What Problems does a Budget Deficit cause for Government Financing? To see more of our products visit our website at Ruth Tarrant

A budget deficit exists when government spending exceeds the tax revenue. Budget deficits are normal in times of recession as the revenue earned from taxation falls and the level of government spending on benefits rises. Deficits can also occur in times of boom as governments increase capital and current spending to meet political or longer-term economic goals. Prudent governments usually aim to balance the books over the course of the economic cycle.

This compares with the record peacetime deficit in 2009/10 of £155bn. This can be contrasted with only £30bn borrowing in 2006/07, although as we were experiencing economic growth at the time, many economists would argue that it was higher than it should have been. The overall deficit for the financial year 2010/11 is forecast to be £149bn.

When government spends more that is earned through tax revenue then the shortfall has to be borrowed. The amount the government owes reached £927.4bn at the end of July It means that out of every household’s tax payments, £1,891 goes to paying the interest which has accrued on government debts. This is equivalent to £32,500 for every person in employment in the UK.

Governments are similar to households. If a household spends more than it earns, it must borrow money, possibly using credit cards or a bank loan. If household debts become too high household members may have to declare themselves bankrupt. This process is similar for countries. Governments will borrow by issuing government bonds. These are IOU’s whereby the government promises to pay back to the lender the full sum borrowed at a later date, and in the meantime will pay the lender interest. This yearly interest is known as a ‘yield’.

There is a relationship between risk and return. The more trust investors have in the government to repay the loan, the lower the rate of interest they will accept. This level of trust is reflected in the ‘ratings score’ given by the main ratings agencies such as Standard & Poor’s. Debt that is awarded AAA status is considered ‘prime debt’ and thus very safe for an investor. Debt graded BBB or BBB- is considered relatively safe but susceptible to adverse economic circumstances. Debt graded BB down to D is considered ‘junk debt’ and only good for speculation.

Continued budget deficits and rising national debts can lead to debt being ‘downgraded’ as happened to Greece and Spain in Debt that becomes more risky will require investors to be rewarded with higher interest rates or yields. This makes future government borrowing even more expensive and may force governments to radically cut the amount they spend above tax revenue.

Capital flight: Those who invest in a country, either through the stock market or through Foreign Direct Investment, may be unwilling to put their funds into a country which has severe debt problems. At the very least this will reduce tax revenue and put further pressure on government financing. Over austerity: This is where countries like the UK, introduce radical budgets to cut government spending. Some argue that this will cause a fall in aggregate demand and could be recessionary. Other see an austerity budget as a necessary ‘signal’ to investors that the government is acting decisively.

Prudent governments in developed countries should not experience significant problems when running a budget deficit in times of recession. But, if the deficit becomes very large and prolonged investors may become worried about lending money to the government. Unless governments can dispel these fears the cost of financing the debt can become unmanageably large. This would slow down the economy and reduce living standards.

The UK’s budget deficit for 2010/11 is forecast to be around £149b, and the national debt just under £1,000bn. Budget deficits are finances through borrowing from the bonds market by issuing government bonds. If purchasers of these bonds become less confident about the value of the bond they hold, interest rates on the bond will rise, causing total government debt to rise further. Budget deficits can also be financed through higher taxes, which are politically unpopular and difficult to introduce in times of slow economic growth.

What are the main causes of the high budget deficit and national debt? Investigate some of the various types of government bond and explain the differences between them. One controversial way of reducing the value of national debt is to allow inflation. Explain how inflation could reduce the value of the debt, and comment on whether you think it is a good idea. To what extent do you think a downgrade in credit rating would affect an economy such as the UK? What are the possible macroeconomic effects of the UK government’s austerity budget?