What mechanisms enable individuals and governments to run deficits? How can governments run persistent deficits? Many people draw incorrect analogies between government finance and business or household budgeting because they do not understand the different spending constraints facing the private and the public sectors.
Private Budget Constraints
The availability of funds limits spending by households, proprietors, and partnerships. Funds are made available through (a) sales of current assets, (b) current income (including inheritance or gifts), or (c) borrowing against assets or expected future income. You know how tightly credit is rationed to fund private spending if you have ever exceeded your MasterCard credit limit. Even young people with great potential future income have problems borrowing. (This is one reason the government guarantees most student loans.) Sole proprietorships and partnerships face similar spending constraints, but big corporations tend to have fewer problems acquiring funds.
The idea that corporations regularly balance their budgets is false. Most corporate giants become more indebted with each passing decade, but they also have more revenue and hold more assets. Big corporations establish huge lines of credit with major financial intermediaries, and also borrow by issuing bonds. Their bonds are usually more salable than IOUs from households, proprietorships, or partnerships, because most large corporations are superior credit risks. Corporations have an additional source of purchasing power available---they can sell stock to finance spending. The ability to sell bonds and to offer ownership shares (stock) gives corporations more flexibility and power than other firms in securing funds to cover operating expenses or new investments in plant and equipment.
Local Government Budget Constraints
States, counties, cities, school districts, and other local government units face slightly different spending constraints. Like proprietorships or partnerships, they finance current spending with revenues from selling goods and services or some of their assets. Like corporations, they may issue bonds to obtain purchasing power, but government does not sell ownership shares (stock).
Another major difference between the private sector and government is that government can enact taxes to finance spending, which gives it enormous power to acquire resources. But even the power to tax allows only limited command over resources. Overly optimistic revenue projections or excessive spending by local governments sometimes results in loan defaults. Some hobbyists collect defunct municipal bonds the way others collect stamps. They know that few of these bonds will ever be redeemed; rarity and appearance alone determine their values.
Lotteries now augment revenues in many states, with proceeds (half of ticket revenues) usually being "ear-marked" for parks or schools. Advocates favor lotteries as "voluntary taxes," but critics oppose them as regressive---poor people buy disproportionate numbers of tickets, despite incredible odds against striking it rich. (Las Vegas slot machines have much better pay-off ratios.) Moreover, lotteries provide only tiny shares of total revenues to states that offer them.
Regulation or Confiscation
Government also channels resource allocations through regulation or confiscation. For example, regulations force car owners to buy emission-controlling exhaust systems and limit firms' pollution levels. Through such regulations, the government buys a cleaner environment for all of us, and we pay for it without explicit tax increases. You may think that government in the United States does not use direct confiscation. The right of eminent domain, however, is used by all levels of government to secure land for such things as highway rights-of-way or areas for dams or parks. When government exercises eminent domain, those forced to sell their property are paid a government-determined "fair market value." Although the military draft is not used at present, it is another example of government confiscating resources.
The Federal Budget Constraint
A national government has another major tool at hand: It can print additional monetary base to pay for its outlays. (Recall that the monetary base equals currency plus all reserves in the banking system.) In many countries, the central bank covers government outlays by issuing bonds, collecting taxes, or creating additional monetary base. In the United States, financing a deficit (G - T) with monetary base is a more indirect process because, in an accounting sense, our Treasury "borrows" money from the FED, which actually creates the additional monetary base.
The Treasury first issues new bonds to cover a federal deficit. The FED then buys the bonds through expansionary open-market operations. Bank reserves grow, and are transformed into new money through the money multiplier process. Bonds bought by the FED are considered, for accounting purposes, to be part of national debt. It is nonsense, however, to suggest that total debt is larger because one government agency (Treasury) owes another (the FED). Thus, in what follows, we ignore Treasury bonds held by the FED when we count the national debt.
In summary, government can secure resources to provide goods and services through (a) sales of current assets or outputs; (b) loans from U.S. citizens and firms, foreign citizens or governments, or commercial banks; (c) taxation; (d) confiscation; or (e) expansion of the monetary base (currency in circulation plus bank reserves).
Confiscation can be regarded as taxation in kind, so central government outlays are characterized by a government budget constraint.
The government budget constraint identifies financing options open to the federal government:
G = T + DB + DMB
where G = total governmental outlays, T = total governmental revenues from taxes, charges, and sales, DB = change in the national debt and DMB = change in the monetary base (currency in circulation plus bank reserves). Consequently, the federal deficit can also be expressed as
G - T = DB + DMB.
In plain English, this equation means that if the federal government spends more than it collects (G - T > 0), it must either borrow (DB > 0) or create (print) the monetary base difference (DMB > 0). The money expansion process applies to any growth of the monetary base, as described earlier. If the government collects more than it spends (G - T < 0), it can either retire some existing debt (DB < 0) or retire some money it has previously created (DMB < 0). Budget deficits cause growth in the national debt or in the money supply, while government surpluses make it possible to pay off some of the national debt and/or remove some money from circulation. Borrowing money or selling current assets to secure purchasing power are common to both private and government decision makers. But private citizens cannot legally tax, confiscate, or create (print) more monetary base.
When thinking about the national debt, few people take into account that wealthier people or organizations usually owe far more than poorer ones. For example, you probably owe more now than when you were ten years old. Similarly, each of the world's 1,000 largest industrial corporations probably owes more than any recent start-up company. Most analysts conclude that if the federal government had a garage sale to sell all federally-owned parks, equipment, highways, and buildings, it could easily retire all its debt. In Figure 2, we trace the debt of U.S. households, businesses, and government entities as percentages of U.S. GDP. Notice that private debt has often grown, relative to national income, as fast or faster than federal debt, but that federal debt, which had been on a downward path relative to GDP from World War II into the 1970s, has climbed steadily in more recent years.
Figure 2 Private and Public Debt as Percentages of U.S. Gross Domestic Product
National debt as a percentage of U.S. GDP peaked during World War II, declined until 1975, and has been rising since then. Household debt has also been rising across the decades, it surpassed privately-held federal debt in the 1960s now exceeds 70 percent of our GDP. Corporate debt is also rising, in part because of funding required to finance recurrent waves of corporate mergers.
Are there limits to a government's command over resources? The ultimate limit is people's faith that government will survive, honor its contracts, and maintain the money it issues at reasonably stable values. The worthlessness of bonds issued by Russian czars, Chinese warlords, and other dictators overthrown by military coups or revolutions attests that this faith is not always justified. Fiscal mismanagement has been the problem as frequently as political oppression or widespread corruption.