Deficit financing is when a government spends more money than it takes in and borrows money to cover the shortfall. That shortfall is referred to as a deficit, and the total amount of deficits that are being financed make up national debt. You can also engage in personal deficit financing, whether you take out a mortgage to buy a house or run up credit card debt to pay day-to-day expenses.
Impact of Deficit Financing on Government Expenditures
In the short term, deficit financing has a positive effect on government expenditures. If the government can borrow money to spend today, it can spend more. At times of war, or when a major national project is being undertaken, this can be a healthy thing, much like taking out a mortgage. Over time, though, once the money is spent, the government has to pay the interest on the debt, to say nothing of paying the debt back. This ends up reducing the amount of money the government has available to spend on other things, necessitating either fewer government services or higher taxes for the same services. A higher deficit could mean a rise in taxes, an increase in the retirement age for Social Security, increases in fees to enter national parks, or the cutback or cancellation of programs such as human space exploration.
Impact of Deficit Financing on Inflation and Interest
Historically speaking, high levels of deficit spending have triggered inflation. While people with high levels of debt have no option other than to either spend less to pay off their debt or to not pay the debt, governments have a third option. They can print money to pay off the debt. Although this makes paying off the debt easier, the increase in the money supply means that each piece of money is worth less. Weimar Germany in the 1920s and India in the 1950s are two examples of this, and some feel that the increasing cost of fuel and food in America in the post-Great Recession era are also indications of this. As inflation moves up, interest typically moves in lockstep, such as in the American post-oil-shock economy of the 1970s and early 1980s. When deficit financing leads to a rise in interest rates, home buyers can end up paying 18 percent for a mortgage.
The Problem with Deficit Financing
Many years ago, Alexis de Tocqueville warned that "The American Republic will endure until the day Congress discovers that it can bribe the public with their own money." Unfortunately, deficit financing goes beyond this, allowing Congress to bribe the public with the money of their children and grandchildren. It offers a short-term benefit in exchange for a long-term problem and is an especially powerful tool for politicians who simply want to be reelected. When used wisely, it can allow a country to build major infrastructure, win wars, and change the world and the lives of its citizens. When used unwisely, it has little lasting benefit but generates a large bill to be paid at some point in the future.
The Great Recession of 2007-2009
The Great Recession of 2007 through 2009 may seem to disprove some of these rules applying to deficit financing. As of the middle of 2011, interest rates and core inflation remained low. However, there are two factors that were more subtle. Because of economic upheaval in the rest of the world, especially in normally strong economies such as the eurozone and Japan, the world has been more willing to allow the US more leeway with its deficit financing. As these economies recover, the US may more clearly be impacted as the world moves away from holding dollars, causing increases in both interest and inflation. Also, both inflation and interest increased, albeit in subtle ways. While the CPI did not move up a great deal, the cost of many hard goods, such as fuel and food, skyrocketed, so that a gallon of gas went to $3.50 to $4 from under $2 a few years earlier. In addition, although interest rates remained low, lenders approved loans only for extremely strong borrowers to reduce their exposure to risk.
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