Economics, 3rd Edition

Argument 1: The Government Should Balance its Budget 

When a government fails to balance its 

budget, it has to borrow money by issuing bonds in order to make up the shortfall. The most direct effect 

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  799

of high and rising government debt is to place a burden on future generations of taxpayers. When these 

debts and accumulated interest come due, future taxpayers will face a difficult choice. They can pay 

higher taxes, enjoy less government spending, or both, in order to make resources available to pay off 

the debt and accumulated interest. Or they can delay the day of reckoning and put the government into 

even deeper debt by borrowing once again to pay off the old debt and interest. In essence, when the 

government runs a budget deficit and issues government debt, it allows current taxpayers to pass the bill 

for some of their government spending on to future taxpayers. Inheriting such a large debt may lower the 

living standard of future generations.

In addition to this direct effect, budget deficits also have various macroeconomic effects. Because 

budget deficits represent negative public saving, they lower national saving (the sum of private and public 

saving). Reduced national saving causes real interest rates to rise and investment to fall. Reduced invest-

ment leads over time to a smaller stock of capital. A lower capital stock reduces labour productivity, real 

wages, and the economy’s production of goods and services. Thus, when the government increases its 

debt, future generations are born into an economy with lower incomes as well as higher taxes.

There are, nevertheless, situations in which running a budget deficit is justifiable. Throughout history, 

the most common cause of increased government debt is war. When a military conflict raises govern-

ment spending temporarily, it is reasonable to finance this extra spending by borrowing. Otherwise, taxes 

during wartime would have to rise precipitously. Such high tax rates would greatly distort the incentives 

faced by those who are taxed, leading to large deadweight losses. In addition, such high tax rates would 

be unfair to current generations of taxpayers, who already have to make the sacrifice of fighting the war.

Similarly, it is reasonable to allow a budget deficit during a temporary downturn in economic activity. 

When the economy goes into a recession, tax revenue falls automatically, because income tax and payroll 

taxes are levied on measures of income, and transfer payments such as unemployment benefit increase. 

People also spend less so that government income from indirect taxes also falls. If the government tried 

to balance its budget during a recession, it would have to raise taxes or cut spending at a time of high 

unemployment. Such a policy would tend to depress aggregate demand at precisely the time it needed 

to be stimulated and, therefore, would tend to increase the magnitude of economic fluctuations. When 

the economy goes into recovery, however, the opposite is true: tax receipts rise as the level of economic 

activity rises and transfer payments tend to fall. The government should therefore be able to run a budget 

surplus and use the money to pay off the debt incurred by the budget deficit it ran during the recession.

Wars aside, therefore, over the course of the business cycle, there is no excuse for not balancing the 

budget. If the government runs a deficit when the economy is in a recession, it should run a comparable 

surplus when the economy recovers, so that on average the budget balances. Compared to the alternative 

of on-going budget deficits, a balanced budget – or, at least, a budget that is balanced over the business 

cycle – means greater national saving, investment and economic growth. It means that future university 

graduates will enter a more prosperous economy.