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Deficits and the National Debt

Deficits and the National Debt



Many people are confused about the difference between a deficit and a debt.

A deficit refers to an excess of expenditures over revenue during a specific time period. The national deficit usually refers to the amount by which government spending is in excess of tax revenue in a given year. This is a flow concept. It involves activity over a period of time.

A debt refers to the balance of all funds owed from prior commitments. The national debt refers to the balance of all payments owed due to previous deficit spending. The national debt is the total amount of government bonds outstanding. Essentially, it is a running total of previous deficits, less payments made on prior debts. This is a stock concept. It involves a balance at a specific point in time.

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Both national deficits and national debts are created by borrowing instead of using tax revenue to pay for government expenditures. Governments borrow money by issuing government bonds to the public. These government bonds represent financial investments to the purchasers, but they represent an obligation to repay for the government that issues the bonds.

One measure of the national debt is it percentage of GDP. This measure serves as a reference point. It will put the debt into perspective as to the size of the economy.

Consequences of Deficits and the National Debt



Crowding out:


It is not entirely clear that crowding out occurs, so differences of opinions exist among economists from different schools of thought.

When governments run a deficit, they finance spending by borrowing. This involves selling bonds on the open market. When the government sells bonds, it increases the supply of bonds, decreasing the market price of all bonds on the market. It can influence the market prices because the government's transactions are often a large percentage of the activity in the bond market, giving the government market power. When bond prices decrease, their yields increase, raising the interest rates for bonds. If this in turn causes other interest rates in the economy to increase, then the cost of borrowing will increase for firms planning private investment. If firms decrease investment because of these higher interest rates, then private investment is "crowded out". This will decrease real GDP both in the present time period and in the future.


Trade deficits:


Some economists believe that budget deficits lead to trade deficits. If budget deficits do indeed raise real interest rates and cause crowding out, then domestic securities will be more attractive to foreign investors. If foreign investors buy more domestic securities as a result, this will increase demand for the domestic currency. The domestic currency will appreciate in value due to an increase in demand. This changes the exchange rates for currencies, making foreign-made goods cheaper for domestic consumers and domestic-made goods more expensive for foreign consumers. As a result, net exports will decrease, which will also decrease real GDP.


Interest payments as a portion of future government budgets:


The national debt requires the government to make interest payments in the future. These interest payments represent money that the government cannot use for something else, including tax relief.

To the extent that these payments are made to domestic investors, and are paid for with taxes collected from domestic taxpayers, the immediate net change in national wealth would be zero. This has been called "owing money to ourselves". This would, however, have a redistribution effect, which could affect future real GDP in a number of ways. Wealth would be redistributed from the taxpayer class to the investor class.

To the extent that these interest payments are made to foreign investors, they represent wealth leaving the domestic economy. This would be a reduction in the domestic standard of living. In this sense, having foreigners own government bonds - and therefore a sizeable portion of the national debt - becomes a real issue, not just political rhetoric.

However, the real effect of foreign ownership of domestic government bonds needs to be evaluated in terms of opportunity costs. If the proceeds from foreign purchases of bonds leads to an increase in domestic output that would not have occurred otherwise, this creates a benefit to having foreign ownership. This benefit may very well outweigh the loss of wealth created later when the interest payments leave the country.

The short run vs the long run



Some government deficits are caused by fiscal policies which are designed to offset the negative consequences of the business cycle. Many of these policies fall into the category of automatic stabilizers. Automatic stabilizers are not related to current policy decisions, but instead are policies created in the past. When unemployment is high, and output (real GDP) is low, then tax revenues will decrease, partially offsetting the decrease in disposable income caused by a recession. To the extent that this affects the income classes with a high marginal propensity to consume, the economic recovery can be aided with the use of a progressive income tax structure. Increased transfer payments - caused by an increase in the number of people who qualify for public assistance such as unemployment insurance benefits and welfare - are also automatic stabilizers. Less tax revenue plus higher transfer payments from automatic stabilizers will increase deficits in the short run. These deficits are considered to be short term deficits because they will automatically disappear when the economy gains strength.

Besides automatic stabilizers, other forms of stabilizers that result in short run deficits include things like one time only economic stimulus plans.

Short term deficits are also known as cyclical deficits. They are deficits which exist due to a downturn in the business cycle.

Deficits caused by policies that are unrelated to the business cycle are considered to be long term deficits. Short run (cyclical) deficits can reduce long term deficit spending if they succeed in helping turn the economy around.

For more on the relationships among deficits, debt, and fiscal economic policies - including the opportunity costs of deficit spending - see “Fiscal and Monetary Policies”