Friday, March 30, 2007

Should government worry about a budget deficit.

The US is currently running a budget deficit of $650 bn. Such a deficit seems hard to comprehend; it is greater than the combined GDP of several sub Saharan African economies.

1. It is important not to get confused with the current account (balance of payments) deficit. The current account deals with a deficit in terms of trade. Spending being greater than taxation causes a government deficit.

2. It is important to look at the deficit in terms of a % of GDP. For example the US budget deficit represents 3% of GDP. The national debt (total cumulative debt equals 63%) This is a lot but less than countries like Greece where national debt = 107% of GDP.

3. Most of the US national debt is not owned by foreigners but domestic finance bodies.

Problems of Budget deficits.

1. Increase national debt and annual debt interest payments. These represent taxation revenues spent on servicing debt. There is an opportunity cost; for example these debt interest payments could have been used on financing health care.

2. May require higher taxes and/or lower spending in the future.

3. Put upward pressure on interest rates. A large deficit means the government needs to borrow more. As this debt grows they may need to raise interest rates in order to encourage enough people to buy the debt. Higher interest rates cause lower growth and may crowd out private sector investment. This is known as financial crowding out.

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