Effects of Long-Term Deficit Spending

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The Effects of Long-term Deficit Spending

ECO 203
Prof. Kristian Morales
October 3, 2011

The Effects of Long-term Deficit Spending

In times of hardship, economist Maynard Keynes noted that the federal government not only has a responsibility to help revive the economy, but is often the only solution when a recession grows deep enough. He argued that the basic problem of a severe recession is a lack of investment on the part of business despite low interest rates. The answer when neither business nor consumers are able to awaken the economy is that the government needs to step in and encourage investment through borrowing and spending. Government spending can reactivate a dull economy and spur on new investment and growth. When an economy is sluggish, the government spends monies in excess of collected tax revenues through deficit spending, Keynesian economists typically argue that deficit spending is necessary in an economic downturn. Deficit spending allows a government to offset shortfalls in aggregate demand, and paying these deficits down during times of economic prosperity (Buchanan, 2009). While a big deficit may ease short-term economic pain, economists generally agree that high budget deficits today will reduce the growth rate of the economy in the future with higher taxes, interest payments, and an increasing reliance on foreign capital.

Economic growth automatically reduces deficits by increasing tax revenues and reducing transfer payments like unemployment benefits and other spending. As the economy grows the deficits falls as revenues increase and the debt becomes easier to pay (Sharing the pain; dealing with fiscal deficits, 2010). Conversely, when the economy is in a slump, the government in response will increase spending both in response to increased unemployment and as a matter of monetary policy to invigorate investment. This increased spending is funded through debt the government takes. In many ways, it is similar to how a household might use credit cards to get over a rough financial period, eventually paying down the debt when finances even out.

Like credit card debt, deficit spending is not inherently bad. According to most economists, it’s necessary as a response to deep economic downturns where government intervention is the only logical solution. But like credit card debt, too much deficit over too long a period can trigger it’s own economic downturn. Part of the reason why is how the government funds the deficit. The deficit is funded through the sale of government securities. As these bonds go up for sale on the open market, they divert investment money that would normally have gone into riskier, but higher return capital stocks. Capital stocks are the major source of funding for business growth and expansion. Large deficits mean a crowding out of capital stock investment. In fact, each increasing dollar of government debt reduces U.S. capital stock by about 60 cents. Large deficits also raise interest rates, by 0.25 to .050 percent for each one percent increase in the long-term federal deficit as a share of GDP (Hubbard, 2003).

The type of deficit, that is the type of debt the government has, is extremely important when determining how government debt can and will affect the GDP. While many government debts are simply cash-flow solutions like payroll, project funding, wars, and infrastructure improvements, other debts are permanent structural debts that continue to increase over time. Cash-flow debts are “money-in/money-out” debts, debts that are paid for with current year taxes or bond sales. These investments are immediate, but not permanent. In the case of an infrastructure improvement, like building new roads or libraries, the government expense is complete once the project is complete. A war only needs to be funded until its conclusion. These deficits are controllable expenses that are both discretionary and non-obligatory, no matter how “essential” they seem....
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