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Governments with strong budgetary positions are those whose budgets are structured such that under normal circumstances, the government’s current disbursements are equal to its current receipts. Thus under normal circumstances the budget balance will be zero.
- Advantages of strong budgetary positions:
- Automatic stabilizers can operate as well without the fear of accumulating a large debt.
The structure of many governments’ budgets is such that their promised disbursements exceed the structure of their receipts. In this case the government, even under normal circumstances, will run a budget deficit and accumulate debt. This deficit bias became apparent in Europe starting in the mid-1970s.
- Problems with a deficit biased position:
- Recall that a government runs a deficit by issuing government bonds and borrowing money now to be paid back later.
- As the government continually borrows year after year, accumulating more and more debt, the purchasers of the bonds may begin to worry that the government will not be able to pay back its loan.
- Potential bond holders sense the risk and ask for a higher interest rate to compensate, making it more expensive for the government to pay back the loan, and further worsening the deficit position. Some people stop purchasing bonds all together.
- At some point there are not enough willing buyers of government bonds and the government cannot raise the money to pay those who it already owes. The government has an unsustainable debt and the government must default on its loans.
- Defaulting on a loan has very dire economic consequences.
- Even if a government does not use discretionary fiscal policy, its deficit is going to worsen during an unfavorable economic fluctuation because of automatic stabilizers. Thus, any problem in the economy is amplified by fears of debt sustainability.
- Note: There is no official level of debt that leads to default. It is those who purchase the bonds that determine when the debt has become unsustainable. Italy has had a debt to GDP ratio of well over 100% for years and has not had to default on any loans.