Debt vs. Deficit

Introduction

What is a deficit? How does deficit spending create debt? Can you have debt after eliminating a budget deficit?

When expenses exceed income, there is a budget deficit. When there are repeated deficits that cannot be made up from savings or prior months' surpluses, the result is debt.
When expenses exceed income, there is a budget deficit. When there are repeated deficits that cannot be made up from savings or prior months' surpluses, the result is debt. | Source

What is a Deficit?

The simplest definition of a deficit is a shortfall, having less than what is required. The definition of a financial deficit is the difference between the money brought in and the money spent.

A financial deficit occurs when your outgo is greater than your income or spending is greater than revenue. On a national scale, the deficit is the difference between government spending and tax revenues.

How Budget Deficits Create Debt

If you spend more than you bring in, there are only two sources of money that you can use to pay the deficit. If you have an emergency fund or savings, this money is used to make up the difference. Individuals use savings or emergency funds to cover their expenses when this is greater than their income. Businesses use retained earnings, essentially money that they have saved from their earnings and can use when they have a budget shortfall or deficit.

Governments, individuals and businesses have another way to fund a deficit; the deficit can be met temporarily by debt. You borrow from creditors for money to spend today. Individuals may take out loans or rack up debt on credit cards to cover a temporary budget deficit. Corporations and governments can take out loans or issue bonds, long term debt instruments with set payment terms, to fund deficit spending.

Relationship between Deficits and Debt in Budgeting

If you have a budget deficit and do not have savings to cover the shortfall, you must go deeper into debt to continue deficit spending. If the next year also results in a budget deficit, you pay interest on last year’s loans to cover last year’s deficit while taking on new debt to pay this year’s deficit.

The deficit for a nation is its budget shortfall that year. Budget deficits will vary from year to year. The national debt is the debt acquired over multiple years of deficit spending and the interest that debt has accrued. National debts increase with each new budget deficit and the borrowing to fund it.

Can You Have Deficit Spending Without Debt?

The only time national governments have had deficit spending without relying on savings accounts or officially taking on new debt is through inflation. If the government issues bonds that it buys directly through the treasury, this is monetization of the debt. As long as the economy is contracting and faces deflationary pressure, monetization of debt helps the government pay its deficit without causing inflation.

When the economy starts to improve, the deflation will become modest inflation, and monetization of the debt leads to higher inflation. High inflation also occurs when investors do not trust a government to stop overspending, and they demand a higher interest rate to compensate for the risk of currency devaluation through inflation or the risk of default. Individuals in this scenario see the interest rates on their debts rise as their credit scores sink, since creditors see them as riskier borrowers.

When governments default on their debts, they repudiate their debts. They no longer have national debts, but the common result is currency devaluation, a spike in inflation and budget cuts simply because their governments cannot borrow to pay for deficit spending. For individuals, this is equivalent to declaring bankruptcy and living off rice and beans afterward.

A saying going back several thousand years is that the borrower is slave to the lender. If you didn't pay your debts, you were enslaved.
A saying going back several thousand years is that the borrower is slave to the lender. If you didn't pay your debts, you were enslaved. | Source

Can You Have Debt Without a Deficit?

Yes, you can have debt without running a budget deficit.

If you balance your budget so that your income equals your expenses, you no longer have a budget deficit. However, you ran up debt to fund prior deficit spending. Having a balanced budget this year doesn't eliminate last year's debt caused by deficit spending in prior years. Making today's expenses plus debt service payments without borrowing any more means you have a debt that is being paid but without a deficit.

If interest rates on the debt increase faster than the ability to make payments, the debt will continue to grow through compounding interest even if there are no more budget deficits. If the debt payments are being deferred, the interest accrues and debt load grows but today's budget balances. In these situations, there is no deficit but the debt is increasing.

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Comments 4 comments

stanfrommarietta profile image

stanfrommarietta 2 years ago

I find that there is a general misunderstanding of the nature of the national debt. It really isn't a problem. There are two general ways in which the debt gets handled:

(1) The treasury swaps new securities at current interest rates for mature securities with the lenders. This is done over and over indefinitely, never paying off the 'debt'. Taxpayer money is not needed if the Federal Reserve is available to pay the interest or the Treasury can also issue securities just to get money from banks for the interest. And these will be rolled over as well.

(2) The Federal Reserve buys the securities used for deficit spending back from the banks that bought them. It pays for these with new money it creates for the purchase, which is implemented by the Fed simply introducing additional money in the banks' reserve accounts at the Fed. The securities come into possession of the Fed, which is an agency and entity within the Federal Government as far as these transactions are concerned. The Fed creates money by delegation to it of powers to create money given in the Constitution to Congress.

The effect of rolling over the "debt" by swapping securities between investors and Treasury does not effectively create new money other than that the money lent is never paid back.

The effect of the Fed buying the securities from the banks that acquired them for loans to the Treasury for deficit spending is to redeem, cancel the debts of the government to the banks. The mature securities passed to the Fed still are 'live' in the sense that the government's promise to pay the holder the face value of the security remains, but becomes inactive as long as it is held by the Fed which is the agent of the Federal government. Government does not owe itself for its promise.

The Fed will use these mature securities in the event inflation arises (as it can and will). First the Fed will swap mature securities it has for new securities with new future redemption dates. The Fed will then sell these new securities to banks by offering higher interest to drain some of the banks' reserves, thereby constraining their lending power.

Another effect of the Fed doing this is that the money original obtained from the banks by the Treasury and spent is no longer owed back to the banks, since the debt has been paid by the Fed with its new money when it bought the securities. The banks have given up the holding of the securities and no longer have a claim on the government for them.

Because the money spent by Treasury (obtained originally from the banks) is equal in value to the new money the banks got in selling them to the Fed, one can regard the deficit-spending money as if it were the new money created by the Fed. The banks are back to their original position in their reserves with respect to the securities they bought from the Treasury. They can now also create new money by making loans as if they had not originally bought the securities. But the new money actually in the economy, being spent, is found in the deficit-spending money. But it is not physically the money given by the Fed to the Treasury because the Fed is prohibited from buying from or giving money to the Treasury. It is just "fungibly" equivalent money. Money is fungible because any amount of it can be replaced by an equal amount, often from a different source.

It is crucially important to distinguish between Treasury securities bought by private and foreign investors, which are like time deposit CD's at private banks, and securities bought by private banks and large financial institutions from Treasury for deficit spending. The Fed often handles sales of these securities to private investors. They are not buying securities to help the government fund its operations. They are seeking ultra safe interest-earning places to keep their dollars, and these securities are perhaps the safest in the world insofar as the Fed can create any money needed to redeem them. Other investments are more risky, even in a private bank (especially these days).

Federal operations are funded with Treasury securities to cover deficits and most likely ultimately bought by the Fed eliminating any such debt incurred to the banks.

I know this is complex and maybe difficult to understand. I think it is that way because the banks that worked behind the scenes to craft the laws governing this practice did not want it to be easy to understand. But it is what it is, and if you want to know how things work in paying off the debt, this is what you have to learn.


Millionaire Tips profile image

Millionaire Tips 3 years ago from USA

Governmental deficits and debt can seem pretty complicated, especially when you have to take politics and inflation into consideration. You've provided an easy to understand explanation here. Voted up.


tamarawilhite profile image

tamarawilhite 4 years ago from Fort Worth, Texas Author

I do not want to add predictions to this article for the future of the U.S., because that will turn evergreen content into a dated political piece.

I'm glad you like it.


swb78 profile image

swb78 4 years ago from Gainesville Georgia

This was a very interesting read. I wish you could add some predictions of how this can effect the economy--either negative or positive. I presume that it can only have a negative effect over the long haul personally, but, I am not an expert. I feel this is an important issue during the crisis we now face and the up coming election. Voting up, useful, and sharing--WP

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