Understanding the Effects of Fiscal Deficits on an Economy

Understanding the Effects of Fiscal Deficits on an Economy
Fiscal deficits are negative balances that 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 higher expenditures than revenues for all but four years. In fact, recent years show a fiscal deficit per year of more than $1 trillion.1
KEY TAKEAWAYS

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  A government runs a fiscal deficit when, for a specific period, it spends more money than it takes in from taxes and other revenues, excluding debt.
  
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  This gap between income and spending is subsequently closed by government borrowing, increasing the national debt.
  
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  An increase in the fiscal deficit, in theory, can boost a sluggish economy by giving more money to people who can then buy and invest more.
  
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  Long-term deficits, however, can be detrimental for economic growth and stability.
  
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  The U.S. has run deficits consistently over the past decade.
  

Fiscal Deficit Impact on the Economy
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. The sluggish recovery from the Great Recession of 2007 to 2009 was attributable to the reluctance of Congress to run larger deficits to boost aggregate demand.2
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.
Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. Then, the Keynesian revolution and the rise of demand-driven macroeconomics made it politically feasible for governments to spend more than they brought in.
Governments could borrow money and increase spending as part of a targeted fiscal policy. Keynes rejected the idea that the economy would return to a natural state of equilibrium on its own. Instead, he argued that once an economic downturn set in, for whatever reason, the fear and gloom that it engenders among businesses and investors would tend to become self-fulfilling. That, it turn, could lead to a sustained period of depressed economic activity and unemployment.
As a result, Keynes advocated a countercyclical fiscal policy during periods of economic woe. During such times, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand.3
 
A fiscal deficit is fundamentally different from a trade deficit, which occurs when a country imports relatively more value of goods than it exports abroad.