Overview
Purpose:
To show that deficits can be helpful or harmful, depending on the circumstances.
Objectives:
1. Deficits can rise not only because policy makers raise spending or lower taxes, but also when the economy is in a recession. During recessions, unemployment benefits and welfare payments rise automatically while tax receipts drop. One way to separate the cyclical and structural components of the deficit is to estimate what the deficit would be if the economy were operating at full employment.
2. In the short run, deficits can have two potentially damaging effects on the economy. First, if the economy is at full employment, a government deficit is inflationary, because the excess of government spending over government revenues adds to aggregate demand pressures in the economy. Second, to the extent that federal deficits raise interest rates, they can retard growth in investment and housing activities, which are interest-sensitive.
3. In the long run, deficits can be harmful if they add to the debt burden. Persistent deficits mean a rising national debt. If the national debt rises fast than GNP, then this can have serious negative ramifications for the future growth potential of the U.S. Moreover, if a large portion of the debt is held by other countries, then this means that foreigners have a large claim on U.S. resources.
4. Government budgets should not necessarily be balanced at all times. Specifically, in a recession, balancing the budget means cutting spending and/or raising taxes – both of which have a contractionary effect on GNP. Nevertheless, in the long run the structural deficit (as measured by the full-employment deficit, for example) should be close to zero.
5. It is important to distinguish between balancing the budget and reducing the size of the government. A large government can have a balanced budget while s small government can run a large deficit.
| Key Economic Concepts full employment budget, fiscal drag and fiscal dividend, annually balanced budget, debt-to-GNP ratio, cyclically balanced budget, internal versus external debt, public debt, size of the deficit vs size of the government. |
| Contemporary Issues After four years of U.S. federal budget surpluses (from 1998 to 2001), the red ink began to flow again in 2002. Much of this swing was due to large tax cuts and increases in defense and homeland security spending in the War Against Terror (a structural shift in the deficit). However, some of the deterioration on the U.S. fiscal balance was due to the recession of 2001 and the subsequent lackluster recovery (a cyclical shift in the deficit). Is a cyclical shift from surplus to deficit more or less problematic than a structural shift? Why? |
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