Deficit Spending


Government expenditure in excess of tax revenue over a specific period of time.

By definition, deficit spending entails recourse to government borrowing (typically through the sale of bonds). Since 1945, it has been widely acknowledged that the Keynesian revolution, which witnessed the overthrow of classical economics, produced a theoretical justification for deficit spending. Nevertheless, there has been considerable debate on the extent to which John Maynard Keynes himself favored deficit spending as a policy option. In contributing to the debate, J. A. Kregel has contended that Keynes never explicitly proposed “government deficits as a tool of stabilization policy.” It is necessary, therefore, to trace the evolution of Keynes’s ideas on the subject.

Amidst the economic chaos produced by World War I and the draconian Treaty of Versailles, Keynes critiqued not just classical economic theory but also British economic policy. In the 1920s, Keynes attacked the “treasury view,” held by Ralph Hawtrey and Winston Churchill, that increased public expenditure would crowd out private expenditure. Accordingly, he advocated loan-financed public works as a remedy for unemployment. Subsequently, in “An Open Letter to President Roosevelt” (1933), Keynes criticized the U.S. government for striving to maintain a balanced budget in the midst of an unprecedented crisis. More precisely, Keynes pointed to “the increase of national purchasing power resulting from governmental expenditure … financed by loans and not by taxing present incomes.” Finally, in The General Theory of Employment, Interest and Money (1936), Keynes attributed the Great Depression to deficient aggregate demand. Thus, in an effort to explain the multiplier effect (in which the monetary supply expands through banks’ lending), he argued that “public works even of doubtful utility [would] pay for themselves over and over again in times of severe unemployment.” It is not surprising that Alvin Hansen’s Full Recovery or Stagnation (1938) stressed the “income-stimulating expenditures of the federal government.” In a similar vein, Abba Lerner’s “Functional Finance and the Public Debt” (1943) attributed the idea of functional finance (as distinguished from the more orthodox sound finance) to Keynes.

To recapitulate, owing to the exigencies of the depression, Keynesian revolutionaries (especially in the United States) interpreted Keynes’s General Theory as a justification for countercyclical demand management (or stabilization policy). In the Keynesian view, stabilization would be achieved by manipulating the balance between spending and taxation. Thus, faced with the threat of recession, the government would increase public spending and/or decrease taxes. Conversely, faced with the threat of inflationary expansion, the government would decrease public spending and/or increase taxes. By alternating between deficit and surplus, the government would regulate the business cycle.

Throughout the “Keynesian consensus”—a period of time between the end of World War II (1945) and the year the United States went off the gold standard (1973) when scholars and economists believed that deficit spending would help the economy—the United States employed a version of functional finance in the regulation of the business cycle (despite the inflationary pressures the policy seemed to produce). In recent years, however, deficit spending has fallen into disrepute across the political spectrum (not least because deficits have been equated with deferred taxation).

Next post:

Previous post: