The Effects of Fiscal Deficits on an Economy

Fiscal deficits arise whenever a government spends more money than it brings in during the fiscal year. This imbalance is common among global economies. Between 1970 and 2022, the U.S. government has had higher expenditures than revenues for all but four years. As of September 2023, the U.S. national deficit was $1.52 trillion.

History of Fiscal Deficits

Keynesian macroeconomics, named after British economist John Maynard Keynes, promotes spending to drive economic activity and stimulate a slumping economy by running large deficits.The first American deficit plan was conceived and executed in 1789 by Alexander Hamilton, then Secretary of the Treasury. Hamilton saw deficits as a means of asserting government influence, similar to how war bonds helped Great Britain out-finance France during 18th-century conflicts.

Economists and policy analysts disagree about the impact of fiscal deficits on the economy. Nobel laureate Paul Krugman has suggested that the sluggish recovery from the Great Recession of 2007 to 2009 was attributable to the reluctance of Congress to run deficits to boost the economy.Others argue that budget deficits crowd out private borrowing, manipulate capital structures and interest rates, decrease net exports, and lead to either higher taxes, higher inflation, or both.

Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. The Keynesian revolution advocated a countercyclical fiscal policy during periods of economic woe. During such times, the government uses deficit spending to make up for the decline in investment and boost consumer spending to stabilize aggregate demand.

A Growing U.S. Deficit

Since 2001, the federal government budget has run a deficit each year. Some contributing factors include:

• The "War on Terror" following the events of 9/11 added $2.02 trillion to the debt, coupled with increased military spending.
• Beginning in 2016, spending on Social Security, health care, and interest on federal debt outpaced the growth of federal revenue. Medicare spending accounted for 15% of total federal spending in 2018, with per capita spending expected to grow at an average annual rate of 5.1% through 2028.
• Due to the COVID-19 pandemic, the U.S. federal shortfall for fiscal year 2020 was $3.1 trillion, an increase from 2019's deficit of $984 billion.Additionally, Congress passed the $2.2 trillion CARES Act.
• The Trump tax cuts reduced revenue and increased the deficit. These tax cuts were expected to total $1.5 trillion over ten years. The Joint Committee on Taxation expects cuts to stimulate growth by 0.7% annually, but the deficit will increase by $1 trillion over ten years. 
• The federal deficit in FY 2022 decreased by 50% from FY 2021 to $1.4 trillion but was still the fourth-largest deficit in U.S. history.

Impacts on the Economy

The long-term macroeconomic impacts of fiscal deficits are subject to debate. If the deficit arises due to short-term spending projects such as infrastructure spending or business grants, these sectors commonly see a boost in operations and profitability. If the deficit increases because receipts have fallen, either through tax cuts or a decline in business activity, this activity will not usually stimulate the economy.

Politicians and policymakers rely on fiscal deficits to expand popular policies, such as welfare programs and public works. Both conservative and liberal administrations tend to run deficits in the name of tax cuts, stimulus spending, welfare, public good, infrastructure, war financing, and environmental protection.

Some economists argue against government budget deficits for crowding out private borrowing and distorting interest rates. However, fiscal deficits have remained popular among government economists since Keynes legitimized them in the 1930s. Expansionary fiscal policy forms the basis of Keynesian anti-recession techniques and provides an economic justification for spending money with reduced short-term consequences.

Financing a Deficit

Deficits are financed through the sale of government securities, such as Treasury bonds (T-bonds). Individuals, businesses, and other governments purchase bonds and lend money to the government with the promise of future repayment.

Government borrowing reduces the pool of available funds that can be invested in other businesses. An individual who lends $5,000 to the government cannot use that same $5,000 to purchase the stocks or bonds of a private company. All deficits tend to reduce the potential capital stock in the economy.

The sale of government securities has a direct impact on interest rates. The interest rate paid on loans to the government represents nearly risk-free investments against which all other financial instruments must compete. If the government bonds pay 2% interest, other financial assets must pay a rate to entice buyers away from government bonds. This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy.

Federal Limits

There are practical, legal, theoretical, and political limitations for debt on the government's balance sheet. The U.S. government cannot fund its deficits without attracting borrowers. Backed only by the full faith and credit of the federal government, U.S. bonds and Treasury bills (T-bills) are purchased by individuals, businesses, and other governments.

The Federal Reserve also purchases bonds as part of its monetary policy procedures. Should the government ever run out of willing borrowers, there is a genuine sense that deficits would be limited and default would occur.

Total government debt has real and negative long-term consequences. If interest payments on the debt become untenable through tax-and-borrow revenue streams, the government faces three options. It can cut spending and sell assets to make payments. It can print money to cover the shortfall, or the country can default on loan obligations.

The Bottom Line

While macroeconomic proposals under the Keynesian school argue that deficits are sometimes necessary to stimulate aggregate demand, some economists claim that deficits crowd out private borrowing, distort the marketplace, and unfairly burden future generations of taxpayers.