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