Effects of Budget Deficit on Economic Growth


Effects of Budget Deficit on Economic Growth

James Galbraith is one of the top experts in economic research and is the author of several well-received works including “The Causes Of International Finance”. In this book, he addresses the effects of budget deficits on various aspects of the economy. The main focus of the book is the domestic, but he makes a convincing case for examining the effects of budget deficits on other countries as well.

Effects of Budget Deficit


First, James Galbraith examines the relationship between budget surpluses and domestic economic growth; he suggests that there is little empirical support for the hypothesis that budget deficits lead to economic growth because both inflation and growth are cyclical phenomena. In addition, to sort out the ambiguous nature of the direct relationship, he gives new empirical findings suggesting that budget cuts usually tend to reduce the domestic growth rate of nations with good economic records, while an expansionary policy may boost such nations’ growth rates. Finally, James examines how budget deficits affect bank credit risk, pointing out that interest-only mortgages do not help banks make up for losses caused by their own loans. These criticisms all point to deficiencies in the theoretical framework underlying the two types of analysis.


But these shortcomings are not enough to cast doubt on James Galbraith’s fundamental arguments. Indeed, while empirical research can provide limited and preliminary insights into the effects of budget deficits on economic performance, it is only with more sophisticated methods that truly comprehensive analyses can be conducted. And as James Galbraith also points out, the best way to ensure that a budget deficit does not have adverse economic effects is to target its negative effects on private sectors and finance markets directly rather than indirectly.


It is true that a budget deficit can result in a reduction in domestic spending and reduce gross domestic product (GDP) growth. But a significant adverse effect on the strength of the US dollar rate, which has a major impact on the strength of the nation’s currency, is likely to be realized only when inflation starts to rise above the targeted level. In fact, experts have indicated that a sudden and significant increase in inflation would force the Federal Reserve to reduce its highly accommodative policies and reverse the effects of its quantitative easing program. If this happens, the central bank would suffer a large loss, which would lead to tighter credit conditions, more stringent mortgage lending rules, and more aggressive stance toward the money market.


One might argue that it is the Federal Reserve that causes inflationary pressures, not the sluggish domestic economy. However, this argument does not hold water. Since monetary policy is the tool that the Fed uses to respond to changes in the supply of money and the demand for it, a tightening cycle in the credit market will occur only when the Federal Reserve starts to tighten the monetary base or tighten the stance toward excess credit growth. In this case, the tightening of credit conditions would translate into lower aggregate demand in the economy and lower inflationary pressures as well. If the Fed were to reverse course and increase the interest rate targeting the desired level of inflation, the tightening of monetary policy would again trigger aggregate demand growth.


An alternative to assessing the macroeconomic consequences of budget deficits is to use the instrument of foreign exchange rate risk. The simple concept is that if the domestic monetary base is reduced, the foreign exchange rate will follow suit. According to some experts, the stock market should be seen as a technical indicator of the state of the economy. Accordingly, if the stock prices of world currencies move against the US dollar, then this would mean that there is a possibility of a large scale appreciation of the US dollar against other currencies. This kind of reaction is called a run up in the stock market and it may eventually lead to a break out of the exchange rate mechanism. If the analysis is right, then this could be a very bad day for the US economy.


In addition to the foreign currency component of budget deficit, there are also some non-monetary impacts of budget deficits. One of these is the reduction in the employment prospects of the United States workforce. As the US economy braces for retrenchment, this reduction in employment prospects will have a negative impact on the overall economic outlook of the country. Moreover, the effect of this measure on the employment prospects will be felt most in the manufacturing sector where the number of jobs cuts is likely to affect the production capacity of the industry. The effects of this fiscal policy on the balance sheets of US corporations can amount to around 1.2% of GDP at the best of times.


Finally, there are indirect effects of the fiscal deficit as well. The indirect effect is the rise of inflationary pressures throughout the economy as a result of a worsening fiscal position in the United States. Inflation is always the byproduct of increasing governmental debts and falling natural interest rates. When the government starts printing more money (and also increases the level of real exchange rates) in order to make up for its budget deficit, the prices of all products start rising in the market leading to price inflation which is another significant adverse affect of budget deficits on economic growth.


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