Budget deficit or surplus: Who can balance the economy?

Budget deficits, as well as surpluses can be part of our everyday financial life, together with their effects. But, the impact they reflect to economic environment is the most important effect for the future.

Business investment  spending on physical capital such as factories, computers, software, and machines is an important determinant of the long-term size of the economy. Physical capital investment allows businesses to produce more goods and services with the same amount of labor and raw materials. As such, government deficits that lead to lower levels of business investment can result in lower quantities of physical capital and therefore may reduce the productive capacity of the economy in the long term

Budget deficits, but also the surpluses can help to put in balance the economy. Mostly, the governments prefer to finance their deficits instead of balancing the budget. Government bonds usually are used to finance the deficit. Most creditors think that the government is highly likely to repay its creditors. That makes government bonds more attractive than other risky financial investments. As a result, interest rates remain relatively low. That allows governments to keep running deficits for years.

If the economy enters a recession taxes will fall as income and employment fall. At the same time, government spending will increase as people are given unemployment compensation and other transfers such as welfare (social protection) payments.

These changes in revenue and expenditures work to increase the deficit. At the same time, they also work to mitigate the decrease in disposable income that households are experiencing. This maintains consumption at a higher level than would otherwise be the case. This helps to maintain the level of aggregate demand and thereby soften the effects of recession.

In the relationship between deficit and surplus enters the fiscal stimulus, presented strongly recently in last decades by the governments.

Continuous fiscal stimulus can result in a rising debt-to-GDP ratio and lead to an unsustainable level of public debt. A rising debt-to-GDP ratio can be problematic if the perceived or real risk of the government defaulting on that debt begins to rise. As the perceived risk of default begins to increase, investors will demand higher interest rates to compensate themselves.

The tipping point at which public debt becomes unsustainable is difficult to predict. A continually rising debt-to-GDP ratio is likely to lead to an unsustainable level of debt over time. The threshold at which a country’s debt becomes unsustainable depends on a number of factors, such as the debt ownership, political circumstances and potentially most importantly what constitutes basic economic conditions. A change in these circumstances may shift a country’s debt to be unsustainable without the underlying amount of debt changing at all.

The government can withdraw fiscal stimulus by increasing taxes, decreasing spending, or a combination of the two. When the government raises individual income taxes, for example, individuals have less disposable income and decrease their spending on goods and services in response. The decrease in spending reduces aggregate demand for goods and services, slowing economic growth temporarily. Alternatively, when the government reduces spending, it reduces aggregate demand in the economy, which again temporarily slows economic growth. As such, when the government reduces the deficit, regardless of the mix of fiscal policy choices used to do so, aggregate demand is expected to decrease in the near term. However, withdrawing fiscal stimulus is expected to result in lower interest rates and more investment, a depreciation of the Lek and a shrinking trade deficit, and a slowing inflation rate.

When recession happen, we can see that revenue falls while expenditures rise thereby creating a deficit. To balance the budget, government must raise more revenue (by increasing taxes and fees) and moderately cut expenditures. Both of these actions will lower disposable income. As a result, consumption and aggregate demand will fall. As aggregate demand falls, the recession getting worse.

If the deficit is financed through the issuance of money there will be relatively little effect on the interest rate. However, the expansionary effect of the increase in government expenditures will be compounded by the expansionary effect of the increase in the money supply. As a result, there will be a relatively large increase in aggregate demand. Because the economy is already at full employment there will be no increase in output. Instead, the increase in aggregate demand will be reflected in a relatively large increase in the price level.

In the case of surplus there are several reasons to consider it as an undesirable way to reduce debt. In the way the economy goes on year after year, for the governments it may be desirable to run a deficit in order to help balance the economic recovery after budget troubles (deficit and growing demand for expenditures). If the annual surplus were targeted, the possibility of using fiscal policy to stabilize the economy during times of declining economy or recession would be overlooked.

In fact, it is possible that this practice would make the recession more severe. Sometimes it’s desirable to borrow to increase the flow of income or services in the future. For example, it may be desirable for government to invest in a IT system that will yield services far into the future. Any time a project will yield a flow of services or benefits in the future that are sufficient to repay the loans, it is desirable for government to borrow in order to undertake the project.

On these circumstances, it would be better to reduce or eliminate the budget deficit. So debt grows more slowly than the opportunity to achieve annual surpluses to reduce debt. If deficit will be reduced and the economy will grow, then the debt to GDP ratio would be in decline and the budget will become less dependent to borrow policy.

Given the reality of public debt management in recent years, raising or suspending the debt ceiling has not directly changed the amount of borrowing or ongoing expenses. Instead, it has allowed the government to pay for programs and services it has already approved.

Given the need to raise or suspend the public debt ceiling is not a reliable indicator of the sustainability of budget policy. For example, although the debt-to-GDP ratio fell by 4 percentage points during the period 2014-2019, we see that the sustainability of budget policy has slightly improved.

The main drivers of deficit are still mandatory spending programs, namely Social Security, the largest government program, but the increasing costs for infrastructure and investments in IT are to be important in 2-3 next years . Their costs, which currently account for nearly half of all budget spending, are expected to surge as a percentage of GDP because of the non consulted with deep analysis and civil society actors. Yet, corresponding tax revenues are projected to remain a bit better, but that’s the old story told to people since ’90.

Meanwhile, interest payments on the debt, which now account for nearly 2 percent of the GDP, are expected to rise, while discretionary spending in this period of crisis (costs and expenses that are not substantial), including programs such as transportation infrastructure is expected to increase as a proportion of the budget.

At the end of this analysis, is important that to attain better economic conditions, both surplus and deficit should be at equilibrium with budget needs in long prospective view.