Deficit Spending

What is 'Deficit Spending '

Deficit spending occurs whenever a government's expenditures exceed its revenues over a fiscal period, creating or enlarging a government debt balance. Traditionally, government deficits are financed through the sale of public securities, particularly government bonds. Many economists, especially in the Keynesian tradition, believe government deficits can be used as a tool of stimulative fiscal policy.

BREAKING DOWN 'Deficit Spending '

Deficit spending is an accounting phenomenon. It is only possible to engage in deficit spending when revenues fall short of expenditures. However, nearly all of the academic and political debate surrounding deficit spending focuses on economic theory, not accounting.

Deficit Spending as Fiscal Policy

According to demand-side economic theory, a government can begin deficit spending after the economy falls into recession. The famed British economist John Maynard Keynes is often credited with the concept of deficit spending as fiscal policy, though most of his ideas were re-interpretations or modifications of older mercantilist arguments.

In fact, many of Keynes’ spending ideas were tried before “The General Theory” was published in 1936. Herbert Hoover, for example, fought the Great Depression by increasing federal government spending more than 50% and engaging in massive public works projects during his four years in office between 1928 and 1932.

What Keynes managed in 1936 was to give academic and intellectual legitimacy to deficit spending programs. He argued a drop in consumer spending during the recession could be met by a corresponding increase in government deficit spending, maintaining the correct level of aggregate demand to prevent high levels of unemployment. Once full employment was achieved, Keynes believed, the market could return to a more laissez-faire approach and the debt could be repaid. If the extra government spending were to cause inflation, Keynes believed the government could simply raise taxes and drain extra money out of the economy.

Deficit Spending and Economic Growth

Deficit spending is often misinterpreted as a pro-growth policy tool. This may be because deficit spending is positively correlated with gross domestic product (GDP). However, since one of the key components of the GDP equation is government spending, it is tautological and not empirical that the two tend to rise and fall together.

As Keynes articulated, the main role of deficit spending is to prevent or reverse rising unemployment during a recession. Keynes did believe there could arise a secondary benefit of government spending, something often called “the multiplier effect.” According to the theory, a single dollar of government spending might increase total economic output by more than $1.

There are plenty of theoretical and empirical challenges to the notion of the Keynesian multiplier. A huge series of econometric tests have been run, with various and inconclusive results.

If left unchecked, some economists argue, the effects of deficit spending pose a threat to economic growth. Too large a debt, wrought by consistent deficits, might force government to raise taxes, pursue inflationary monetary policies, or default on their debt obligations. Additionally, the sale of government bonds crowds out private issuers and might distort prices and interest rates in capital markets.