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Introduction
In their bid to provide services to their citizens, Federal and State governments are often faced with the challenge of an imbalance between their expenditures and revenues, a state referred to as deficit spending. Deficit spending is, therefore, a state where a government’s level of expenditure exceeds its revenue collection level within a given fiscal period, which could contribute to the government’s increased debt balance. To salvage themselves from the adverse consequences of such imbalances, the government often sells government bonds to finance such deficits (Longrigg, 2017). Different economic scholars have advanced pros and cons to the situation in a bid to explain and interpret the situation in a manner useful for future budgetary processes.
Advantages of Deficit Spending
Deficit spending presents relatively measurable merits and demerits to an economy with both short-term and long-term effects. John Maynard Keynes argued that deficit spending could be a useful fiscal tool for governments in stimulating aggregate demand in their economies. According to Keynes, a decrease in consumer spending is restorable through a corresponding rise in government deficit spending (Javed, 2019). Resultantly, this increase in spending would ultimately lead to a restoration in the economy’s aggregate demand thus avoiding high levels of unemployment. Keynes argued that once optimal employment levels are reached, then the markets could self-adjust themselves, and the deficits repaid. In the unfortunate event that this move by the government leads to inflation, Keynes stated that raising taxes could help drain excess capital out of the economy.
Deficit spending could also be useful in saving an economy from adverse economic situations such as a recession. The four major global recessions after World War II were commonly characterized by massive declines in industrial and trade activities and a huge decline in nations’ annual per capita. The 1929 Great Depression, for example, saw President Franklin D. Roosevelt of the USA increase the Nation’s deficit spending by $3.1 billion each year to stabilize the Nation (Longrigg, 2017). However, this move ultimately worsened the situation as it did not help the USA out of the economic crisis. From the Roosevelt experience, it would be sustainable to opt for deficit spending to boost a recession-affected economy only if the targeted economy’s GDP growth is growing at a healthy 2-3% range. With this kind of range, the Federal government can restore a balanced budget. Additionally, caution ought to be taken on the debt-to-GDP ratio when opting for an increase in an increase in a nation’s debt to finance a deficit. A ratio that nears 100% should dissuade a Federal government from pursuing public debt increment as such debts risk being bad debts.
Disadvantages of Deficit Spending
However, many economists criticize Keynes’ concept citing flaws in his school of thought. Economist scholars hold on to the stand that the consequences of government deficit spending if not controlled or not checked could amount to slow economic growth. This is because a continuous increase in government expenditure against low revenue leads to increased government debt (Skousen, 2016). With an upsurge in public debt levels, Federal governments will be forced to raise taxes to finance the imbalance, which may lead to unsustainable inflation levels. However, Keynes counters this criticism using his famous ‘multiplier effect’ concept. His theory argues that for every $1 spent by the Federal government, the economy’s total output is projected to grow by more than $1. This concept has attracted divergent views that question its practicability and therefore not an idea to hold on to.
A continuous rise in deficit spending could also risk a nation’s sovereignty (Javed, 2019). Most financial lenders, more so nations and global financial institutions tend to propose unfavorable demands before approving loans. Such demands may include adjusting of the borrower’s financial spending policies to fit the lender’s needs. In other adverse events, borrowers could even end up selling or franchising some of their State assets to finance such debts. In such activities, a nation’s sovereignty is challenged. Additionally, if a nation is unable to settle its international loans, they tend to paint a negative national image which is likely to cause future finance to shy off from coming to such a nation’s help in times of financial crisis.
The Crowding-out Effect
With the federal government’s move to raise funds through increased taxation to finance its deficit, ‘the crowding out’ effect is unavoidable. In the context of deficit spending, this macroeconomic term refers to the situation where the government’s borrowing activities absorb all the existing lending abilities within the economy (Zhao, & Lu, 2019). This event automatically spikes the lending interest rates high, making it uneconomical for private investors to borrow money to expand their businesses. A reduced willingness by private investors to pursue expansion will create an economic downturn as tax revenues from the private sector will decline (Mahmoudzadeh, Sadeghi, & Sadeghi, 2017). A decline in tax revenues from the private sector, which is the major contributor to government revenue, will imply that Federal governments will even be forced to borrow more to fund their expenditures.
A fall in private sector investment will also inhibit the creation of more employment opportunities as some firms will even be forced to downsize their workforce to minimize their operational costs leading to a rise in unemployment levels in the economy (Mahmoudzadeh, Sadeghi, & Sadeghi, 2017). Finally, if not checked the ‘crowding out’ effect is likely to lead to inflation in the long term (Zhao, & Lu, 2019). As the raised tax rates force investors to remit more of their revenues to the Federal government, they are left with an immediate option of raising the prices of their commodities to compensate for the tax costs. As the government continuously increases its tax rates, commodity prices hike too which gradually spreads across the economy leading to inflation.
Conclusion: Deficit Spending hinders Economic Growth
In conclusion, from the challenges and risks surrounding deficit spending by governments, it is evident that this action attracts more demerits than merits which have a negative effect on economic growth. Increased government debts reduce both public and private sector investments (Zhao, & Lu, 2019). Since deficits are proof of the government’s inability to sustainably use its existing resources to generate revenue to finance its expenditures, the government’s ability to invest in public utilities among other infrastructure is likely to be slowed down due to insufficient funds. On the other hand, as the government raises taxes, more so on private investors, most of them are likely to shut down if the taxes are unfavorable as potential investors also get discouraged owing to the prevailing high taxes. Such actions by private investors will automatically slow down economic growth or at the extreme paralyze growth.
References
- Javed, S. A. (2019). Limitless Deficit Financing for Economic Prosperity: Where They Got the Keynes’s Deficit Spending Wrong? Journal of King Abdulaziz University: Islamic Economics, 32(1).
- Longrigg, S. (2017). The Great Depression. Routledge.
- Mahmoudzadeh, M., Sadeghi, S., & Sadeghi, S. (2017). Fiscal spending and crowding out effect: a comparison between developed and developing countries. Institutions and Economies, 31-40.
- Skousen, M. (2016). Move over Keynes: replacing Keynesianism with a better model. In What’s Wrong with Keynesian Economic Theory? Edward Elgar Publishing.
- Zhao, J., & Lu, J. (2019). The crowding‐out effect within government funding: Implications for within‐source diversification. Nonprofit Management and Leadership, 29(4), 611-622.
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