How Federal Budget Deficits Work

I will begin today’s discussion by stating what a federal budget deficit is not. A deficit is not:

When US Government spending is greater than its income from federal taxes. 

Now, why is this wrong? The word “income” is what makes it wrong. There is no such thing as an “income” for a sovereign currency issuer like the US Government. Therefore, the textbook definition of a federal budget deficit is wrong, even though it seems to be correct. The above definition leads to all kinds of misunderstandings and nonsense concerning federal spending which, frankly, every last one of us can do without. 

As we’ve discussed many times before, the US Government’s budget is nothing like a household budget. The reason for this is simple: A household does not have the authority to issue US dollars. A household, therefore, needs an income. It must find a way to earn US dollars. Conversely, a national government that issues currency, like the US Government, does not require an income, because it creates US dollars at will when it wishes to spend to buy guns, planes, paper, desks, ink, and other goods and services. So, let us remove the word “income” as it is highly misleading. Correctly defined, a federal budget deficit is:

When the US Government’s spending is greater than that which it taxes. 

We can express this mathematically as (G > T) or (G – T > 0) where Government Spending (G) minus Taxes (T) is greater than zero. While the US Government is the centerpiece in a modern monetary economy, there are three total sectors to the US economy which we must consider and each can be mathematically expressed as the Sectoral Balances Equation.

The Three Economic Sectors

The three sectors comprising the US economy are: Government, Domestic Private and External. Expressed mathematically:

(G - T) is the government sector.
(S - I) is the domestic private sector.
(X - M) is the external sector.

The domestic private and external sectors comprise the “non-government” sector, because they exist outside of government. We can distinguish between the government and non-government sectors in a form of the sectoral balances equation like so: 

(G - T) = (S - I) - (X - M)

Or in layman’s terms:

(The US Dollar Issuer) = (US Dollar Users)

In this form of the sectoral balances equation, on the left side we see the US Government at the head and whatever it spends goes into the non-government sector on the right and whatever it taxes is removed from the non-government sector. Understanding this, let’s look at the function of federal deficits.

The Function of Deficits

In macroeconomic terms, the purpose of a federal budget deficit is to inject net financial assets into the non-government sector. In layman’s terms, the purpose of a deficit is to add more US dollars to the economy. The reverse of this process is called a federal budget surplus. Applying the sectoral balances equation, we will uncover the reality behind federal deficits.

We will assume that the US Government spends $2 trillion and taxes $1 trillion. So then, 

(G – T) = $2 trillion - $1 trillion = $1 trillion

Now then, whatever the US Government spends, the total amount of US dollars spent can be divided up between the private domestic and external sector in many ways. It doesn’t necessarily have to be equal. For instance, if the US Government spent $2,000, the domestic private sector received $1,000 and the external sector received $1,000. Each sector can receive different amounts. What matters here is that the total amount spent by the US Government will be found in the other two sectors. 

So, if:

(G – T) = (S – I) – (X – M)

($2 trillion - $1 trillion) = ($1 trillion) 

then we understand that a $1 trillion federal budget deficit equals, to the penny, a $1 trillion surplus for the non-government sector.

(Federal Deficit) = (Non-Government Sector Surplus)

What we can now see clearly, is that a federal budget deficit cannot and does not create a deficit for you and I. Such a condition is impossible. To create a private, non-government deficit, the US Government needs to run a federal budget surplus and to do that, the US Government must tax away more than it spends.

We will assume that the US Government spends $1 trillion and taxes $2 trillion. So then, 

(G – T) = $1 trillion - $2 trillion = - $1 trillion

So, if:

(G – T) = (S – I) – (X – M)

($1 trillion - $2 trillion) = (- $1 trillion) 

then we understand that a $1 trillion federal budget surplus equals, to the penny, a $1 trillion deficit for the non-government sector.

(Federal Surplus) = (Non-Government Sector Deficit)

A federal budget deficit adds US dollars to the US economy and a federal budget surplus extracts US dollars from the US economy. Let us now turn to deficit spending and understand how deficits work.

Deficit Spending

Rather than the US Treasury managing spending, taxation and the banking system, another government agency called The Federal Reserve, or quite simply, the Central Bank of the United States was created to handle the banking system. The Federal Reserve is not a private bank. It is a government agency. Depository institutions (private banks) are attached to the Federal Reserve system via membership. Stock is held, which is very different than corporate stock and cannot be transferred, sold or used as collateral. This “stock” denotes “membership” in the Federal Reserve System, not “ownership”. 

Commercial banks attach themselves to the government agency, The Federal Reserve, which then allows them to hold reserve accounts. These reserve accounts contain US dollars which always remain at the Federal Reserve and ensure that the payments system will function properly. For instance, if you have an account at Chase and wrote a check for $500 to someone who has an account at Bank of America (BoA), when that person deposits the check, Chase’s reserve account held at the Federal Reserve drops by $500 and BoA’s rises by $500. Hence, the payment cleared. Again, at no time do these reserves ever enter the economy. They always remain at the Federal Reserve, merely shifting back and forth between different accounts.

The US Treasury maintains accounts as well, but these accounts sit outside of the private banking sector. The Federal Reserve acts as the banking arm of the US Government, or quite simply, the Federal Reserve handles the day to day financial transactions between the Government and the Non-Government sector. Together, the US Treasury and the Federal Reserve are the “Consolidated Federal Government of the United States”.

All federal fiscal spending originates in Congress and further, all federal spending occurs prior to federal taxation. Congress determines what it wants to buy and therefore, allocates how many US dollars will be issued to “pay for” these things. Once approved, the US Treasury will then credit the bank accounts to obtain the goods, services or payments for anything it determines appropriate. Through keystrokes, the US Treasury accomplishes federal spending. For instance, if Congress decided that Bob Jones was to receive $1 million for being a really nice guy, the US Treasury would go into Bob’s bank account and type the number:

1,000,000

And one million US dollars would suddenly exist. The reserve account of Bob’s bank then rises by $1,000,000 and Bob’s account shows the number 1,000,000. Should Bob wish to spend $10,000 to buy a car, then the reserves would shift from Bob’s bank to another bank. The Federal Reserve manages everything, keeping track of who has what at all times and stands ready to add reserves to the banking system should the need arise, to prevent the payments system from collapsing.

On a daily basis, as the US Government is spending, it is also collecting tax payments. This means that US dollars are flowing out of the banking system. When the Treasury collects taxes, it removes reserves from the private banks in question, thereby destroying those US dollars. In other words, the US dollars shift out of the banking system entirely and exit the US economy. 

If the US Government taxes less than it has spent, more US dollars remain in the banking system than have been removed and what remains is the amount of US dollars added to the economy for you and I to use, or in short, a federal budget deficit exists. Therefore, we understand that since all US dollars come from the US Government and that an economy needs US dollars to pay workers to make goods and perform services, then we also understand that when the federal deficit is too low, unemployment will be the result. Related to unemployment and deficits that are too low, is the concept of automatic stabilizers and their effect on the economy and the deficit. So, let us explore how deficits can automatically rise without any action from the US Government. 

Automatic Stabilizers and The Federal Deficit

The economy employs mechanisms to prevent a dramatic fall in aggregate demand, which can lead to a recession or depression. Two of these mechanisms in the US are SNAP and Unemployment Insurance. When the economy is doing well, SNAP and Unemployment Insurance payments drop as more people are working. When the economy experiences a stall or downturn, SNAP and Unemployment Insurance claims begin to rise automatically as people turn to these programs for help with meeting living expenses. As a result, the federal deficit automatically begins to rise. This explains why it seems that in an economic downturn, the rising federal deficit is causing the downturn, but it is not. What actually happened was that the deficit was too low to begin with. Consumer spending then contracted and the economy stalled, jobs were lost and people began applying for and receiving SNAP and Unemployment Insurance and the deficit began to automatically rise in order to prevent aggregate demand from falling further. So, what we understand is that rising federal deficits in the face of recessions are not the cause of the recession and such thinking is illusory. 

Lastly, how can we determine whether or not a federal deficit is appropriate? The answer lies in the external sector.

Is a Federal Deficit Appropriate?

Recall the sectoral balances equation from earlier:

(G – T) = (S – I) – (X – M)

We will focus this final section on (X – M).

The financial position of the external sector, comprised of exports, which we define as (X) and imports defined as (M), constitutes a determining factor for whether a federal budget surplus (G – T < 0) or deficit (G – T > 0) is desirable. Depending on the condition of (X – M), whether it be in surplus (X – M > 0) and thus exports are increasing the inflow of that particular nation’s currency, or in deficit (X – M < 0) where imports are increasing the outflow of currency, affects whether or not the external sector can finance the private domestic sector’s desire to net save and exceed it and thus, whether or not the federal government should assume a fiscal position of a budget deficit or a surplus.

A problem occurs when the federal government attempts to alter its fiscal position in a discretionary manner, without regard for external sector considerations, reflecting a need for the federal government to fund future spending and thus, a need to save in its own currency, which is an impossible condition for the federal government of the United States. At no time, can a sovereign currency issuing government save in its own currency, because all spending by that government is the creation and issuance of currency which is necessarily initiated prior to taxation.

The condition (X – M > 0) is sufficient, provided that the size of the surplus is large enough to finance (S – I) desire to net save and exceed it. The determining factor being whether or not the inflow of currency is large enough to both support the private domestic sector’s desire to net save and also illicit economic growth. If the level of (X – M > 0) is sufficiently high, then a federal budget surplus (G – T < 0) is possible on the basis that a federal budget deficit (G – T > 0) would exceed the real ability of the economy to produce, resulting in an undesirable demand-pull inflationary episode.

The condition (X – M < 0) clearly being insufficient to finance (S – I) as the outflow of the nation’s currency is greater than the inflow of the nation’s currency. Therefore, whenever an external sector deficit (X – M < 0) coincides with a federal budget surplus (G – T < 0), the domestic private sector must be in a condition of deficit. It is clear that (G) injections must be greater than the leakages imposed by taxation (T), and so, the federal government’s budget stance must necessarily be one of deficit (G – T > 0). We therefore conclude that a federal budget surplus (G – T < 0) is an undesirable fiscal stance when (X – M < 0) as the drain of net financial assets from the non-government sector would result in a recession.

So, we now understand that if the external sector is importing more than it is exporting, the US Government must run deficits. If it seeks to cut its deficit or run a surplus when the external sector is in deficit, then a recession will result. Furthermore, we now have a clear understanding of federal deficits, how they work and their necessity for economic stability.