Three Budget Philosophies

Economists have varying opinions about how a government budget should be managed. The three most common budget philosophies are

1. The Annually Balanced Budget.

A government annually balances its budget when, within one fiscal year, expenditures equal revenues. Most states, counties, and municipalities in the United States are required by law to balance their budgets. The United States federal government is not required to balance its budget. Attempts have been made to pass a constitutional amendment to balance the federal government’s budget. These attempts have failed primarily because of the Keynesian belief that the federal government needs to incur deficits in order to stimulate the economy during economic recessions.

Classical economists believe that governments should balance their budgets each year. Some economists would even like to go beyond merely balancing our budget. They propose that governments should incur surpluses and set aside funds “for a rainy day” during healthy economic times. If the economy experiences a downturn, the surplus money should be used to finance essential government programs, without having to raise taxes and without causing the disadvantages of deficits mentioned at the bottom of this section.

2. The Cyclically Balanced Budget.

A government cyclically balances its budget when, within the course of one business cycle, expenditures equal revenues. A business cycle consists of one expansion followed by a recession. Keynes proposed that the government should increase its expenditures and decrease its taxes during recessions in order to create jobs and provide people with more expendable money. Conversely, he recommended that a government should incur a surplus during economic expansions.

Critics of the cyclically balanced budget theory claim that politicians rarely manage to incur surpluses because it requires decreasing government spending or increasing taxes. In particular, politicians are reluctant to decrease spending, because taking away funds from programs and departments is not a popular thing to do.

3. Functional Finance.

Proponents of this theory believe that government budget deficits and national debts do not harm the economy. Full employment is the main objective, and if it is achieved, a national debt is a worthwhile sacrifice. Judging from the national debt data in Section 3, this appears to be the approach taken by administrations of industrialized countries. In the United States, federal budget surpluses have occurred only an average of one in twenty years during the past six decades.

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Disadvantages of Debts and Deficits

While running deficits and incurring debts may have a stimulating effect on the economy in the short term, it has the following disadvantages in the long term:

1. Deficits cause higher real interest rates.
When the government incurs a deficit, it borrows money from the private sector. A decrease in private sector fund availability leads to fewer private sector investments and leads to higher interest rates as compared to a situation in which the government doesn’t incur deficits.

2. Deficits, if financed by increases in the money supply, lead to higher inflation.
The Federal Reserve System, through Open Market Operations (see Unit 9) purchases bonds from the public with newly printed money. The public purchases these bonds from the United States Treasury. Indirectly, therefore, the Federal Reserve System finances the national debt. Putting newly printed money into circulation with the public is inflationary.

3. Deficits usually lead to higher taxes and/or lower government spending in the future.
Unless government spending decreases (which has proven to be a challenging task for any government), taxes will need to increase if in the future an attempt is made to pay down the national debt. Even if the national debt is never paid off, the increasing interest payments on the national debt cause government spending and taxes to be higher as compared to a situation with little or no national debt.

4. A large national debt can lead to a country’s bankruptcy.
If a country’s national debt rises to a point where it can no longer pay it creditors, the country will default on its bonds. This means that the country’s bondholders will not get paid, or they will get paid only a fraction of the original value of the bonds. In addition, this country can no longer borrow money and is forced to implement austerity measures (lower government and/or raise taxes considerably). This is what happened to Greece after the 2008 recession. It caused its economy and its people significant economic hardship for many years.