Intro: Typical opposition to fiscal deficits centers on the symptoms of fiscal deficits and not the causes. Deficits are bad for the economy because they tend to reflect too much government spending relative to what is optimal, undermining productivity, and they discourage savings in the aggregate, weakening the potential for investment.
It seems intuitive that running persistent, large fiscal deficits is a bad idea, but it’s important to know exactly why so we can benefit by predicting what their impact might be. In a nutshell, deficits are bad for economic growth for two reasons:
- They tend to reflect too much government spending relative to what is optimal, undermining productivity.
- They discourage savings in the aggregate, weakening the potential for investment.
Before we delve into why exactly fiscal deficits tend to be negative for economic growth, let’s first look at the common reasons why and when deficits are considered to be a problem, and the common objections to these reasons, before exposing why these explanations do not get to the heart of the issue.
Conventional Misconceptions
The majority of economists seem to believe that one or more of the following factors explain why deficits are problematic, at least in the long term:
Inflation Risk
Conventional Wisdom: If governments spend more than they take in it this will be inflationary as overall spending will rise and production will not rise in tandem, resulting in ‘too much money chasing too few goods’.
Conventional Counter Argument: Inflation is currently low anyway and there is no problem with inflation rising if incomes rise concomitantly.
Rising Interest Rates
Conventional Wisdom: If governments increases bond issuance to fund the fiscal deficit, this will lower bond prices and raise the yield on government bonds, undermining investment.
Conventional Counter Argument: Governments can rely on central banks to buy bonds to keep interest rates low, preventing rising interest rates from undermining investment.
Default Risk
Conventional Wisdom: If debt continues to grow relative to tax revenues it will eventually become impossible to be repaid, resulting in default and economic bust.
Conventional Counter Argument: As the debt can be bought by the central bank, which can print money at will, there is no reason for a government to default unless it wants to.
The above arguments all focus on symptoms rather than underlying causes and so fail to address the actual economic effects at play when governments run fiscal deficits. Inflation, for instance is rarely a problem in its own right, but rather tends to reflect economic weakness caused by excessive government spending. Similarly, rising interest rates are a symptom of a lack of savings relative to investment, which can result in weak growth, but they are not the cause of weak growth. On the issue of default, while it is true that a government that has debt denominated in local currency can avoid default indefinitely, it cannot avoid the real implications of excessive spending.
Deficits are Bad Because they Reduce Productivity and Savings
As mentioned above, deficits are bad for economic growth for two reasons:
- They tend to reflect too much government spending relative to what is optimal, undermining productivity.
Growth tends to be stronger if the government has less control over the country’s resources beyond the provision of goods and services that the free market cannot produce. The less government control of resources and less income redistribution, the more land, labour, and capital that entrepreneurs can use to generate productivity and profits, driving production.
- They discourage savings in the aggregate, weakening the potential for investment.
Even if a government runs a large fiscal deficit due to low taxes (with government spending at low levels of say 20% of GDP), this will still tend to be economically harmful relative to if the budget was balanced by higher taxes. This may seem counterintuitive as low taxes are something that seems highly appealing to us all. However, low taxes only tend to be good for growth if they are accompanied by low levels of government spending.
Not only do deficits caused by low taxes not support economic growth, but they tend to undermine it. The reason being that, all else equal, if taxation revenues are below the levels of government spending, savings on the aggregate will be undermined, reducing the potential for investment. Looking at the maths of the situation, real physical investment by the private sector is funded by a combination of private sector savings, government sector savings, or foreign savings, so the greater the level of government dissaving (the larger the deficit) the less resources that are available for investment and the greater the reliance on foreign borrowing for any given level of investment.