Budget deficits carry both costs and benefits for the economy. Any assessment of their desirability must weigh these costs and benefits carefully.

1. Lower unemployment. Allowing budget deficits permits Keynesian fiscal policy (as described in chapter 4) to keep the economy closer to full employment than might otherwise be the case. Movements into recession are automatically dampened if recession-induced decreases in tax revenues and increases in unemployment insurance payments are permitted to create a deficit. Output lost as a result of unemployment above its natural rate can be substantial and is output lost forever. Furthermore, the human cost of unemployment is considerable by any measure.

2. Public investment. Allowing budget deficits permits the government to borrow to invest in projects that have a high social payoff, such as education or infrastructure. This borrowing is similar to a private corporation borrowing to invest in a project whose payoff is expected to be high enough to pay back the loan with interest.

3. Lower national saving. A deficit requires that the government bid up the interest rate to obtain financing for its deficit, crowding out private financing needs, prominent among which are private investment projects. This crowding out inhibits long-run growth directly by constraining growth in the capital stock, and indirectly by lowering productivity growth. (Chapter 6 discussed how budget deficits reduce national saving.)

4. International implications. Higher interest rates attract foreign investors. To buy our bonds foreigners must first obtain our dollars. This increase in the demand for our dollar increases its value, making our exports expensive to foreigners and their goods cheap to us, as well as making life difficult for exporters and those competing against importers. Furthermore, the associated buildup of foreign ownership of our assets implies that more future income must be sent abroad in the form of interest and dividends. (The international dimension of the budget deficit issue is discussed further in chapter 15.)

5. Debt monetization. Budget deficits create a danger that government will choose to finance them by monetizing them—by printing money—and thereby create inflation. This danger is not high in countries such as the United States that have a central bank quite independent of politicians.

6. Growing national debt. Continued budget deficits increase the national debt. A growing national debt has several important implications:

a. A growing national debt means growing interest payments on that national debt. Over time, the interest payments may become a sufficiently large fraction of the government’s financing needs that they render fiscal policy inflexible. Fiscal policy to attack unemployment, for example, may not be undertaken because financing is not available.

b. A growing national debt inevitably means that tax rates rise as much as politicians dare, to facilitate handling the high interest payments. Tax increases create disincentive effects, as emphasized by the supply-siders.

c. A growing national debt means that we may be placing a burden on future generations who will inherit that debt. Many view this practice as morally wrong. (See section 14.3 for discussion of this issue.)

d. A national debt could grow to the point where it will become too large for the country to service, causing a major crisis in the economy, such as that experienced by New Zealand in the 1980s. One way of measuring whether an economy is headed in this direction is to calculate the structural deficit.