Deficit Spending

What Is Deficit Spending?

In the simplest terms, deficit spending is when a government's expenditures exceed its revenues during a fiscal period, causing it to run a budget deficit. The phrase "deficit spending" often implies a Keynesian approach to economic stimulus, in which the government takes on debt while using its spending power to create demand and stimulate the economy.

Understanding Deficit Spending

The concept of deficit spending as economic stimulus is typically credited to the liberal British economist John Maynard Keynes. In his 1936 book The General Theory of Employment, Interest and Employment, Keynes argued that during a recession or depression, a decline in consumer spending could be balanced by an increase in government spending.

To Keynes, maintaining aggregate demand — the sum of spending by consumers, businesses and the government — was key to avoiding long periods of high unemployment that can worsen a recession or depression, creating a downward spiral in which weakening demand causes businesses to lay off even more workers, and so on.

Once the economy is growing again and full employment is reached, Keynes said, the government's accumulated debt could be repaid. In the event that extra government spending caused excessive inflation, Keynes argued, the government could simply raise taxes and drain extra capital out of the economy.

Deficit Spending and the Multiplier Effect

Keynes believed there was a secondary benefit of government spending, something known as the multiplier effect. This theory suggests that $1 of government spending could increase total economic output by more than $1. The idea is that when the $1 changes hands, so to speak, the party on the receiving end will then go on to spend it, and on and on.

While widely accepted, deficit spending also has its critics, particularly among the conservative Chicago School of Economics.

Criticism of Deficit Spending

Many economists, particularly conservative ones, disagree with Keynes. Those from the Chicago School of Economics, who oppose what they describe as government interference in the economy, argue that deficit spending won't have the intended psychological effect on consumers and investors because people know that it is short-term — and ultimately will need to be offset with higher taxes and interest rates.

This view dates to 19th century British economist David Ricardo, who argued that because people know the deficit spending must eventually be repaid through higher taxes, they will save their money instead of spending it. This will deprive the economy of the fuel that deficit spending is meant to create.

Some economists also say deficit spending, if left unchecked, could threaten economic growth. Too much debt could cause a government to raise taxes or even default on its debt. What's more, the sale of government bonds could crowd out corporate and other private issuers, which might distort prices and interest rates in capital markets.

Modern Monetary Theory

A new school of economic thought called Modern Monetary Theory (MMT) has taken up fight on behalf of Keynesian deficit spending and is gaining influence, particularly on the left. Proponents of MMT argue that as long as inflation is contained, a country with its own currency doesn't need to worry about accumulating too much debt through deficit spending because it can always print more money to pay for it.