The Budget Deficit and How It Affects the Economy

Why the Government Can Run a Budget Deficit and You Can't

Couple planning finances
••• Photo by Corey Jenkins/Getty Images 

​A budget deficit is when spending exceeds income. The term usually applies to governments, although individuals, companies, and other organizations can run deficits.

There are immediate penalties for most organizations that run persistent deficits. If an individual or family does so, their creditors come calling. As the bills go unpaid, their credit score plummets. That makes new credit more expensive. Eventually, they may declare bankruptcy.

The same applies to companies who have ongoing budget deficits. Their bond rating falls. When that happens, they have to pay higher interest rates to get any loans at all.

Governments are different. They receive income from taxes. Their expenses benefit the people who pay the taxes. Government leaders retain popular support by providing services. If they want to continue being elected, they will spend as much as possible. That's because most voters don't care about the impact of the debt.

How the U.S. Deficit Is Financed

Government bonds finance the deficit. Most creditors think that the government is highly likely to repay its creditors. That makes government bonds more attractive than riskier corporate bonds. As a result, government interest rates remain relatively low. That allows governments to keep running deficits for years. 

The United States finances its deficit with Treasury bills, notes and bonds. That's the government's way of printing money. It is creating more credit denominated in that country's currency. Over time, it lowers the value of that country's currency. That's because, as bonds flood the market, the supply outweighs the demand.

Many countries, including the United States, are able to print their own currency. As bills come due, they simply create more credit and pay it off. That lowers the value of the currency as the money supply increases. If the deficit is moderate, it doesn't hurt the economy. Instead, it boosts economic growth. That's because government spending is a component of a nation's total output, known as gross domestic product

The United States benefits from its unique position. The U.S. dollar functions as a global currency. That means it's used for most international transactions. For example, almost all oil contracts are priced in dollars. As a result, the United States can safely run a larger debt than any other country. 

The consequences aren't immediate. Creditors are satisfied because they know they will get paid. Elected officials keep promising constituents more benefits, services, and tax cuts. Telling them they will get less from the government would be political suicide. As a result, most presidents increased the budget deficit.

Budget Deficit History

For most of its history, the U.S. budget deficit remained below 3 percent of GDP. It exceeded that ratio to finance wars and during recessions. Once the wars and recessions ended, the deficit-to-GDP ratio returned to typical levels.

An examination of the deficit by year reveals the deficit-to-GDP ratio tripled during the financial crisis. Part of the reason was lower economic growth. But part was increased spending to get growth back on track.

The Deficit and the Debt

Each year the deficit adds to a country's sovereign debt. As the debt grows, it increases the deficit in two ways. First, the interest on the debt must be paid each year. This increases spending while not providing any benefits. If the interest payments get high enough, it creates a drag on economic growth, as those funds could have been used to stimulate the economy.

Second, higher debt levels can make it more difficult for the government to raise funds. Creditors become concerned about a country's ability to repay its debt. When this happens, they demand higher interest rates rise to provide a greater return on this higher risk. That increases the deficit each year. The World Bank says this tipping point is when a country's debt to GDP ratio is 77 percent or higher.

It becomes a self-defeating loop, as countries take on new debt to repay their old debt. Interest rates on the new debt skyrockets. It becomes ever more expensive for countries to roll over debt. If it continues long enough, a country may default on its debt. That's what caused the Greece debt crisis in 2009.  

The United States is different. During the 2008 financial crisis, the dollar's value strengthened by 22 percent when compared to the euro. That's because the dollar is a safe haven investment. The dollar rose again in 2010 as a result of the eurozone debt crisis. As the dollar's value rises, interest rates fall. That's why U.S. legislators didn't have to worry about rising Treasury note yields, even as the debt doubled. As a result, high U.S. deficits added to the debt

In 2016, interest rates began rising. That will make the interest on the national debt double in four years. The debt will increase the deficit to the point where investors questions whether the United States can pay it off.