Home > Fiscal Policy > Are Deficits “Good” or “Bad”?

Are Deficits “Good” or “Bad”?

I should probably steer clear of this well-trodden path, but it’s hard to resist.  The fiscal deficit dominates UK politics and economics.  Yet I find the economics becomes murkier as time passes.

I can understand a world in which monetary policy determines the size of the sun the level of nominal GDP.  I can understand a world in which fiscal policy affects lots of things, including the velocity of money.  I struggle to understand a world in which fiscal policy determines the level of nominal GDP.   And nominal GDP is what we really care about in terms of demand management.  Everybody is signed up to that, right?  But let’s pretend we can ignore monetary policy for the moment.

The defining narrative of our times was that the Coalition government is cutting the deficit “too far, too fast”.  The implication is that running deficits is “good”, and contributes positively to aggregate demand (NGDP).  Running smaller deficits will “hurt growth”.  We can interpret those claims in terms of the effect on the level, or growth rate, of nominal GDP.

(Economists do themselves no favours by talking exclusively about real not nominal aggregates when discussing demand management.  It’s a shoddy trick, because supply-side changes get mixed in with demand-side changes.)

But this is the Guardian in November 2011:

Britain will borrow a “staggering” £158bn more than the government planned a year ago, Ed Balls claimed on Tuesday as he accused George Osborne of presiding over a “truly colossal failure” in his economic plans.

And here the narrative shifts, or at least becomes murky.  Can it still be that deficits are “good” per se? Ed Balls thinks that running large(r) deficits is a sign of failure!

Duncan Weldon is dubious about Nick Clegg’s claim that UK and US fiscal policy have been similar.  He quotes Adam Posen’s paper comparing the two, which said that:

For almost the entire period since March 2007, and particularly since March 2010, the US has run a looser overall fiscal stance – a more stimulative fiscal policy – than the UK, even taking the full operation of the larger automatic stabilizers in the UK into account.  Cumulatively, since 2007Q1, the difference has amounted to 3% of GDP.

This is from a paragraph talking about deficits, measured as a percentage of GDPSo here is more support for use of the deficit (% of GDP) as a “measure” of how fiscal stance affects aggregate demand.

Even if the deficit did tell us the “correct” measure of the fiscal stance… which deficit?  The ONS inconveniently give us two for the UK: one including the effects of financial interventions, one which doesn’t.  Similarly, US deficits are “flattered” (reduced) by the regular return of coupons paid on Treasury bonds held by the Federal Reserve – a reasonably chunky number due to the large purchase of bonds under QE.  The Bank of England is not doing the same.  (Simon Ward has suggested the BoE return the accumulated profits from QE to HM Treasury as a one-off improvement to the deficit.  I wonder if this idea might be revisited this year in light of gloomy projections for the fiscal position?)

Then we can head over to Brad DeLong on “self-financing fiscal expansion“, or Simon Wren-Lewis for a discussion of the “Balanced Budget Multiplier”.  The latter is the idea that an increase in fiscal spending and taxation by £x will increase aggregate demand by £m*x but hold the deficit fixed.  If the deficit is held constant in nominal terms, but nominal GDP is rising, that means the deficit is falling as a percentage of GDP.  So… we can have “fiscal stimulus” and “falling deficits”?  Now I’m really confused.

Should we instead talk about the level of fiscal spending as the measure of the fiscal stance?   OK, but then Mr Posen’s comparison of deficits is totally meaningless.  And we need a more nuanced take on the fiscal policy of “Slasher Osborne”, who has always planned to increase the level of total fiscal spending (Total Managed Expenditure rising from £696.8bn in 2010-11 to £757.5bn 2015-16, in the June 2010 Budget).  That’s a slightly slower rate of increase than planned under Labour, but it’s still an increase.  Yes, we could add in the multiplier fairy, and say that increases in current spending will not offset cuts to capital spending.  But it all requires some pretty heroic assumptions.

And if Osborne is increasing spending, and increasing taxes (in 2011 at least), how exactly does that differ from a “self-financing fiscal expansion”?

I’m left more confused than enlighted by the whole debate.

Categories: Fiscal Policy
  1. Duncan Weldon
    September 27, 2012 at 10:08

    I think my own views are pretty much in line with this Romer piece:


    • September 27, 2012 at 12:11

      Hi Duncan. I’m not sure how that gets us any further. Romer talks about “cutting spending” as an example of “austerity”, but TME really is rising. She also uses the “cyclically adjusted budget balance” as a measure of austerity, but that’s to a large extent an accounting trick. A supply-side change in the estimate of potential output will change the structural/cyclical split; could that possibly affect the level of nominal spending?

  2. September 27, 2012 at 11:36

    Very good post.I agree. I think the deficit can push up when it is an aid to prívate sector delevaraging. Government take private debts financing it through Central Bank, which buy Treasuries.
    In any case, the deficit must be monetizased. So, the fiscal deficit Is an inforcement of monetary policy.

    • September 27, 2012 at 13:07

      If fiscal policy does not “work” without monetary policy, even at the ZLB, then you need a theory of monetary policy that excludes monetary policy being “impotent” at zero rates. If you have a theory of monetary policy which still works at the ZLB, you don’t “need” fiscal policy at all.

      • September 27, 2012 at 13:08

        … for demand management, that is!

  3. Duncan Weldon
    September 27, 2012 at 13:21


    I define ‘Austerity’ as Romer does, as discretionary change in policy. It is perfectly possible to austerity alongside rising TME.

    I’m equally suspicious of any talk of cyclically adjusted budget positions (and as an aide think the structural deficit is a very silly policy target).

    • September 27, 2012 at 13:45

      Hmmm. That seems to elevate the role of the baseline. Consider a counter-factual:

      A Darling March 2010 Budget sets fiscal policy with TME rising 10% every year to 2015, deficit soaring to the moon, whatever.

      Now, Osborne comes along and says “woah, austerity”, and reverts to the plan we *actually* saw from Darling, moderate rises in TME.

      I can totally appreciate from a political perspective that putting TME on a lower path than was previously expected is “austere”. But from an economic perspective? Having spending rise 5% is “contractionary” for GDP – merely because there exists a budget in the mind of a previous chancellor which had spending rising at 10%? This seems unconvincing.

      Reductio ad absurdum: doubling fiscal spending is “austere” if your predecessor planned to triple it.

      Do we need a role for expectations in fiscal policy too? (I think somebody has done a blog post on that)

  4. October 3, 2012 at 14:39

    Late coming to this one, but in terms of your opening, about monetary policy shaping NGDP and fiscal policy only really impacting through the velocity of circulation, then the question you pose about the role of fiscal policy depends on the monetary policymaker’s response function, surely? To simplify massively, in quantity theory terms, if V is otherwise stable and M is set on a 5% growth path and no changes are made to it, then fiscal policy’s influence on V will directly impact on PY. Result: growth! In real life, the BoJ then tightens policy, who knows about the BoE.

    Anyway, that assumes the fiscal policy change is purely to aggregate demand, but it often has real effects along the way. Back when the Obama administration was putting together its stimulus package in 2009, Kevin Murphy offered a quick model by which to evaluate the proposal (link below), which points out that its efficacy will depend on government’s efficiency, its ability to reach underemployed resources, and the deadweight cost of raising the revenue. Works better for me than guessing at multipliers, balanced-budget or otherwise:


    Re your discussion in the comments: I’m with you, ‘austerity’ is a word used so loosely as to be meaningless. To say only that it’s “discretion changes in policy” means disaggregating the effect from automatic stabilisers – which brings us back to the jiggery-pokery of calculating structural budget balances. I also agree that it’s stretching language to argue that reduction in prospective spending growth is ‘austerity’, although I agree fiscal policy expectations do matter – you know, like people seeing a deficit and preparing for increased taxes…

    • October 3, 2012 at 16:05

      Hi Duncan.

      “depends on the monetary policymaker’s response function”

      I agree with that 100%. I suppose I am trying with this post to consider the fiscalist/Kenyesian position that fiscal policy can directly affect AD (at the ZLB at least), ignoring all the awkward caveats about “holding monetary policy constant” etc.

      “In real life, the BoJ then tightens” made me laugh. :)

      If we all agree with “monetary policy always and everywhere controls NGDP” then it seems reasonable to say that fiscal policy is mostly about “real” effects, or distortions, yes.

      Your point about expectations and Ricardian Equivalence is extremely well made! I didn’t make that logical leap, but it’s very good one.

  5. October 3, 2012 at 16:43

    I guess, in these terms, the Keynesian position is that, if you assume that at the ZLB there is a broken monetary transmission mechanisms, then increases in M simply contribute to a sharper decline in V (i.e. money just accumulates through some liquidity trap mechanism), and therefore fiscal policy is needed to get the cash moving, by directly spending it.

    The problem with this is that, stutteringly, increased M through QE does seem to have driven increased PY – albeit that when nominal spending did increase in 2010-11, it turned out to be more P than Y. That being the case, albeit a little sluggishly, people clearly are spending the money; it’s just that the supply-side isn’t able to respond with proportionately more goods and services. In terms of the ZLB, inflation lowers the real interest rate; problem solved.

    The other way of looking at it, I gather, is the flow-of-funds one; with households and corporates deleveraging and saving, the government needs to supply sufficient low-risk assets to meet their demand, especially because of the increased price of risk means they don’t want to put their money elsewhere. To which, Japan: how much cash do you have to borrow and spend before the private sector is supposed to get started? What’s the exit strategy? So I’d therefore prefer to try government balance-sheet operations together with committing to sustained increase in nominal spending.

    (Not that I’m against higher borrowing for sound infrastructure projects, rigorously evaluated for their returns. But that probably doesn’t mean building whole new school buildings when existing ones can be repaired, or a huge new trainline that’ll take decades to actually start work. Give me a few motorways, the odd electrification and a new runway instead!)

    • October 3, 2012 at 21:23

      I think the supply-side pessimism is overblown; I’ve done a few posts on that. VAT rises plus commodity price blowouts mostly explain the poor nominal/real split in 2010/11, and more recently poor nominal growth is mostly a sufficient.

      Looking at flow-of-funds tells us nothing about causation. Household consumption spending has been one of the more robust growth sectors in the GDP data, so I think the deleveraging “story” is also overblown.

      I agree about infrastructure. And I think the government is a real constraint on private sector capital projects like new runways, housebuilding, etc. I see epic failures in the planning system very frequently.

  6. October 3, 2012 at 23:51

    Not so sure on supply. I think the relatively high employment level (participation rates are back where they were in 1997), the current account deficit, and the fact that even this year’s anaemic NGDP growth is completely overwhelmed by inflation all add up to signs that we’re in trouble. My guess is that this is a combination of (1) lower trend growth than we’d thought; (2) supply shocks, through commodities, but also in risk preferences, and especially in financial services; and unfortunately some degree of (3) hysteresis. When it comes to output gap – a fairly slippery concept at best – I think, in a service-dominated economy, risk preferences can mean a big falling back of how far people are prepared to stretch (if you work in services, you soon realise that capacity is to some extent a matter of willingness and perception of opportunity; if you think there’s a long-term gain, you’ll work the extra hours).

    Agreed on role of government as a capacity constraint – although this plays back to the supply-side too. When people talk about developers sitting on a “bank” of housing-approved land, they neglect the dynamics of a scarce market: if you think the current stock of approved land is going to be all that’s available into the future, you’ll sit on it until prices go up.

  7. October 3, 2012 at 23:52

    By current account deficit, I mean the size of it, not its existence per se.

  1. October 10, 2012 at 10:30
  2. October 22, 2012 at 20:12

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