Do Budget Deficits Matter?

Budget deficit is defined as a financial condition when expenditures exceed revenue. The term budget deficit is usually used in the context of a government or country although it can also be used to describe the financial condition of an individual or a business entity. In this article, the term is used in the context of a government or country.

Every year, a government will set out its own budget, listing down all its estimated expenditures and revenues for the following year. As the budget is prepared based on the needs and goals of the government, it is common to see the estimated expenditures to exceed the expected revenue. For example, if a government has targeted to stimulate its domestic economy which has been through a recession in the past few years, it can plan to spend more on building public infrastructures in the coming years in order to create more jobs, although at the same time it will expect to receive a lower revenue from taxes or other forms of revenue due to the weaker economic condition. The step to increase government expenditures although revenues are not expected to increase in the example given earlier is important to boost economic growth, reduce unemployment rate and bring the nation out of the recession even though this will probably result in a budget deficit. On the other hand, a budget deficit is expected to reduce in times of economic prosperity, as lower unemployment rate and higher corporate earnings will result in higher tax revenue for the government.

To fund the budget deficit, a government can borrow by issuing financial securities such as treasury bills, notes and bonds. In the case of an individual or business entity that runs into a budget deficit when they could not pay their bills, their credit ratings will be affected which makes new credit even more expensive and eventually, they may have to declare bankruptcy. However, a government can run into moderate budget deficits for years as the likelihood that the government is able to repay its creditors is high. This confidence from the creditors has also enabled the government to simply issue new debt instruments to repay its existing debts that are due. A government can also increase taxes to repay its debt whenever necessary. Furthermore, most governments posses a powerful tool when it comes to repaying its debt, which is to print money from its central bank, although this would lower the value of its currency. In fact, the weakening currency value and inflation have in a certain way helped governments in repaying its debt as the repayments are done in nominal value instead of real value. For example, the $250 billion debt of the US Federal Government during the post World War II era in the 1950s would have become $2.3 trillion today if adjusted for inflation rate. However, it is important to note that the benefit of inflation to the government is only applicable to longer term debts.

The budget deficit is most commonly measured in relative to the GDP of a country. For example, the Budget 2014 of Malaysia presented by Prime Minister Najib Razak stated that the budget deficit is expected to be reduced from 4% of GDP in 2013 to 3.5% of GDP in 2014. Note that these are annulised figures and do not represent the total amount of debt that the government has. The national debt on the other hand, represents the total amount of debt that a national has accumulated every year since its existance. Malaysia has a self imposed debt ceiling of 55% of the GDP, with the current debt-to-GDP ratio of 53.5%, representing the total amount of national debt that the government owes to its creditors. Malaysia has been in budget deficit consecutively for the past 15 years, since 1999. In fact, according to historical data, Malaysia has been experiencing budget deficit as early as 1988, with an exception of the 5 years from 1994 to 1998 where it had enjoyed budget surpluses. Looking at the federal budget of the world’s largest economy today - the United States, it is found that the nation had been on budget deficit as early as 1940. In the period of 73 years, from 1940 to 2013, the country has only had 12 years of budget surplus, with the most recent ones recorded from 1998 to 2001. This has shown that the US economy and national grwoth has been supported and funded by debt financing to become the world’s largest economy today. The US currently has a budget deficit of 6.9% of its GDP. Other developed countries that have been in budget deficits most of the time includes Japan (latest budget deficit of 9.9% of GDP) and the United Kingdom (latest budget deficit of 8.2% of GDP). On the other side of the picture, the world’s top three highest budget surplus nations today are Kuwait (surplus of 33% of GDP), Libya (surplus of 27.5% of GDP) and Macao (surplus of 25.6% of GDP). From the list, it can be noted that a nation with a budget surplus does not necessarily bring about prosperity.

GDP = C + I + G + ( X – M)

Where,
C = Consumer Spendings or Consumption
I = Investment
G = Government Spending
X = Total Export
M = Total Import

The formula representing the Gross Domestic Product (GDP) of a nation above stated that the GDP is a function of consumer spending, investment, government spending and net export, which is the net of total export and total import. The GDP is brought to the discussion on this article as it is one of the best indicator of the economic growth of a nation. The Keynesian critique was that, when a country is producing below its capacity, a debt-financed expansion in government spending would be a suitable way to boost output. Moreover, when the private sector hoards cash, the government could borrow that cash, spend it, and boost output to stimulate economic growth, which will in turn increase private sector revenue and profit, thus creating a higher tax revenue for the government. On the other hand, if a country falls into recession, which then will have lower C and I in the formula, the only way to bring the country out of recession is by increasing G, the government spending, which will naturally requires more borrowings that will eventually lead to budget deficits. It can therefore be seen in this illustration that budget deficit is important and necessary in difficult economic conditions.

There has always been a general misconception that borrowings are bad and one should not borrow unless absolute necessary. This misconception is especially strong in the Asian region, which is somewhat influenced by Confucianism teachings that was passed down from the earlier generations. There is nothing wrong with borrowing. It is how one uses the money borrowed that counts. If the borrowed money is used to invest wisely, the investment will generate a stream of future income and one can use part of that stream of income to repay the debt, while still have a good bit of money left over. Let’s put the same concept into the context of a government or country. A country has infinite lifespan, it can technically operate in deficit forever as long as annual deficit is equal or below the nominal GDP growth rate. Nominal growth rate is important when measuring debt while real GDP, which is inflation adjusted is relevant when measuring the standard of living. One should not be confused when using nominal GDP or real GDP in the analysis. For example, the US has a nominal GDP of $16.01 trillion last year, compared to $16.7 trillion nominal GDP this year, representing a nominal GDP growth rate of 4.3%. This is compared with latest budget deficit of 4.1%. From this, one can state that the US economy grew by 4.3% last year compared to the deficit of 4.1%, which is acceptable as the borrowed fund is put to good use for economic growth and the revenue generated from better economic condition will be able to repay the debt incurred last year. From this example, one can see that inflation works in the way of the debtors because it is the nominal dollar amount that needs to be repaid to the creditors. Also, it has shown that as long as the money borrowed is put into good use to generate growth and income, budget deficit does not really matter .

There has been on going arguments and concerns about budget deficit since the past decades, which some argued that the borrowings of today will burden the future generations when it comes to repaying the debt. The argument goes back to how the borrowed fund is used. Does the government put the borrowed funds into good use for national development that will eventually bring to a better standard of living? There is really no point keeping a surplus budget and national development is slowed down or ignored while the rest of the world are being developed to provide its citizen a better place to live. It is the responsibility of the current generation to make the world a better place to live for the future generations and this can only be achieved through continuous national developments. More efforts and energy should be put into making sure that the funds borrowed are used efficiently for development rather than bickering on the budget deficits topic over and over again.

- Written in December 2013.