Why run a deficit?

Unless you’ve been living under a rock (or living on a planet that makes sense), you will have no doubt heard repeated rhetoric over the last few years from politicians of all shades, stating that “tough decisions” must be taken to close the deficit and balance the budget.

Without prior knowledge, all these claims make sense, but all these claims do is propagate myths built on the misunderstanding that the government finances are comparable to a household, politically constraining the government’s ability to support the private sector’s ability to net save, and in turn subduing the consumer demand required to keep the economy growing.

In my previous post I covered national accounting and the zero-sum relationship between the government, private and foreign sectors. As stated there, an attempt by one or two sector to spend less than its income (i.e. save) is balanced by the remaining sector(s) spending more than it income, resulting in a deficit. On average, the private sector is a net saver, and its desire to save can be met either by a government deficit, a trade surplus, or a combination of the two. A strong trade surplus provides an alternative source of earnings for the private sector (as well as more taxes for the government) which can be saved, reducing the need for a government deficit. An example of a country like this is Germany, which has a history of running a trade surplus that helps sustain its budget surplus.

In countries with a trade deficit (typically developed countries where it is generally cheaper to import goods from abroad due to lower manufacturing costs), the ‘burden’ falls on the government to provide a source of earnings to support saving (the alternative is an increase in private debt, which increases the susceptibility of the economy to shocks), and run a deficit. A simplified illustration of the flow of money between the government and non-government sectors is shown below (note that there are other sources of income  other than taxation, but this is the primary one).

national accounts arrangement

Government spending provides a safe financial asset for the non-government sector to use as payment for goods, services, debt and taxes, as well as an asset to hold as a form of savings. The national debt simply represents the cumulative sum of all government deficits, and the sum of all financial assets (denominated in £s) held by the non-government sector. Deficit spending increases the supply of these assets in aggregate, increasing the amount that can be held for the purpose of saving. During downturns, deficit spending (this typically occurs in the form of welfare payments, which increase as more people become unemployed during a downturn) helps reverse the fall in aggregate demand by meeting the non-government sector’s desire to save, without lowering its level of spending.

So deficits, not so scary right?

I will (probably) touch on why the government can sustain its deficits, and why the size of the deficit on its own is irrelevant to the health of the economy in the next post.

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