Fiscal deficits arise whenever a government spends more money than it brings in during the fiscal year. This imbalance, sometimes called the current accounts deficit or the budget deficit, is common among contemporary governments all over the world. Since 1970, the U.S. government has had greater expenditures than revenues for all but four years. The four largest budget deficits in American history occurred between 2009 and 2012, each year showing a deficit of more than $1 trillion.
Economists and policy analysts disagree about the impact of fiscal deficits on the economy. Some, such as Nobel laureate Paul Krugman, suggest that the government does not spend enough money and that the sluggish recovery from the Great Recession of 2007-09 was attributable to the reluctance of Congress to run larger deficits to boost aggregate demand. Others argue that budget deficits crowd out private borrowing, manipulate capital structures and interest rates, decrease net exports, and lead to either higher taxes, higher inflation or both.
Even though the long-term macroeconomic impact of fiscal deficits are subject to debate, there is far less debate about certain immediate, short-term consequences. However, these consequences depend on the nature of the deficit. If the deficit arises because the government has engaged in extra spending projects – for example, infrastructure spending or grants to businesses – then those sectors chosen to receive the money receive a short-term boost in operations and profitability. If the deficit arises because receipts to the government have fallen, either through tax cuts or a decline in business activity, then no such stimulus takes place. Whether stimulus spending is desirable is also a subject of debate, but there can be no doubt that certain sectors benefit from it in the short run.
All government deficits need to be financed. This is initially done through the sale of government securities, such as Treasury bonds (T-bonds). Individuals, businesses and other governments purchase these bonds and lend money to the government with the promise of future payment. The clear, initial impact of government borrowing is that it reduces the pool of available funds to be lent to or invested in other businesses. This is necessarily true: an individual who lends $5,000 to the government cannot use that same $5,000 to purchase the stocks or bonds of a private company. Thus, all government deficits have the effect of reducing the potential capital stock in the economy. This would differ if the Federal Reserve monetized the debt entirely; the danger would be inflation rather than capital reduction.
Additionally, the sale of government securities used to finance the deficit has a direct impact on interest rates. Government bonds are considered to be extremely safe investments, so the interest rate paid on loans to the government represent risk-free investments against which nearly all other financial instruments must compete. If the government bonds are paying 2% interest, other types of financial assets must pay a high enough rate to entice buyers away from government bonds. This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy.
Federal Limits on Fiscal Deficits
Even though federal deficits seem to grow with abandon and the total debt liabilities on the federal ledger have risen to astronomical proportions, there are practical, legal, theoretical and political limitations on just how far into the red the government’s balance sheet can run, even if those limits aren’t nearly as low as many would like.
As a practical matter, the U.S. government cannot fund its deficits …