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Unit 24 — Federal Deficits

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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 GDP/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 GDP/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 a small government can run a large deficit.

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Meet the Series Experts

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Alice Rivlin

Alice Rivlin

Senior Fellow at the Brookings Institution and Member of President Barack Obama’s 2010 Federal Debt Commission, known for her expertise on fiscal and monetary policy.

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Raymond Saulnier

Raymond Saulnier

Chairman of the Council of Economic Advisers (CEA) under President Dwight D. Eisenhower.

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Charles L. Schultze

Charles L. Schultze

Public policy analyst and Senior Fellow Emeritus of the Economic Studies Program at the Brookings Institution since 1977.

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Alan Simpson

Alan Simpson

U.S. Senator from Wyoming, 1979–1997, and Co-Chair of President Barack Obama’s 2010 National Commission on Fiscal Responsibility and Reform.

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WHAT’S YOUR
ECONOMICS IQ?

  1. Suppose that the president faces an economy plagued by stagflation. Output is predicted to drop steadily over the next two quarters. Unemployment is at record levels. If there is a deficit, and the president, under these circumstances, endeavors to balance the budget, which of the following will MOST LIKELY result?

    Inflation may be relieved somewhat, but unemployment will be seriously aggravated. During a recession, balancing the budget will mean cutting spending and/or raising taxes, both of which will have negative effects on GNP and employment levels.

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  2. A budgetary policy which states that the government’s budget should be set to promote a socially optimal combination of unemployment and inflation is known as:

    functional finance.

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  3. Suppose that the actual federal budget shows a deficit. But the full-employment budget, by contrast, shows a surplus. As an economic adviser who agrees with the thinking of most 1980s economists, you would MOST LIKELY conclude from this comparison that:

    current fiscal policy is probably doing a fair job of stabilizing the economy.

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  4. Again using the circumstances in the previous question, as an economic adviser you would probably attribute the deficit shown in the actual budget to:

    unemployment.

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  5. Following World War II, Americans had a great deal of money to spend for the first time in many years. However, there were few commodities—even necessities—available for purchase. During this period, many economists feel that severe unemployment and even a recurrence of the Depression might have resulted except for the fact that:

    the government borrowed heavily to finance the war debt.

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  6. True or false: A counter-cyclical policy calls for budget surpluses in bad times to provide a strong reserve, and budget deficits in good times to keep things moving.

    False. Just the opposite is true.

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Glossary

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