Budget Deficit: How It Affects the Economy

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

Bureau Of Engraving And Printing Prints New Anti-Counterfeit 100 Dollar Bills
The U.S. can run budget deficits because it can create as much money as it needs. Photo: Mark Wilson/Getty Images

Definition: 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 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 want to spend as much as possible. 

How Is the Deficit Financed?

The deficit is financed by government bonds. 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. But, if the deficit is moderate, it doesn't hurt the economy. In fact, it can boost economic growth. That's because government spending is a component of a nation's total output, known as Gross Domestic Product (GDP). Find out the current U.S. budget deficit is and compare it to the Federal income

The United States benefits from its unique position. The dollar is 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. Find out Which President Had the Biggest Budget Deficits?

Budget Deficit History

For most of U.S. history, the 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.

For details, see Deficit by Year.

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. As the debt to GDP ratio is 77 percent or higher, 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. (Source: "Finding the Tipping Point," The World Bank.)

It becomes a self-defeating loop, as countries go deeper into debt to repay their debt. At some tipping point, interest rates on new debt can skyrocket as it becomes ever more expensive for countries to roll over debt. If it continues, long enough, a country may default. That's what caused the Greece debt crisis in 2009.  For more, see How the U.S. Deficit and Debt Affect Each Other

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 for investors. 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 didnt't have to worry about rising Treasury note yields, even as the debt doubled.

In 2016, interest rates began rising. That will make the interest on the national debt double in four years. The Treasury must pay this interest or suffer the consequences of a debt default.