Does deficit spending by the federal government have more good or ill effects?

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I took an undergrad macro economics class at Drake University a few years back and I had a hard time understanding the professor on several issues. (I want to say that I'm not politically motivated here, or trying to make a political point). One issue was regarding national debt and deficit spending. In class we discussed how historically the USA general public and government hadn't looked favorably on holding debt until the 1930's. During this time through borrowing and spending on domestic projects the federal government helped pull the nation out of the grips of the depression. Since then it's been an accepted part of life that deficit spending by the federal government has more good than ill effects. Sometimes I think this works, but too often it's just assumed it works and we've worked ourselves into a massive financial hole by this unchallenged assumption. The rational he used was the debt was being bought by citizens and thus the interest on this debt was owed to ourselves, and when the gov repaid the debt and interest there was a gain somewhere in the US economy for purchase or investment in something else. I could buy this point of view if the Treasury sales were restricted to US citizens, but the fact is there are many international purchasers of our debt so we are actually paying out interest to England, Canada, Japan, China, etc. So the beneficiaries are not ourselves, but foreigners. I'm not sure if the professor was getting his point of view from a textbook or his own judgement, but I'm curious why these viewpoints are not scrutinized more in academia. Any insight would be helpful, thanks!


Your understanding is correct that government debt allows governments to handle economic recessions better. When the private sector employment and therefore consumption demand is shrinking, the government can increase its public sector spending (by borrowing) which not only increases public sector employment but also provides for safety net to unemployed (benefits) and helps sustain aggregate demand in the economy. In general, government debt serves as a useful tool for conducting both monetary and fiscal policy. By allowing federal, state, and municipal governments to borrow, it lets these entities build infrastructure and create human and knowledge capital that can serve future generations. As it may not be possible for the government to fund these projects from current tax revenues, it is justified to borrow from the current generation and then pay them back by taxing future generations who are most likely to benefit from these long run projects. However, for smoothing business cycles, the underlying policy principle is that ‘spend in bad times and save in good times’, which would require that the government run surpluses when the economy is doing well. Unfortunately, in the last forty years, the US government has run (relatively small) surpluses only during 1998 – 2001. In the rest, it has run deficits. As a result, the current US debt to GDP stands slightly above 100%, which in the developing world is considered high – only few countries, e.g., Japan and Italy have a higher government debt to GDP ratio. The key issue right now is whether the present level of debt and ongoing deficits are sustainable. There is a general agreement that current benefits under Medicare and Social security programs cannot be funded from current revenue streams and as more and more baby boomers retire, these programs will eventually be bankrupt. Either benefits under these programs need to be reduced (which people on the right argue), or tax revenues need to be increased (which people on the left suggest) in order to meet future benefit obligations. Otherwise, the government will continue running deficits, and its debt will continue to grow, and in the end servicing and repaying this debt will itself become impossible – that is, the debt will become unsustainable. About a third of US debt is held by foreigners (and largest chunks by China and Japan). US treasuries are the safest assets (despite S&P downgrading it to AA+ last years), and all foreign central banks want to hold it as reserves that provides with them with a critical cushion in times of their financial and currency crisis. The dollar happens to be the most desirable currency because of its stability. This can be a boon but also a curse: due to worldwide demand for US treasuries, the interest rate is low. As treasury interest rates work as benchmark interest rates for most of the other US financial products (including mortgages), a low interest rate (relative to fundamental) may encourage over borrowing – this is one of the reasons for extremely low US savings rates before the subprime crisis. Indeed, due to dollar assets being the safest assets, foreigners have paid much less interest on their US asset holdings than they could have earned by holding other securities (euro assets for example).

Answered by:
Dr. Rajesh Singh