A budget deficit occurs when spending exceeds income. The term applies to governments, although individuals, companies, and other organizations can run deficits.
A deficit must be paid. If it isn't, then it creates debt. Each year's deficit adds to the 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. Second, higher debt levels can make it more difficult to raise funds. Creditors become concerned about the borrower's ability to repay the debt. When this happens, the creditors demand higher interest rates to provide a greater return on this higher risk. That further increases each year's deficit.
The opposite of a budget deficit is a surplus. It occurs when spending is lower than income. A budget surplus allows for savings. If the surplus is not spent, it is like money borrowed from the present to create a better future. If a deficit is financed by debt, then it has the opposite effect. It is money borrowed from the future to pay for the present standard of living.
A balanced budget is when revenues equal spending. Most U.S. states must balance their budgets. The federal government does not have that restriction.
Many situations can cause spending to exceed revenue. An involuntary job loss can eliminate revenue. Sudden medical expenses can quickly send spending skyward. Spending can easily outpace revenue if the consequences of debt aren't too bad. That occurs in the early stages of credit card debt. The debtor keeps charging, and only paying the minimum payment. It's only when interest charges become excessive that overspending becomes too painful.
Like families, governments also lose revenue during recessions. When workers lose jobs, they pay less taxes, which means there are less taxes coming in to the government.
Unlike families, the federal government can keep adding each year's deficit to the debt for a long time. As long as interest rates remain low, the interest on the national debt is reasonable.
The federal budget deficit is not an accident. The president and Congress intentionally create it in each fiscal year's budget. That's because government spending drives economic growth. It's a result of expansionary fiscal policy. Job creation gives more people money to spend, which further boosts growth. Tax cuts also expand the economy.
For this reason, politicians get re-elected for running budget deficits if they are creating jobs and growing the economy. They lose elections when unemployment is high and when they raise taxes.
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 ratings fall. When that happens, they have to pay higher interest rates to get any loans at all. These are called junk bonds.
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. Most voters don't care about the impact of the debt. As a result, deficit spending has increased the U.S. debt to unsustainable levels. The World Bank says this tipping point is when a country's debt to gross domestic product ratio is 77% or higher.
How to Reduce a Budget Deficit
There are only two ways to reduce a budget deficit. You must either increase revenue or decrease spending. On a personal level, you can increase revenue by getting a raise, finding a better job, or working two jobs. You can also start a business on the side, draw down investment income, or rent out real estate.
Decreasing spending is easier in the short-term. Many experts recommend cutting out non-essentials, like Starbucks coffees and cable subscriptions. It also works for someone with a spending addiction, if they get help. But increasing revenue is more sustainable in the long run. Constantly evaluate and improve your skills to maximize your revenue from the job market.
Governments can only increase revenue by raising taxes or increasing economic growth. Tax increases are tricky. If they are too excessive, they will slow growth. Politically, they often end a politician's career. Increasing growth can only be done moderately. If growth is faster than the ideal range of 2-3 percent, it will create a boom, which leads to a bust.
Cutting spending also has pitfalls. Government spending is a component of gross domestic product (GDP). If the government cuts spending too much, economic growth will slow. That leads to lower revenues and potentially a larger deficit. The best solution is to cut spending on areas that do not create many jobs.
Most governments prefer to finance their deficits instead of balancing the budget. 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. 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.
The United States benefits from its unique position. The U.S. dollar functions as a global currency. 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 politically damaging. As a result, most presidents increased the budget deficit.
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 Greek debt crisis in 2009.
Budget Deficit History
For most of its history, the U.S. budget deficit remained below 3% 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 slower economic growth. But part was increased spending to get growth back on track. Military spending also doubled to pay for the wars in Iraq and Afghanistan.
Also during the 2008 financial crisis, the dollar's value strengthened by 22% when compared to the euro. Investors consider the dollar to be 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.
According to budget projections by the Congressional Budget Office, interest on the debt relative to GDP is expected to triple by 2050. The debt will increase the deficit to the point where investors will question whether the United States can pay it off. That will send interest rates even higher. At that point, Congress will be forced to reduce its budget deficit.
Frequently Asked Questions (FAQs)
In which period did the federal budget show the greatest deficit?
The U.S. government recorded its highest deficit ever in 2020, during the worst of the COVID-19 pandemic. That year's $3.1 trillion deficit eclipsed the previous record of $1.4 trillion in 2009.
Why do few economists favor balancing the federal budget every year?
Economists generally agree that budgetary policy must depend on the state of the economy in a given year. If the government were required to balance the budget every year, regardless of economic circumstances, it would risk making recessions worse and further weakening the economy.