Budget Deficit

Budget Deficit

Budget Deficit

Introduction

A budget deficit can be defined as “A situation where government spending exceeds government revenue from taxation”. A budget deficit therefore represents the net addition to the spending in the economy of a country. On going budget deficits decreases national saving, which reduces domestic investment and increases borrowing from abroad. The reduction in national saving raises domestic interest rates, which attracts investment and capital from abroad. The external borrowing that helps to finance the budget deficit is reflected in a larger current account deficit, creating a connection between the budget deficit and the current account deficit. The reduction in domestic investment (which lowers productivity growth) and the increase in the current account deficit (which requires that more of the returns from the domestic capital stock accrue to foreigners) both reduce future national income, with the loss in income steadily increasing over time, the costs imposed by sustained deficits tend to build gradually over time, rather than occurring suddenly.

Discussion

The adverse consequences of sustained large budget deficits may well be far larger and

occur suddenly. however. Substantial deficits expected far into the future can cause a downward shift in market expectations and a related loss of confidence both at home and abroad. Substantial ongoing deficits may severely and adversely affect expectations and confidence.

The loss of investor and creditor confidence, both at home and abroad, may cause

investors and creditors to reallocate funds away from currency-based investments, (causing a depreciation of the exchange rate) and to demand sharply higher interest rates on government debt. Moreover the increase of interest rates would reduce investment and interest-sensitive consumption.

The inability of the federal government to control the budget deficit could be interpreted as a broader failure of the nation to address its economic problems, and thus prompt a loss of business and consumer confidence, which would undermine capital spending and real economic activity. A potentially sharp downward movement in the exchange rate could cause unexpected shifts in input costs and export opportunities across different sectors, which could cause short-term economic dislocations.

The drop in asset prices and increase in interest rates could also spark a wave of bankruptcies, which could further restrain real economic activity.

These various effects can feed on each other to create a dangerous cycle; for example, increased interest rates and diminished economic activity may further worsen the fiscal imbalance. Continuing budget deficits decreases national saving, which reduces domestic investment and increases borrowing from abroad, the external borrowing that facilitates to finance the budget deficit is reflected in a larger current account deficit.

The current account deficit reflects aggregate net foreign investment from other countries. Having access to international capital is beneficial, but not so beneficial as financing the investment through domestic saving. Foreign creditors understandably demand some return on their capital, with the required return presumably increasing as the amount that they lend increases. The future returns to the domestic investments financed by such borrowing from abroad increase over time. If these returns were gained through domestic finance, it could be spent ...