Why Deficit Spending During Recessions is Good

Why do most economists believe that governments should run deficits during recession? Isn’t borrowing money bad?

There’s some truth to the idea that borrowing money is often a bad idea for individuals and families. But we all know there are exceptions. For one, when there’s an emergency, you might not have any choice. And, contrary to popular analogies, government finances are very different from those of families.

Government revenues (aka “taxes”) are closely related to families’ and companies’ incomes, but that’s about where the similarity ends. When people lose their jobs in a recession, governments collect less in taxes. When corporate profits decrease, governments collect less in taxes. And we’re talking about governments at all levels here, from local to state to federal.

So what do governments do when they’re receiving less revenue? Local and state governments essentially have to run balanced budgets by law, so they cut spending. And this hurts the economy even more, causing more unemployment, and leading to even less tax revenue. What’s worse, the effects of decreased government spending get multiplied as the reduced money flows around the macroeconomy.

To be fair, there are natural forces that do eventually help economies recover. Real wages may fall to the point where companies finally start hiring again, for example. Eventually economies do tend to right themselves. The key word here is “eventually”. Unfortunately, it can take a country’s economy a decade or more to “fix itself”. Look at the Great Depression, or Japan’s Lost Decade.

To help the economy recover faster, we need to make up for the decreased investment spending by firms and decreased consumer spending. For better or for worse, the only entity in a position to do that is the federal government, since unlike state and local governments it is able to borrow money fairly easily.

As a result, the best minds in economics say that running a federal deficit during recessions is a good idea. Doing so will help to pull the economy out of the recession faster, and will reduce its severity.

There are some caveats, though.

Most importantly, governments should not be running deficits during expansions. If anything, the federal government should be running surpluses during expansions in order to pay down the public debt. This helps to clean up the government balance sheets in preparation for the next recession. Unfortunately, U.S. governments have shown an inability to do this. With the exception of the late 1990s, when politicians have seen surpluses, they’ve seen the opportunity to buy votes with tax cuts. This sounds good to many voters, but it’s bad news for the economy.

Second, borrowing money even for good reasons has implications. For one, you have to pay interest on it, and that costs money down the road. This is another good reason to pay down the debt during expansions.

Third, someone has to be willing to lend you the money. So far, the interest rates that the U.S. has to pay for the money it is borrowing are still low, partly because most other countries are even worse shape than the U.S. But as public debt as a percentage of GDP continues to increase, the interest rates the U.S. government will have to pay are bound to eventually start to increase, and that can cause serious problems. See Greece, Spain, and Italy for more of that. At the end of the day, no government can continue to borrow more and more money at an increasing rate indefinitely.

So the bottom line is that deficit spending during recessions is a necessary evil. Economists don’t like governments having to borrow money, but in downturns, it’s for a good cause. But there’s always a trade-off, and there are limits to how much any government can and should borrow. Eventually we’re going to hit those, and at that point we’ll have run out of options.


One response to “Why Deficit Spending During Recessions is Good

  1. Pingback: A Quick and Easy Debt and Deficit Primer | Economics on the Brain

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