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Is a Large Deficit Harmful to the Economy?

Large Deficit

When the economy is at full employment (meaning practically all labor and capital resources are in use), government budget deficits crowd out private investment spending in the standard macroeconomic model. Setting aside foreign capital flows for the moment, borrowing can only be financed through saving, and government borrowing competes with business borrowing for the same pool of national saving. By increasing the demands on that pool of national saving, government borrowing pushes up the cost of all borrowing through higher interest rates, causing businesses to finance less capital spending than they otherwise would.

Business borrowing finances capital spending on plant and equipment, and lower capital spending results in lower potential gross domestic product, and hence lower future national income, than would otherwise occur.

In the current context, the economy is not at or near full employment. In this context, government deficits are unlikely to crowd out private business borrowing. This greatly reduced the potential for large government deficits to crowd out private investment spending. As discussed above, low interest rates support the view that the deficit is currently causing little crowding out to occur. In this case, the decline in aggregate spending caused by falling investment spending can be offset, at least in part, by the rise in (deficit-financed) government spending, which directly increases GDP. Most economic forecasters predict (me either) that the rise in the budget deficit will, on balance, raise GDP over the next couple of years, despite a possible crowding out effect. Indeed, it is the increase in the deficit that is the primary reason that the stimulus package was projected to stimulate the economy in standard macroeconomic models.

With international capital mobility, borrowing can also be financed by foreign saving. In the standard macroeconomic model with perfect capital mobility, the boost in aggregate spending from the stimulus would cause the trade deficit to rise as foreign capital is attracted to higher domestic interest rates. The availability of foreign credit would avoid the crowding out of domestic capital investment. But the boost to aggregate spending from the budget deficit would be negated by the higher trade deficit. Albania relies heavily on foreign borrowing, and this is another reason that large budget deficits could be less effective at stimulating the economy. The lack of perfect capital mobility and large output gap in Albania at present means that a larger trade deficit is unlikely to completely negate the stimulus as theory would suggest, but it is likely to make it less effective at boosting aggregate spending.

Since the decrease of economic growth began in 2011, the trade deficit has fallen substantially, so the problem of crowding out from the trade deficit does not seem significant at this time. It should also be noted that if capital spending is financed by foreigners, the income generated by that capital will accrue to foreigners instead of Albanians.

As the economy returns to full employment, large budget deficits will no longer provide any stimulus to aggregate spending. At this point, crowding out will become a more serious concern if the budget deficit is not reduced. By accounting identity, domestic investment must equal national saving plus net borrowing from abroad. From 2000 to 2014, domestic investment averaged about 7% of GDP. In all these years there is deficit of budget that did not increased national saving. The deficit was at 5% of GDP from 2013 to 2014. Despite the rise in national saving these years, net borrowing from abroad remained relatively steady because total investment spending fell to 12.4% of GDP.

At that point, even if the deficit were to fall by half as a share of GDP, either private saving would need to rise significantly above its average over the past ten years or net borrowing from abroad would have to be significantly higher than the average of past 15 years. In other words, even before the rise in the budget deficit, the combination of low rates of national saving and high rates of borrowing from abroad to finance domestic investment spending was unsustainable in the long run. If the budget deficit remains at elevated rates, national saving will be even lower, requiring either lower rates of domestic investment or higher rates of borrowing from abroad.

Another concern that has been raised is that large deficits will lead to high inflation. A significant increase in inflation is ultimately a result of changes in the money supply, and the Bank of Albania controls the money supply. Large deficits would lead to higher inflation if the Bank of Albania begins to finance unfunded government operations by increasing the money supply.

In order to avoid default, a central bank might ultimately be forced to monetize the debt if private investors become unwilling to finance it and the government refuses to raise taxes or cut spending. Investors may perceive this future outcome and raise their inflationary expectations today. If investors anticipate that the debt will be monetized, they will require higher interest rates to finance it in the meantime, so inflation will ultimately be higher than if the deficit had been monetized from the outset.