Government budget balance

• 1. Introduction

  ›

  The government budget balance is the gap between what a government takes in and what it spends. A positive gap is a surplus; a negative one is a deficit. That simple arithmetic sits at the center of some of the most heated debates in modern political life.

  But behind the headline numbers lies a web of relationships that most people never see. Deficits connect governments to private savers, to foreign investors, to central banks, and to the everyday household that borrows to pay its bills. Surpluses, far from being automatically virtuous, can drain financial assets out of the private sector entirely.

  Why do economists argue that deficits can sometimes be a necessity rather than a failure? Who was William Vickrey, the Nobel Prize-winning economist who called deficit fears a fallacy? And what actually happened to the U.S. budget between 2007 and 2009, when the deficit reached its peak? Those questions are where this story begins.

• 2. Surplus, Deficit, and the Flow of Money

  ›

  A surplus occurs when a government taxes more than it spends; a deficit occurs when it spends more than it taxes. These are not merely accounting entries. They represent real flows of money into and out of the private economy.

  British economist Wynne Godley developed the sectoral analysis framework that makes this concrete. Godley showed that the economy can be split into three sectors: the government, the foreign sector, and the private sector. By definition, the surpluses and deficits of all three must sum to zero. If the foreign sector is running a surplus by exporting capital into a country, and the private sector is also saving more than it invests, then the government sector must be in deficit.

  The U.S. in 2011 illustrated this precisely. The federal and state government deficit that year was approximately 10% of GDP. It was offset by a capital surplus from abroad of 4% of GDP and a private sector surplus of 6% of GDP. The three sectors balanced to zero, as Godley's framework requires.

  Sectoral balances analysis makes one implication clear: government budget deficits add net financial assets to the private sector. A deficit means the government has deposited more money and bonds into private hands than it has removed through taxes. A surplus does the reverse, pulling financial assets out of the private sector. This is not a political argument. It is an accounting identity.

• 3. The 2007-2009 Collapse

  ›

  Financial journalist Martin Wolf described what happened to the U.S. private sector between the third quarter of 2007 and the second quarter of 2009 as an "almost unbelievable" shift. The private sector's financial balance swung toward surplus by a cumulative total of 11.2 percent of gross domestic product. That was precisely when the U.S. government deficit, federal and state combined, hit its peak.

  Wolf's argument was direct: no significant fiscal policy changes caused the collapse into large deficit between 2007 and 2009. The cause was the private sector's massive move from deficit into surplus, or in other words, from boom to bust.

  Economist Paul Krugman, writing in December 2011, identified the specific forces driving that private-sector shift. The end of the housing bubble, a sharp rise in household saving, and a collapse of business investment due to weak customer demand all pushed the private sector toward surplus simultaneously. When the private sector saves more and spends less, the government balance must absorb the difference, mechanically, by moving into deeper deficit.

  Understanding this sequence matters. The government did not go into deficit first and cause a crisis. The private sector crisis came first, and the government deficit was, in large part, the automatic arithmetic result.

• 4. Primary Balance and Interest Payments

  ›

  The total deficit that makes headlines is actually the sum of two distinct components. The primary deficit captures the gap between what a government currently spends on goods and services and what it collects in taxes net of transfer payments. On top of that sits the interest payments owed on previously accumulated debt.

  The OECD defines the primary balance as government net borrowing or net lending, with interest payments on consolidated government liabilities excluded entirely. A government can be running a primary surplus, meaning it is collecting more than it spends on current operations, while still running an overall deficit because past debt carries high interest costs.

  This distinction matters enormously for countries already carrying large debts. When the debt-to-GDP ratio climbs, creditors demand higher interest rates on new loans to compensate for perceived risk. Those higher rates increase interest payments, which widens the total deficit further, which can make the debt ratio climb again. Countries with very high debt-to-GDP ratios are considered more financially vulnerable during recessions, and Greece and Japan are cited as developed nations whose debt levels would create severe difficulties if interest rates rose significantly.

• 5. Structural Versus Cyclical Deficits

  ›

  At the lowest point of the business cycle, unemployment is high, tax revenues fall, and social security spending rises. At the peak of the cycle, unemployment drops, revenues rise, and social security spending falls. The extra borrowing needed at the bottom of the cycle is the cyclical deficit, and by definition it should be repaid by a surplus at the top.

  The structural deficit is what remains across the full cycle. It reflects a general government spending level that exceeds prevailing tax revenues regardless of where the economy stands. The total observed deficit at any moment equals the structural deficit plus or minus the cyclical component.

  Economists Alan Auerbach and Laurence Kotlikoff proposed a longer-range version of this analysis called the fiscal gap. The fiscal gap measures the difference between government spending and revenues over the very long term, typically expressed as a percentage of GDP. A fiscal gap of 5 percent, for example, could in theory be closed by an immediate permanent 5 percent increase in taxes or reduction in spending, or some combination. The fiscal gap includes not just today's structural deficit but also the gap between promised future spending, particularly on health and retirement, and planned future revenues. In many developed countries, the elderly population is growing faster than the young population, which makes this long-run gap a matter of particular concern.

• 6. William Vickrey and the Deficit Fallacy

  ›

  William Vickrey, awarded the 1996 Nobel Memorial Prize in Economic Sciences, argued that the conventional fear of deficits rests on a false analogy. The analogy compares government borrowing to household borrowing, and Vickrey insisted current reality is almost the exact opposite of what that analogy implies.

  Deficits, Vickrey wrote, add to the net disposable income of individuals to the extent that government payments to recipients exceed what is taken back through taxes and fees. That added purchasing power, when spent, creates markets for private production. Producers then invest in additional plant capacity, which becomes part of the real inheritance left to future generations. Public investment in infrastructure, education, and research adds to that inheritance as well.

  Vickrey used a pointed comparison. If General Motors, AT&T, and individual households had each been required to balance their budgets in the way that is often demanded of the federal government, there would be no corporate bonds, no mortgages, no bank loans, and far fewer automobiles, telephones, and houses. The deficit he judged genuinely harmful was one that exceeded the gap created by maximum feasible growth in real output. He saw no evidence that the U.S. was anywhere near that level.

  His position carried the weight of a laureate, but it also fits within a broader Modern Money Theory argument: for a government that issues its own currency, the budget deficit is in reality a policy tool that regulates inflation and unemployment, not a mechanism for funding government activities in the way a household funds its expenses.

• 7. Ricardian Equivalence and Crowding Out

  ›

  Two competing theories challenge the idea that deficit spending stimulates the economy. The first is the Ricardian equivalence hypothesis, named after the English political economist and Member of Parliament David Ricardo.

  Ricardian equivalence holds that households, anticipating that a current deficit must eventually be paid through future taxes, will save more now to offset those future obligations. If true, a tax cut financed by borrowing would not boost spending, because households would simply set aside the tax savings. Ricardian equivalence requires strong assumptions: households behaving as if they were infinite-lived dynasties, no uncertainty, and no liquidity constraints. For the theory to hold in full, deficit spending would also need to be permanent; temporary deficit spending would imply a smaller annual tax burden than the original deficit and would still be expansionary. Empirical evidence on Ricardian equivalence has been mixed.

  The crowding-out hypothesis works through interest rates. When a government borrows to cover a deficit, its demand for credit rises, pushing up the interest rate. Higher interest rates make private investment more expensive, so some private investment that would otherwise have occurred does not. The argument is that government borrowing "crowds out" private borrowing, partially or fully offsetting the stimulus effect of the deficit. The degree to which this actually occurs is a longstanding empirical debate in macroeconomics.

• 8. Financing Deficits Through History

  ›

  Before governments could issue bonds, the only way to finance a deficit was through direct loans from private investors or other nations. A prominent example from the late 18th and 19th centuries was the Rothschild dynasty, though the Peruzzi family represents an even earlier case. These arrangements became viable only once private financiers had accumulated enough capital to offer large sums, and once governments had lost the practical option of simply printing money to cover expenses, given the inflation that followed.

  Large long-term loans carried real risk for lenders, and so commanded high interest rates. Governments found a way to reduce those costs: they began issuing bonds payable to the bearer rather than to the original purchaser. This meant lenders could sell part or all of the debt to someone else, spreading the risk and reducing its cost. British Consols and American Treasury bill bonds are examples of this bearer structure.

  The Budget Control Act of 2011 in the United States was intended to reduce the federal deficit by $2.1 trillion over a ten-year period through caps on discretionary spending and automatic cuts if those caps were exceeded. The Tax Cuts and Jobs Act of 2017 cut taxes significantly for individuals and corporations; its supporters argued it would stimulate growth, while critics raised concerns about its effect on the deficit. During the Greek government-debt crisis, a cancellation of part of the country's debt in 2011, known as a "haircut," alleviated Greek finances but put pressure on banks elsewhere. Cypriot banks lost 5% of their assets in that haircut, which triggered a banking crisis in Cyprus.