Yet deficit financing of government activity is not a sustainable alternative to increasing revenue or cutting public spending. It is only a means of deferring payment. Just as a household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, neither can a government. There is no permanent option of public spending without raising commensurate revenue.
In normal times, there is no advantage to running large deficits. Public borrowing does not reduce ultimate tax burdens. It tends to crowd out borrowing by the private sector, which could otherwise finance growth, and fosters international borrowing, which means an excess of imports over exports. The private sector may also be discouraged from spending if businesses fear tax increases to pay for the deficit. In normal times, it is the job of the Federal Reserve to increase demand in the economy by adjusting base interest rates, rather than the job of those in charge of deficit financing.
It was essentially this logic that drove the measures — usually bipartisan — taken in the late 1980s and the 1990s to balance the budget. As a consequence of policy steps in 1990, 1993 and 1997, it was possible by 2000 for the Treasury to retire federal debt. Deficit reduction and the associated reduction in capital costs and increase in investment were important contributors to the nation’s strong economic performance during the 1990s, when productivity growth soared and unemployment fell below 4 percent. We enjoyed a virtuous circle in which reduced deficits led to lower capital costs and increased confidence, which led to more rapid growth, which further reduced deficits.
In recent years, of course, circumstances have been anything but normal. High unemployment, few job vacancies and deflationary pressures all indicate that output is not constrained by what the economy is capable of producing but by the level of demand. With base interest rates at or close to zero, the efficacy of monetary policy has been circumscribed.
Under such circumstances, there is every reason to expect that changes in deficit policies will have direct effects on employment and output in ways that are not normally the case. Borrowing to support government or private-sector spending raises demand, increasing output and employment above levels they otherwise would have reached. But these gains will not be offset by reduced private spending because, unlike in normal times, there is substantial excess capacity in the economy. These “multiplier effects” operate far more strongly during economic downturns sparked by financial crises.