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Thursday, September 30, 2010

Running Deficits: Positives and Pitfalls

D. Andrew Austin
Analyst in Economic Policy

Governments run deficits for several reasons. By running short-run deficits, governments can avoid raising taxes during economic downturns, which helps households smooth consumption over time. Running deficits can stimulate aggregate demand in the economy, thus giving policymakers a valuable fiscal policy tool to help support macroeconomic stability. In particular, short-run deficits may help boost economic activity when monetary policy loses its potency. When interest rates fall during an economic downturn, banks can become reluctant to lend when perceived lending risks outweigh anticipated gains, while fewer firms and consumers demand new loans. In such a situation, known as a liquidity trap, a monetary authority such as the Federal Reserve can do little to expand the money supply. Thus, while the monetary authority can cut short-term interest rates to nearly zero—or even to zero—lower interest rates or other monetary policy initiatives may spur little new consumer spending or business investment. Non-traditional monetary policy, however, can play a key role in economic management. During a liquidity trap situation, fiscal policy tools such as increased government spending or tax cuts that increase deficits may be an important complement to monetary policy. So-called “fresh-water” economists have questioned the logic of these fiscal policies. So-called “salt-water” economists, who have sought to put Keynesian fiscal theories on a more modern foundation, contend that government interventions can mitigate economic downturns. Most professional economic forecasters find that deficits can stimulate economic activity when the economy runs below its potential.

In better economic times, deficits may crowd out private investment or worsen trade deficits. But long-run deficits may transfer economic resources from younger to older generations, allowing older generations to enjoy anticipated benefits of future economic growth—long-run deficits may also impose large burdens on future generations. Some have argued this allows politicians to act opportunistically by providing benefits to current constituents while leaving future generations, an unrepresented constituency, with substantial fiscal burdens.

Between 2007 and 2009, federal tax revenues fell by 18.0% and corporate tax revenues fell 62.7%. Government outlays rose during the recession due to “automatic stabilizer” programs such as unemployment insurance and income support programs; federal support provided to Fannie Mae, Freddie Mac, AIG, and other companies; and economic stimulus legislation such as the American Recovery and Reinvestment Act of 2009 (ARRA; H.R. 1, P.L. 111-5).

Anticipation of changes in partisan control of government can motivate deficits, as current policy makers may wish to restrict their successors’ options. Research on state and foreign governments suggests that balanced-budget rules force governments to adjust spending and taxes sharply during economic downturns. Budget enforcement legislation, such as the 1990 Budget Enforcement Act (P.L. 101-508), may have helped preserve budgetary compromises between parties, which may have contributed to a reduction in federal deficits.

Deficits can seriously harm national economies. In the short run, fiscal overstimulation leads to inflation. In the long term, deficits either reduce capital investment, which retards economic growth, or increase foreign borrowing, which swells the share of national income going abroad. Governments can spend more than they collect in revenues by printing money, which causes inflation, or by borrowing. In the long run, governments risk default and bankruptcy if they fail to repay borrowers, at least to the extent of stabilizing the ratio of government debt to gross domestic product.

Date of Report: September 14, 2010
Number of Pages: 22
Order Number: RL33657
Price: $29.95

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