Too embarrassed to ask: what is a deficit?

When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter? 

When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter? 

Traditionally, when a government needs money, it can get it in two ways: it can raise the money through taxation, or it can borrow the money in financial markets, by issuing government bonds. If a government spends more money in a given year than it raises through tax revenues, that means it is running a deficit. In other words, the deficit is the government’s annual overspend.

The “national debt”, on the other hand, is the total overspend. So when a government runs a deficit, it’s adding to the national debt. When it runs a surplus (that is, it raises more in taxes than it spends), it’s reducing the national debt. 

Both the deficit and the national debt are often expressed as percentages of GDP. Generally speaking, borrowing money is seen as more sustainable when the deficit is low as a percentage of GDP. For example, European Union countries are technically supposed to keep deficits to below 3% of GDP, although in practice this doesn’t always happen. 

In theory, the main risk of a country running too big a deficit for too long, is that markets will start charging more for the country to borrow. In extreme cases, investors might shun the currency too, causing it to crash in value. In practice, many countries have been running large deficits since the 2008 financial crisis, and yet borrowing costs have mostly fallen since then. That has led to a situation where, increasingly, some economists are questioning whether deficits matter at all.

Proponents of Modern Monetary Theory (MMT for short) argue that as long as a country controls its own currency – which for example, the UK and the US do, but Italy doesn’t – then the government can never run out of money. It need not tax or borrow, it can simply print what it needs. As a result, governments can spend what they want, for as long as inflation remains under control. 

MMT might sound outlandish. But given the sheer scale of government borrowing amid the coronavirus crisis, it’s a theory we might well see tested to destruction within the next few years. 

For more on the public finances, MMT, and the effect on your investments, subscribe to MoneyWeek magazine.

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