Deficit Myth

Politicians constantly draw false parallels between household budgets and government budgets. Our elected leaders love trotting out the familiar line that governments – like households – need to live within their means. Yet every time they espouse this untrue analogy, they display their ignorance of economics.

Around the world, ill-informed politicians claim that governments should somehow have a balanced budget year-to-year. Politicians show empathy with the electorate by promising to cut government spending in line with belt tightening by households. Governments that run deficits are accused of being poor financial managers.

Balancing the national budget sounds appealing and promising to get it back in the black resonates with many voters. However, policymakers should avoid playing populist politics by trying to imitate family budgets. Fiscal austerity is commendable at a household level but can equate to economic irresponsibility at a sovereign level.

As counter-intuitive as it sounds, governments do not always need to have a balanced budget. In fact, they can run prudent annual deficits indefinitely, as many countries do. Britain has maintained a national debt for more than 300 years. Going back to 1776, the US has been in continuous deficit except for seven short periods.

Government deficits are not intrinsically bad. Indeed, they can be very helpful to an economy. Spending more when the private sector is flagging is a necessary function of government. Deficit spending – through tax cuts or the purchase of goods and services by the government – can help turn an economy around.

Nobel prize-winning economist, Joseph Stiglitz, argues that deficit spending can be a major stimulus to economic growth and can actually lower long-term government debt. When economic growth is restored and unemployment falls, tax revenues increase which eventually lessens the need for a government to borrow.

Another world-renowned economist and Nobel Laureate, Paul Krugman, has often observed that government finances are not like personal finances. While consumers on a spending spree ultimately must pay the piper, a government’s borrowing strategy directly affects economic growth and this delivers social benefits.

A US Professor of Politics adds to the richness of this debate by noting that government spending has a “crowding in” effect that actually encourages more private investment:

That is because much of the money that the government borrows and spends goes to the private sector. Private industry must then prepare to provide the various goods and services demanded by the government….In order to do this, these businesses must invest in new production facilities and greater productivity. This “crowding in” effect thus helps to mitigate any negative effects that public borrowing has on the private sector by indirectly encouraging more private investment and business growth.

[NB: To be clear, there are two measures of sovereign debt: current budget deficit and national public debt. When a government spends more than it collects in any one year, a budget deficit exists. The accumulation of deficits over many years creates the national public debt.]

It can be seen that the debt and deficit narrative is an emotive political construct which does not reflect any underlying economic truth. In the cold light of day, most people would admit that it is more important to create jobs than to reduce the deficit. Balancing the budget does not of itself guarantee growth.

The economy can be likened to a car. Government spending is the accelerator and taxes are the brakes. It follows, therefore, that to speed up the economy you hit the accelerator and to slow it down you apply the brakes. While driving too fast can lead to hyper-inflation, countries invariably slowdown in time.

Let’s say that the Australian government needs to spend say $50 billion more than it is bringing in from existing tax programs. It could, of course, increase personal and business taxes to cover this shortfall. But raising taxes is politically unpopular, plus it leaves taxpayers with less disposable income.

It follows that if we have less to spend on goods and services, businesses will suffer. If sales fall sufficiently, firms might even reduce their workforce. Those without jobs will, in turn, have reduced spending power and so a vicious cycle begins. So, a preferred way for the government to raise the money it needs is to issue bonds.

Bonds can be thought of as another form of money and governments are the sole monopoly issuer of their money. Households cannot issue money, only governments can. This means that government debt is not like private debt as it never needs to be paid off. As bonds become due, they are replaced with new bonds.

As noted by one economics professor, households – unlike governments – can’t roll over debt indefinitely. Also, governments cannot be subject to foreclosure or repossession while households can. Moreover, households can go bankrupt while sovereign governments only default when they choose to do so.

It should be noted that government debt is an incredibly safe investment. Governments, therefore, can borrow money at very low interest rates. In fact, many can borrow at rates lower than inflation. This means that their debt decreases over time in terms of its real value rather than increasing like household debt.

I’ll leave the final word on this emotive topic to University of Melbourne research economist, Warwick Smith. In a (now dated) 2014 article titled – Why the federal budget is not like a household budget – Smith unequivocally stated that it is a myth to believe that Australia must have a balanced federal budget. He went on to say that:

Like many myths, it does have some factual historical origins. Back when currencies were backed by gold it was possible for governments to go broke. Because modern currencies are not backed by anything material, sovereign governments cannot run out of money and can never be insolvent in their own currency. Somehow, mainstream political thinking hasn’t kept up with the dramatic changes in the monetary system that occurred more than 40 years ago.

Hear, hear. All food for thought!