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Budget Deficit

How Deficits Affect the Economy

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The U.S. can issue higher levels of debt because the dollar is the world currency.

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Budget deficits pay for government services, like defense.

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Greece's budget deficits created a crisis for the entire eurozone.

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Definition: A budget deficit is when a country's government spends more than it takes in from taxes or other forms of revenue. Although individuals, companies and other organizations can run deficits, the term usually applies to governments. That's because there are immediate penalties for most organizations that run persistent deficits. If an individual or family does so, their creditors come calling. As the bills go unpaid, their lose a good credit score, which makes new credit more expensive. Eventually, they may have to declare bankruptcy. The same applies to companies who have ongoing budget deficits. Their bond rating is lowered, and they have to pay higher interest to get any loans at all.

However, most governments can run moderate deficits for years. That's because they are usually highly likely to repay their creditors. Government leaders retain popular support by providing services. If they want to continue being elected, they want to spend as much as possible while keeping their lenders happy.

Many countries, including the U.S., have the added benefit of being able to print their own currency. As bills come due, they simply create more credit and pay it off. This does lower the value of the currency as more supply is available. But, if the deficit is moderate, it doesn't hurt the economy. In fact, it can boost economic growth because government spending is a component of a nation's total output, known as Gross Domestic Product (GDP).

The consequences aren't immediate. Creditors are satisfied, because they know they will get paid. The nation's leaders don't have to decide who gets paid, and who doesn't, because the government has the ability to pay everyone. Elected officials just keep promising the voters in their district more and more benefits, military bases, and tax cuts. Telling voters that they will get less from the government would be political suicide. To voters, elected officials, and creditors, the government's ability to run mild deficits means no pain, and all gain -- year after year after year.

How Is the Deficit Financed?

Budget deficits are financed by a country's bonds. In the U.S., it's financed by Treasury bills, notes and bonds. This is the government's way of printing money. Actually, it is creating more credit denominated in that country's currency. However, it has the same effect -- it lowers the value of that country's currency. That's because, as bonds flood the market, the supply outweighs the demand.

The U.S. is the beneficiary of an additional unique position. The dollar is a global currency. That means it's used for most international transactions. For example, almost all oil contracts are priced in dollars.

As a result, the U.S. can safely run a larger debt than any other country. This makes its economy more stable, which reinforces the dollar's status as a safe haven when there is global economic uncertainty.

During the 2008 financial crisis, the dollar's value strengthened by 22% when compared against the euro. It happened again in 2010 as a result of the eurozone debt crisis. The U.S. doesn't have to worry about rising Treasury note yields, even as the debt rises. For this reason, the U.S. will probably never default on its debt. For more, see U.S. Debt Default.

Now that you understand the budget deficit, find out what the current U.S. budget deficit is, and compare it to the Federal budget income, Federal budget spending. There you'll find past budget deficits as well.

The Deficit and the Debt

However, each year the deficit adds to a country's sovereign debt. As the debt grows, it increases the deficit in two ways. First, the interest on the debt must be paid each year. This increase spending while not providing any benefits. If the interest payments gets high enough, it creates a drag on economic growth, as those funds could have been used to stimulate the economy.

Second, higher debt levels can make it more difficult for the government to raise funds. As the debt to GDP ratio is 77% or higher, creditors become concerned about a country's ability to repay its debt. When this happens, they demand higher interest rates rise to provide a greater return on this higher risk. This increases the deficit each year. (Source: World Bank,Finding the Tipping Point)

This becomes a self-defeating loop, as countries go deeper into debt to repay their debt. At some tipping point, interest rates on new debt can skyrocket, as it becomes ever more expensive for countries to roll over debt. If it continues, long enough, a country may default. This is what caused the Greece debt crisis in 2009. Article updated December 4, 2013

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