The Budget Deficit/The Budget Surplus: The Real Story


Thomas E. Nugent


Newspapers are filled with warnings about the potential for growing budget deficits due to President Bush’s proposed fiscal stimulus package. Two years ago, we were going to have surpluses as far as the eye could see—somewhere upwards of $2 trillion. Politicians were ebullient over the likelihood that these record surpluses would allow them to save Social Security, increase spending on pet projects, and give well-heeled constituents a nice fat tax cut. Now these same politicians are all stressed out over the forecasts of ballooning federal deficits. The outlook has changed to burdening our children with the bill for our lifestyles and the fact that Social Security will go broke.

The government plays a critical role in influencing the economy especially when cyclical factors knock a long-term trend off track. In such circumstances the federal government steps in and replaces some of the lost demand that was coming from the private sector by greater spending. The U.S. dollar is not anchored to any particular commodity; the government is free to net spend (spending in excess of revenues) as much money as necessary to keep the economy afloat. When government “spends,” it introduces demand into the economy. For example, when the government orders a fleet of aircraft, it pays for the aircraft with a check drawn on the U.S. government, and credits the appropriate bank account when that check clears through the Fed.  The federal government doesn’t need money to spend money.  There is only one way for our government to spend-- it credits an account for a member bank at the Fed. 

When companies begin producing the planes and hiring the associated workers as a result of the government purchase, income and output goes up.  As a matter of accounting, it is the same money the government spends that, at the end of the day, purchases the government bonds that are ultimately issued with the presumption of ‘financing’ the initial government spending.  In other words, deficit spending creates the new funds to buy the newly issued securities.  The result is an increase in output as well as in increase in savings of net financial assets (in the form of treasury securities) for the private sector. 

The government deficit has important economic consequences, assuming there was excess capacity in the real economy. Economic activity increases; the government acquires goods and services that are needed; unemployment declines; production goes up; the overall economy grows; and individuals and companies savings increase in the form of the newly issued government bonds. 

One can also see that the fears of rising interest rates in the face of rising budget deficits make little sense when all of the impact of government deficit spending is taken into account, since the supply of treasury securities offered by the federal government is always equal to the newly created funds. The net effect is always a wash, and the interest rate is always that which the Fed votes on.  Note that in Japan, with the highest public debt ever recorded, and repeated downgrades, the Japanese government issues treasury bills at .0001%!  If deficits really caused high interest rates, Japan would have shut down long ago!  

Now, how about a budget surplus? Imagine the following: When the federal government runs a budget surplus, it retires federal debt.  So, in effect, rising government tax collections allow the government to buy back this debt from taxpayers who need those funds to pay that net tax.  If we could reduce the economy to a one-person government and a one-person private sector here is what would happen. The government would come to you and say: “you owe me a net tax payment.  I am going to buy back the government bonds you hold so you can thereby cash in that savings and pay me.” The effect of this transaction is that the individual is worse off for two reasons: first, he no longer holds the government bonds as an asset—so his financial wealth goes down. Additionally, he has lost income due to the net tax.  Remember, he is required to pay more in taxes so that the government can buy the bond back from him. Instead of having the cash from the bond sale, he has nothing! No wonder consumers can’t save and ultimately have ‘less confidence’ when the government raises taxes to buy back government bonds!

Some adversaries will say that such a relationship doesn’t exist. I say that when your tax collections are at record levels and that the federal government is buying back bonds, as was the case in 2001, fiscal surpluses were the major villain in pulling the rug out from under the expansion and accelerating the economic decline and prolonging the stock market collapse. One lesson learned from this experience is that large budget surpluses are contractionary and undermine the ability of the economy to prosper.

Oh, yes—and about funding Social Security. There is no way that the government can save now for Social Security payments later although you would think they were—given the bonds in the Social Security Trust Fund.  Payment is simply a matter of crediting an account, and debiting an account.  In a macro economic sense, the funds that government spends don’t ‘come from’ anywhere and taxes collected don’t ‘go anywhere.’  Yes, they are accounted for, but accounting for Social Security taxes subtracted from our bank accounts doesn’t make it any easier or harder for the government to add to our accounts when it makes payments to us.

What matters most is that government payments to us increase our income and savings, and taxes reduce our income and savings.  Yes, too much deficit spending will cause inflation, and a surplus will cause a contraction just as, in the long-term, we’re all dead.  In the short-term, just look at the economy and decide:  does it need to be cooled down with higher taxes and less government spending, or does it need to be assisted with lower taxes and higher spending? Identifying what the economy needs is the real challenge, and not arguing about the government’s budget balance, that is just an accounting residual. 

Faster economic growth, more jobs and higher incomes in the private sector is the only way we will have the wealth available to transfer to the retiring baby boomers.



posted  3/4/2003