Write an essay analyzing the advantages and disadvantages of deficit spending and the effects of federal government borrowing on the economy i.e., the “crowding out” effect.
1. Cover page with a running head
2. Introduction: What is deficit spending and how does it work
3. Crowding-out Effect
4. Conclusions: Do you believe that deficit spending helps or hinders short-term and long-term economic growth?5. References
Deficit spending also known as budget deficit arises when a government’s expenditure exceeds its revenue over a certain fiscal period. To fund this deficit, the government borrows money by issuing instruments such as government bonds. Prominent economists hold different views on the issue of deficit spending. Economist John Keynes was of the view that a budget deficit can be used by governments to stimulate their economies during recession. He argued that deficit spending by external borrowing or other means gave the government money to spend on goods and services that would be useful in lifting the country out of recession. This fiscal policy is referred to as the demand side economic theory (Merino, 2013). The theory by Keynes argues that the low levels of consumer spending experienced during recession can be countered by an increased level of deficit spending by the government. This maintains a favorable level of aggregate demand that prevents high unemployment. Keynes believed that when full employment was achieved, the debt could be paid and if the high government spending caused inflation, this could be countered through high taxation (Hunnicutt, 2010).
However, some economists argue that the issue of deficit spending should not be left unchecked and governments should not engage in it regularly. They argue that it could hinder economic growth since the mounting of debt could result in an economy that is unsustainable in the long-term. Mounting debt brought by consistent borrowing may also force a government to hike its taxes, employ monetary policies that lead to inflation or fail to honor their debt obligation. Moreover, issuance of government bonds may interfere with interest rates and prices in the country’s capital market.
Advantages of Deficit Spending
- Deficit spending is a better way of raising revenue as compared to higher taxation in times of recession.
During recession, aggregate income falls leading to higher unemployment. If the government was to increase federal taxes, this means that the economy would be further diminished as individuals struggled to pay the rising taxes. However, when the government opts to borrow funding from an outside source, the country is able to generate a higher output which boosts employment and national spending which in effect ease the recession (Hunnicutt, 2010).
- Deficit spending pushes economic growth.
Governments use deficit spending on public services such as education and infrastructural projects such as transportation. The governments invest in such projects hoping they will boost productivity and hence be beneficial in the future. With such developments, the economy will attract more investors, open up job opportunities, increase revenue and boost the economy.
- Better control of government spending
Since the government needs to pay back the borrowed funds at particular interest rates, this makes government bodies much more careful when making budgets and choosing projects to invest in. Moreover, high interest rates on borrowed funds will make the government make plans to pay the debts in the shortest time possible.
Disadvantages of Deficit Spending
- No Savings
A government makes no savings in a deficit period. This is a setback because in case of an emergency the government will have no savings to rely on. In case of any emergency the government is forced to borrow again at high interest rates and the vicious cycle of a mounting debt continues.
Deficit spending leads to an inflationary increase in prices. This is due to an increase in government expenditure which results in higher taxation. Developing countries which are more sensitive to inflation are exposed to this pitfall. Additionally, inflation resulting from deficit financing only benefits the producing class and businessmen but hurts those with a fixed income. Consequently, income inequality widens (Merino, 2013).
- Trade deficit
Due to the inflationary increase in prices, the country’s balance of payment deficit increases. An increase in local prices will mean that exports will decline while imports increase.
Crowding Out Effect
Crowding out also referred to as displacement by Keynes refers to when public economic activities displace private economic activities. There is a danger of public borrowing displacing private borrowing and public spending displacing private spending. The theory of crowding out stipulates that rises in public spending could stifle or eliminate private spending (Merino, 2013). One of the ways through which crowding out can take place is when a government increases its borrowing. Heavy borrowing can have an increasing effect on the economy’s real interest rate. An increase in the real interest rate leads to a decrease in the economy’s capacity to lend and decreases investment in capital projects which are mostly funded through debt financing (Hunnicutt, 2010). Crowding out can also be caused by other factors such as increase in taxes by the government leaving the citizens with low disposable income. Government funded infrastructure can also cause crowding out because private enterprises find it unprofitable to venture into similar markets.
In spite of disadvantages such as inflation, deficit spending has its benefits and is inevitable for least developed and developing countries. It is an important fiscal tool for governments to pull themselves out of recession and set themselves for long-term economic growth. Most of its shortcomings can be managed if inflation levels are minimized. To keep inflation within limits and reap the benefits from deficit spending, governments have to ensure that borrowing is kept within safe limits.
Hunnicutt, S. (2010). The Federal Budget Deficit. Detroit MI: Greenhaven Press
Merino, G. (2013). Government Spending. Detroit: Greenhaven Press