Why Do Countries Run Deficits?

Readers Question: Why Do Countries Run Deficits? (what about planned economies) Can an economy function without it if it refused to borrow to smooth out recession or to fund whatever it finds to have a public value worth going into debt for.

Reasons for Deficits include:

1. To Finance Investment in Public Services
2. Counter Cyclical Demand Management – borrow in recessions
3. Political Pressures
4. War

1. Investment A justification for government borrowing is to finance investment in public services. If governments borrow to build infrastructure like roads and railways it is investing in the future productive capacity of the economy. Though it is borrowing, the investment can lead to higher growth and higher tax receipts in the future. It is similar to a firm borrowing to invest in building a new factory.

2. Recession. In a recession, aggregate demand in an economy is falling. Governments usually need to borrow because in a recession tax receipts fall and they spend more on unemployment benefits.

Also, because people fear unemployment, they usually start saving a higher % of their disposable income. Government borrowing is a way of offsetting the rise in private sector saving. It enables a boost to aggregate demand at a time when the economy needs it.

3. Political Pressure. From a political perspective there is usually more political capital from cutting taxes and promising higher spending. It can be difficult to get the political will to reduce borrowing even when necessary. This is often an issue when things like an ageing population put pressure on government finances.

4. War In the great wars, British borrowing increased dramatically. It also increased during Napoleonic wars to over 200% of GDP. The government is often helped by a patriotic fervour for people to buy war bonds, which makes it easier to borrow than in peace time.
borrowing

Can An Economy Function Without Borrowing?

Some economies like Saudi Arabia, Qatar, find it so easy to gain tax revenues from oil, that they don’t need to resort to borrowing. There is no reason economies have to borrow. But, it is not really a priority to have zero government debt.

Can An Economy Function without Borrowing in a Recession?

Attempts to reduce government borrowing in a recession, almost inevitably make the recession worse. In 1931, Treasury official put pressure on the government to reduce government borrowing (through higher taxes and lower unemployment benefits). This further reduces aggregate demand and makes the recession worse. By reducing spending and output, it ironically makes it more difficult to balance a budget.

Is Borrowing Good or Bad?

It depends what a government is borrowing for. It depends when in the economic cycle is borrowing. It depends on the cost of servicing borrowing. Do markets fear the government will default?

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