You can also argue they're merit goods.
Variety of infrastructures are public goods. So by solving market failures, we're improving resource allocation. But also, these policies are boosting living standards, improving the quality of life of households, whatever the form is, especially education and health. But even infrastructures like public transport and key public services improve people's living standards. A lot of these policies can be linked to the redistribution of income.
If government spending on benefits is rising, government spending on education and health could do this. Lower regressive taxation, lower direct taxation like lower income tax on lower income earners can help reduce income inequality, desirable in that sense. Now we can isolate tax cuts, especially direct tax cuts.
We can think about the big long run. good incentives that such tax cuts can bring the incentive to work the incentive to work harder be more productive in work the incentive for greater entrepreneurship the incentive for more immigration all of this is good again for lres can boost long-term growth rates there is also a link to higher productivity from these incentives also greater tax revenue returns from this greater activity from these high productive incentives very very good don't forget those long run returns, not just of direct tax cuts, but also of higher government spending. Bear that all in mind.
And Keynesian economists would argue that more government spending, even if it's debt fuel, let it be, can crowd in the private sector, can promote more private sector investment. The idea is that government spending, which increases AD in the economy, which increases output, which increases activity, is going to promote private sector firms to tap into that. Private firms see all this demand now. And they want to invest, grow their business, create more output so they can sell more.
They can tap into that demand and make more profit. So they say that actually, yeah, we can get more private sector investment this way, which is great news. It keeps growth going in both the short run and the long run and can balance your economic growth as well.
So an interesting Keynesian argument there. But there are significant concerns. Let's look at those now.
Well, of course, the biggest concern comes with the deterioration of government finances. If budget deficits are going up significantly, national debt figures are rising significantly, where people think this is unsustainable, where maybe the government is operating outside of their fiscal rules, there is going to be lower confidence in the state of government finances. People think this is unsustainable by the government.
And the danger is this will be reflected in lower credit ratings on government bonds. Credit ratings simply reflect the risk of lending money to the government. So if credit ratings go down and you buy a government bond, it's basically saying you're at risk of not getting your money back and not getting your annual interest. This means then that the government, to entice people to buy government bonds, have to offer higher coupon rates, higher interest rates, making it harder and more expensive for governments to borrow money over time.
to fund public services, let's say. That's bad news. That's horrible long-term implications on the economy and on living standards. But also there are going to be burdens on future generations, aren't there?
Because this debt will have to be paid back. Whether it's tax rises we expect, that's going to have negative implications. Whether it's cuts to government spending in other parts of the economy, negative implications there.
Or whether it's simply having to pay so much more debt interest to service all this rising government debt. There is an opportunity cost to that. That's unproductive spending.
That money could have been used much more productively elsewhere in the economy. Factor that in, all of these burdens to future generations. We can see in that regard how flexibility of government spending, wherever it's needed in the future, is going to be constrained if government finances are in a really bad way.
But also, if confidence in government finances goes down, that can detract foreign direct investment coming in too, harming short-run and long-term growth. So this is a real concern if government finances get really bad as a result of these policies which increase budget deficits and increase the national debt to unsustainable levels. But also as expansionary fiscal policies we can worry about major conflicts with macro objectives.
Demand pull inflation as AD goes up but also worsening of current account deficits as growth and unemployment improve in the economy we see rising incomes that could be more spending on imports but also Higher demand-pull inflation can erode the international competitiveness of exports, worsening a current account deficit that way too. Free market economists would say, hey look, you know, debt-fueled government spending could crowd out the private sector and harm private sector investment. And they would say that this would increase demand for loanable funds in the loanable funds market, increasing equilibrium interest rates there, making it more expensive for private sector firms to borrow and then fund investment projects. And they would say by harming private sector investment, this is bad news for short run and long run growth.
Bear in mind, I is a key variable in the 80 equation, but also I is a major LRES determinant. Right. But also they would say you're going to get unbalanced growth if you constrain private sector investment.
Too much reliance on the public sector, on government spending for growth, which is not in the long term interests of macro performance. And they would be concerned about the X inefficiency, the wastefulness that comes with government spending. Bearing in mind governments are not profit motivated, bearing in mind governments are not experts when it comes to various infrastructure projects in particular.
So costs can spiral out of control and public money is wasted. But let's now evaluate. When are the pros likely to outweigh the cons or vice versa?
The current state of government finances is absolutely massive. If government finances are already in a bad way with high budget deficits, high national debt, governments are operating outside their fiscal rules. it's likely that the cons, especially of making government finances worse, will outweigh the pros. But if government finances are good already, they're sustainable with low budget deficits, maybe a budget surplus is being run and low national debts, in which case probably the worsening of government finances from that position isn't as bad, the pros could outweigh the cons.
So of course, that's a key point to start with. We've already considered the short run and the long run impacts of these policies. Just remember, there are long run returns.
that come with either increasing government spending or with direct tax cuts. So that's a key part of this debate. We know there is short run debt when these policies are used, but there are long run returns which could outweigh that short run issue. The stage of the economic cycle is massive. You could argue in a recession, Keynesian certainly would, that these policies or running a budget deficit is actually desirable in increasing aggregate demand, closing a negative output gap, returning the economy to full employment.
They would say it's necessary. That's the way. to overcome the pains of a recession.
So they would say, no, it's fine. Take on more debt government in that situation if it means we get out of recession. But in a boom, you could argue these policies are likely to be inflationary, which is undesirable, but also taking on government debt in a boom might not be necessary at all. You could argue that's a time to mend government finances, not to worsen them.
The specific policy used, we've already said how a lot of these pros and cons are specifically related to either an increase in G or a reduction in T. Cuts in direct taxation is reliant on consumer and business confidence being strong. If they're weak, that can limit the effectiveness of direct tax cuts. But also we can think about the role of the automatic stabilizers.
Yes, this is crucial. We've learned already that automatic stabilizers can help naturally to support economic growth, to support output in a recession. So if the role of these is strong, it reduces the need for discretionary fiscal policy. That is expansionary fiscal policy on top of the automatic stabilizers.
So that is something to bear in mind as well. So that, guys, covers everything you need to know about this fascinating topic area. But stay tuned for the next video where we do exactly the same for running a budget surplus. Can't wait to see you guys then.
Thank you so much for watching. I'll see you in that video.