The news that Bush’s proposed budget includes a deficit of $300 billion (around 3 per cent of GDP) for the next two years, and smaller deficits into the indefinite future has been somewhat overshadowed by events of more immediate concern. But when Iraq is off the front pages and the Space Shuttles are flying again, the deficit will still be there. This immediately raises the question: So What ? Some economists seem to be very concerned about budget deficits at all times, some are concerned at some times and not others, and some never seem to worry. What is going on here?

The only satisfactory way to explain this involves a few equations. Since every equation is supposed to reduce readership by a factor of ten, this probably means I will only have two readers for this post, so maybe I should just get Jason and whoever else is still reading to email me. Pressing on regardless, let’s begin with the national income identity

Income = Consumption + Investment + Govt spending + Exports – Imports

This equation is an identity, which means that it’s true by virtue of the definitions of the terms, not because of any particular economic theory. The equation can be rearranged in various ways. The most useful involves taking taxation revenue into account as a transfer from households to governments. Rearranging, it’s then possible to show that the government budget deficit must be equal to the sum of:

Imports less Exports (the current account deficit); and
Private Saving (after-tax income less consumption), net of investment.

Arithmetically at least, a budget deficit must be funded by borrowing either from households or from overseas (in this context, printing money is regarded as a form of taxation, or perhaps of borrowing).

When a government increases spending or cuts taxes, leading to a higher budget deficit one or other of these must change as well since the accounts must balance. Economists’ level of discomfort with budget deficits depends on where they think the change will take place.

The most pessimistic view, called ‘crowding out’ is that investment will decline as private savings are used to fund the budget deficit. Another pessimistic view called ‘twin deficits’ is that the adjustment will take the form of more borrowing from abroad, that is, an increase in the current account deficit. In Australia, deficit hawks have pushed both theories, and some have managed to believe both simultaneously.

The neutral position, called Ricardian equivalence, is that consumption will adjust. In this story, people realise that the budget deficit will imply higher taxes in future, and start saving up now. If you find this story implausible, you can join 99 per cent of the economics profession.

The optimistic position is that income will increase, partly offsetting the original increase in the deficit as tax revenue rises and also allowing for higher private savings. There are two reasons why this might be so.

The Keynesian argument for deficits assumes that there are lots of unemployed workers, idle factories and so on (So far, so good!). The extra demand produced by tax cuts or government spending is met by hiring more workers and reopening factories, which in turn stimulates ‘multiplier’ effects. In a very simplistic model, sometimes referred to as the ‘pump-priming’ model, the growth is sufficient to wipe out the original increase in the budget deficit.

The ‘supply-side’ argument based on the(in)famous Laffer curve applies only to cuts in taxes. It’s claimed that the extra incentives will stimulate more work effort, higher investment and so on, thereby raising income and, in the extreme case, wiping out the original increase in the budget deficit as in the ‘pump-priming’ story. Religious metaphors arise naturally here. George Bush Senior called supply-side economics ‘voodoo’, but it’s gospel to Junior and to most of the US Republican Party

Most economists are Keynesian in the short run, but believe some mixture of crowding out and twin deficit models applies in the long run. This suggests the ideal policy called the ‘golden rule’, running deficits during recessions and surpluses during booms so as to achieve budget balance over the course of the cycle (this leaves open, the question of precisely what is meant by budget balance, but that’s a story for another post).