Truth and Lies About Government Deficits

There is a lot of misinformation spread by politicians and much of the media on the topic of fiscal policy, particularly when it comes to the role and impact of government deficits. When the level of economic activity collapsed in the wake of the global financial crisis, government fiscal balances around the world moved toward, or into, deficit. To a degree, in some countries at least, this occurred as a result of appropriate policy responses to the depressed economic environment. To a larger degree, it was due to the automatic effect of declining income on tax revenues through what economists refer to as the automatic stabilizers. These are fortunately in place to cushion households and businesses from the worst effects of a downturn. Currency-issuing governments, facing no revenue constraint, always have the capacity to run deficits as required.

While the move toward deficits was both necessary and appropriate – and for governments sovereign in their own currencies, unproblematic – lobbyists for the 1 percent, aided by ignorant or complicit politicians and media, soon bombarded the public with a series of alarmist and nonsensical claims. The public was told – falsely – that fiscal deficits would cause all manner of calamities, ranging from escalating interest rates and hyperinflation to crippling debt burdens on future generations.

Not only have these claims proved false, but they have been shown to be the opposite of the truth. In nations with sovereign currencies, interest rates have remained at historic lows. Deflation, rather than excessive inflation, remains the likelier danger. And currency-issuing governments face no risk of insolvency. Put simply, such governments cannot run out of the currency that they themselves issue.

For currency-issuing governments, the size of the deficit in itself is never an issue. What matters is that fiscal policy is tailored to the situation at hand. Even in normal times, a government deficit is usually appropriate, because it enables non-government (which, unlike government, is financially constrained) to maintain a financial surplus, spending less than its income and building some protection against uncertainty.

The situation is different in the case of the member governments of the Eurozone, who voluntarily and recklessly gave up their currency sovereignty to become mere users of a foreign currency, putting themselves at the mercy of the European Central Bank. However, even here, the democratically unaccountable European Central Bank, as issuer of the euro, always has the capacity to ensure a member government’s solvency. Of course, when it does so, strings are invariably attached (austerity, attacks on workers’ rights, fire sale of public assets, etc.) with democracy trashed in the process.

It is easy for media and politicians to confuse the public when it comes to these issues because there is little public understanding of the way in which a government’s fiscal outcome and the level of economic activity interact. On the one hand, a currency-issuing government has control of its policy settings. It can change its spending and taxing measures independently of what is happening in the rest of the economy, and such changes have an impact on total spending and therefore income. Government spending, like any spending, adds directly to income. Tax cuts leave more income in the hands of households and businesses. This enables higher levels of saving and paying down of private debts (which has been necessary for many households) as well as higher levels of private spending than would otherwise be the case. On the other hand, the level of economic activity affects the fiscal outcome. For given policy settings, tax revenues rise and fall automatically with income.

Economists understand this distinction perfectly well. They know that while the government can make exogenous changes to policy, the fiscal outcome itself (once policy has been set) is endogenous. To say that the fiscal outcome is endogenous is to mean that the ultimate size of the deficit depends on the level of income (because tax revenue depends on income).

Although this point is widely understood by economists, it can be a point of confusion for those not trained in economics. This makes it easy for charlatans and others with particular political agendas to make deceptive claims about fiscal policy and its effects.

Consider an economic downturn characterized by a collapse in private spending. Since spending equals income, by definition, the collapse in private spending will mean a decline in total income and employment unless appropriate policy is put in place.

Bad policy option 1: inaction. Suppose a government makes no changes to its spending programs and tax measures despite the depressed economic conditions.

The collapse in income will result in lower tax revenue. Similarly, the collapse in employment will require higher welfare payments. As a result, the fiscal deficit will widen.

In short, government inaction in response to recession will result in a larger fiscal deficit alongside weaker income and employment.

To be clear, the widening of the deficit is not the issue. A currency-issuing government faces no revenue constraint. The problem is the weaker income and employment that has resulted from government inaction.

Lie: The lack of economic recovery proves fiscal policy doesn’t work. The fiscal deficit increased, yet the economy didn’t improve.

Truth: The fiscal balance widened as income weakened, as it is designed to do, to limit the negative impact on spending. Without the welfare payments and lessened tax burdens, the collapse in demand and income would have been even worse.

Lie: Private spending is weak because a widening fiscal deficit harms confidence.

Truth: Business confidence depends primarily on the level of spending (economic activity) and profitability, not the fiscal balance. Stronger spending means a bigger market to sell into. This gives businesses more reason to employ workers and, once recovery is underway, to expand their operations through investment. Similarly, consumer confidence depends primarily on the level of income and employment, not the size of the fiscal deficit.

Bad policy option 2: austerity. The government cuts spending and/or increases tax rates or adds new taxes in a misguided attempt to reduce the deficit or even impose a surplus (which would mean, by definition, a deficit for non-government, requiring households and businesses either to draw down past savings or borrow in order to meet tax commitments).

Effect of austerity: Cuts to government spending exacerbate the downturn in total spending. Income and employment weaken further. This has an additional negative impact on the already soft private spending. Tax hikes fail to deliver a strong increase in tax revenues because of sluggish or even negative income growth. The government, in all likelihood, remains in deficit, though again, the fiscal balance in itself is not an issue for a currency issuer.

The result of austerity is usually a fiscal deficit alongside weaker income and employment.

Lie: There is still a fiscal deficit because the government failed to deliver on its promise to impose austerity. It needs to get serious about imposing austerity, and this time properly.

Truth: Even if it was desirable to balance government spending and tax revenue in a downturn (which it isn’t), it is difficult to do so through spending cuts and tax hikes. These policies weaken income and work against the effort to raise tax receipts. Cuts to welfare mean the poor and unemployed spend less, adding to the problem.

Appropriate policy response: expansionary fiscal policy. The government should increase its spending and/or cut taxes. These measures help to offset the temporary collapse in private spending and maintain total spending, income and employment. This will cause a widening of the fiscal deficit in the short term.

The short-term effect of fiscal expansion is a larger deficit alongside better outcomes for income and employment.

Lie: The government is being irresponsible and imposing an unsustainable debt on our children and grandchildren. The country will go broke. We’ll all be ruined.

Truth: Solvency is not an issue for a currency-issuing government. It can never run out of money. The issue is potential inflation caused by excessive spending. This is the risk of any kind of spending, whether public or private. But keep in mind that the fiscal expansion has occurred in a period of weak spending. There is no danger of inflation from too much spending when the economy is depressed. Instead, the higher level of spending helps to maintain income and employment until private households and businesses are ready to start spending again. Even then, as already mentioned, government deficits will and should be the norm so as to enable the non-government to maintain a financial surplus as protection against uncertain future events.

Effects in the longer term: Fiscal expansion helps to maintain income while households and businesses focus on getting debt burdens under control. By maintaining the level of spending, it also helps to foster an economic environment that is conducive to the eventual recovery of private spending. Once households and firms have paid down debts to more manageable levels, they will be in a position to start spending again.

The eventual recovery of private spending will boost income and employment. Tax revenues will rise automatically (that is, endogenously) because incomes are higher and more people have jobs. The fiscal deficit will narrow automatically. Any temporary government spending programs or tax breaks that were designed to tide the economy over during the period of private-sector weakness can be discontinued to prevent excessive spending. Here, the narrowing of the deficit, though neither good nor bad in itself, occurs because non-government balance sheets are in better shape and households and firms are in a stronger position to spend.

The longer term effect of fiscal expansion is to foster a private-sector recovery that brings about an automatic shrinking of the fiscal deficit.

Lie: The shrinking of the fiscal deficit that occurs in the recovery proves that austerity works. The economy improved because the fiscal deficit narrowed.

Truth: Improvement in the economy is what enables the fiscal deficit to narrow. This required expansionary fiscal policy (and widening of the fiscal balance) for a time until private spending recovered. The expansionary fiscal policy helps to maintain stronger spending, making it more viable for businesses to employ workers and eventually begin to invest again. Without the expansionary fiscal policy, private spending and production can remain depressed for a long time.

Let’s not fall for the lies

The above points are well known to economists. Unfortunately, they are points that – understandably – are not so obvious to anyone who has not studied at least introductory macroeconomics. Some politicians and members of the media take advantage of this and choose to spread misinformation about government spending and fiscal deficits.

There is a basic distinction that needs to be kept in mind to avoid falling for the lies. It is that although changes in government policy have an effect on the economy, the final fiscal outcome depends on what happens, partly as a result of those policies, to income and employment. This is why a larger fiscal deficit can occur alongside either weak income and employment (a “bad deficit”) or strong income and employment (a “good deficit”).

In reality, a currency-issuing government’s fiscal position is not important in itself. What matters is that the government’s fiscal policy is appropriate to the economic circumstances. During a period of economic weakness, the important point is to facilitate a sustained recovery. Once recovery is underway, incomes and tax revenues revive. The fiscal deficit narrows automatically as a result, although this is really neither here nor there. What matters is the strength and sustainability of the economic recovery.