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?
What is a budget deficit?
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 (known as gilts in the UK).
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.
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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.
The latest figures from the Office of Budget Responsibility (OBR) suggest that the UK budget deficit is going to hit 7.1% of GDP in the 2022/23 tax year, the seventh year of the past 15 where the budget deficit has been above 7% of GDP.
Why does a large deficit matter?
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.
And that’s just what happened earlier this year when Lizz Truss and Kwasi Kwarteng unveiled their economic plan for the country.
They hoped to stimulate growth by slashing taxes and ramping up infrastructure spending, but the markets didn’t like the sound of the unfunded tax cuts. The resulting chaos nearly lead to the collapse of the UK’s financial system (the Bank of England had to step into stabilise markets) and ultimately cost Truss and Kwarteng their jobs.
Still, 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 have been questioning whether deficits matter at all.
Can the government just print more money?
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.
As interest rates (and inflation) have jumped over the past year, MMT is being tested to destruction, and as we’ve seen in the UK, while governments might want to keep spending, it’s not clear if the markets will let them.
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