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page updated on June 28, 2017

What is Deficit Spending?

What is deficit spending? Is government debt bad? Can the US Government spend its way to prosperity? In an election year, these questions are increasingly important.

What Does a Recession Mean for the Economy?

In a recession or a depression, people spend less money. That means grocery stores get less revenue. That means the owners of the stores can pay fewer employees. That means the employees can spend less money.

That means restaurants get less revenue, because people don't eat out as much. That means restaurant owners can pay fewer employees. That means the employees can spend less money.

What is the Velocity of Money?

The velocity of money is the economic term for how a dollar spent in the economy gets spent and respent. As you well know, injecting money to the economy at the megabank level does very little for the economy unless that money gets loaned to small businesses like yours and mind. If it merely gets rolled over into exotic financial instruments like credit default swaps and derivatives and mortgage slices, it doesn't circulate in the economy among people who will spend it where that money has a positive velocity.

Compare that to something like SNAP, which has a velocity of around 1.7x. A SNAP dollar gets spent every month in places where it will circulate and recirculate and recirculate. That's one of the highest velocities you can imagine; a dollar going to SNAP increases the GDP by 1.7 times. That's a 70% return on investment. (I'd love to get that on my investments every year.)

Among conservatives who talk economics at all, a few know enough to talk about the ratio of debt to GDP, as if there's some unsustainable threshold of federal debt. There probably is an unsustainable threshold, but if you pick an arbitrary number out of the air because it sounds good ($15 trillion dollars), you're going to miss an important context. The conservative position is often that the current US government owes too much money and so it must cut spending, cut deficits, cut the American debt, cut cut cut.

That position has two problems in practice. First, there's no economic model that demonstrates that the US has a debt to GDP problem at the moment, even in the current economic climate, backed up by historical research. There are economic models, but they don't fit the history, so they don't work. (The Reinhart-Rogoff report, "Growth in a Time of Debt" is a good example of a bad model; not only is the report unrepeatable, but it has serious calculation errors and, worse, methodological problems in that they threw out outlier data that disproved their theories and compressed other data to make their theories look better.)

Second, there's a business cycle of which the entire point of both fiscal (how does the government spend its money) and monetary (how much of a sovereign currency is available at any point in time and why) policy hopes to smooth out. By expanding and contracting the money supply (monetary policy), the central bank tries to keep the GDP growing at a rate of 2-3% every year. When it's growing faster, the central bank raises interest rates (to discourage borrowing and decrease the amount of money in circulation) and reduces the amount of money in circulation (should be obvious now). That's to discourage velocity slightly. When it's growing slower, the central bank lowers interest rates (to encourage borrowing and increase the amount of money in circulation) and increases the amount of money in circulation (you see the connection).

Definition of Deficit Spending?

The definition of deficit spending is borrowing money right now that you'll have to pay back in the future. It's not a short term loan like a 30 day line of credit a business might use to cover payroll. It's borrowing money for 90 or 180 days or one, five, or ten years. It's like taking out a mortgage to buy a house; if getting what you want or need right now is more important or valuable than the money you'll spend on interest, it can be a good deal.

Government deficit spending implies a few things:

  • The government has power to control its spending.
  • The government has the power to spend more than it brings in in revenue in a given fiscal period.
  • The government has the ability to collect revenue—and predict the revenue collected in a given fiscal period.

It's not required that a government have a fiat currency to engage in deficit spending, nor is it required that the government set its own tax rates. All that's required is the ability to set spending levels distinct from (or exceeding) revenue.

How does it really work? The plan for the US economy is to grow. If it grows, more people will work. If more people work, they'll buy more things and more dollars will circulate. The more dollars that circulate, the more tax revenue will come in—even if tax rates stay the same.

Who loans the US government this money? That's a good question!

What is the Debt? What is the Deficit?

The federal government deficit is the current gap between the money brought in as revenue and the money going out as spending. The federal government debt is the cumulative amount of money borrowed. You probably have to incur debt to cover a deficit, but a deficit can be temporary while a debt may stick around for a while.

What is Sovereign Currency?

The US Dollar is a sovereign currency. A sovereign currency is a unit of exchange completely under the control of a single issuing authority (in this case US Treasury and the Federal Reserve). The dollar is also a fiat currency, not tied to an underlying asset such as gold or silver. Because of this, The Fed can control the number of dollars circulating as well as the interest rates banks pay for their reserves (too complicated to go into).

That manages the supply side of dollars. The only problem is that having a lot of dollars available to circulate in the economy (hopefully at a good velocity) is that those dollars only circulate when they get spent. When those dollars don't get spent on groceries, clothes, movies, appliances, vacations, meals, or other consumer goods, you have a demand side slowdown, by definition.

That's what we have in the US right now; that's what we've been having for the past few years.

In a demand side slowdown, you either wait it out (eventually people will find jobs or "exit the workforce", if you care for euphemisms) or you find some entity which is willing to spend money, hopefully in ways where those dollars have a good velocity, and you grow your way back into prosperity.

You need an entity which either has plenty of money to spend (cash reserves) or can borrow money at an attractive interest rate AND which is willing to spend that money. It's kind of like me saying "I have a job offer to write software for the pharmaceutical industry. Maybe I should borrow $100 to buy a nice computer because I can make $200 every paycheck and pay off that loan very quickly." (It's not exactly like that, but it's kind of like that.)

That's the position of the US Government, which has its own sovereign currency (controls the number of dollars) and can borrow at a fantastically low interest rate (can control the rate of return for T-bills, but that's too complicated to understand). In other words, when no one else has cash available to circulate (demand side slowdown), a modern 21st century economy needs a countercyclical entity willing to borrow money to circulate through the economy to help restaurants and grocery stores and appliance stores and clothing stores bring in more revenue and pay their employees who are going to spend their paychecks on mortgages and gasoline and soccer leagues for their kids and pet food and haircuts and everything else that adds up to the GDP.

Why Does the Government Have a Spending Deficit?

Deficit spending by the US government is defined by:

  1. A budget process which allocates more money to spend than it predicts will be received in tax revenue (unlike an accidental bank overdraft)
  2. An approved borrowing limit which the US Treasury cannot exceed without authorization
  3. The ability to create US dollars by printing more of them or to destroy them (fiat currency)

Why does the government use deficit spending? Because it can.

Okay, that's a simplistic answer. The real answer is because borrowing money at a low rate to spend wisely is an investment. Think about this: who's in the market for an aircraft carrier. Not many businesses would or could buy one. If no one buys an aircraft carrier, think of how many people would lose their jobs. You have people who do everything from make and paint the steel to install light fixtures and design computer systems for aircraft carriers.

(You can argue whether the world needs another aircraft carrier, but apply the same argument to building airports or bridges, maintaining freeways, or even sending in the National Guard to help with disaster preparation, rescue, and cleanup.)

If every dollar the government spent had to come from a financial reserve—savings, in fact—then the government would have a huge pile of money just sitting around, doing nothing. Can you think of better uses of that money? (Sure, buying $600 hammers to sit around in a warehouse somewhere is a poor use of money, but that's a matter of waste and not an economic principle.) That money could just as easily go to development of alternative fuels and batteries, scientific research, even loans to small businesses. In other words, investments in the country.

If the cost of borrowing that money is low and if the expected return of the investment is positive, it's a good investment. (Again, the discussion is about an idealized principle. Getting rid of wasteful spending only improves the investment and expected rate of return.)

What's the right way to spend the money? Get it in circulation where the velocity of that money is positive.

A Sovereign Currency During an Economic Downturn

The good news is that the US Government can borrow money at a rate less than even the modest inflation we have right now. In other words, investors are willing to buy T-Bills even though they're losing money on them. (It seems economically obvious that increasing the amount of dollars in supply will cause runaway inflation, but that's only the case where inflation is already a problem. A lot of conservatives have claimed that hyperinflation is just around the corner, but they've been claiming that for several years and it hasn't happened, so we can observe that their models don't match reality very well.)

It's even better news that the budget deficit has gone down because that interest rate is so low—and the projections for long term US federal debt have too, because the cost of debt service is lower than expected.

Is government debt bad? That depends on the government and the current economic state. Is the government stable? How much does it cost to service that debt? What's the interest rate of that debt? What's the ratio of debt to assets or tax revenue or productivity at full employment?

Debt service is an interesting topic—it's a place where conservative economic policy is useful. There is a point at which it's possible to have so much debt that all of your revenue goes to paying the interest on that debt. You can see that in a lot of municipalities which have crippling pension costs, where they're spending more money paying people not to work than they can spend paying people to work. (Note that municipalities don't have their own sovereign currencies and a lot of them have balanced budget amendments.)

Countercyclical Monetary Policy

To make all of this work at the federal level, fiscal policy has to be countercyclical. In other words, when the economy is slow, the federal government acts as spender of last resort, injecting money into the economy hopefully in places where those dollars have a high velocity. When the economy is high, the federal government should pay down its debt (obviously the cost of borrowing has gone up, so it shouldn't be borrowing) and even consider socking away some reserves for a rainy day. (Drop the Debt to GDP ratio so that that ratio is healthier when the business cycle turns again.)

This is the economic model that's guided modern economies since at least the Great Depression in the US. Keep in mind that most of the (capitalist) economics in the 20th century has tried to answer the question "How can we prevent another Great Depression?" The good news is that this economic model fits the data really well. Where it doesn't (Greece, Portugal), you can see the damage that not having a sovereign currency can do.

This is a complicated subject and parts of it seem counterintuitive at first, because these ideas are very different from how you manage your own budget. Keep in mind that you can't compare federal spending to your household spending, because you don't have a sovereign, fiat currency and you don't control the global dollar supply. (Whenever someone tries to answer the question "How does the government work?" by comparing it to a family or small business, walk away. You're only going to get a misleading answer.) Because the US federal government does have a sovereign currency and can control the global dollar supply, it has many more options for managing both the number of dollars in circulation globally (monetary policy) and how and when those dollars get spent (fiscal policy). One of those options is deficit spending—because it's cheap to borrow money from the entity which can create infinite amounts of money.

The most important thing to remember for fiscal policy is the velocity of money; you can work out a lot of the rest of the economics from that.