A fiscal imbalance is the result of a gap between expenditures and income in the public sector. The public sector is a crucial part of the economy. It includes central government, local governments and social insurance. And in countries which have a federal government structure, like the United States, Germany, or India, the public sector includes the federal states as well. The total fiscal balance gives us total income minus total expenditure for the public sector. If income exceeds expenditures, we have a surplus. And if expenditures exceed income, then we have a deficit. In practise, a public deficit is by far the most common scenario.
A public sector deficit arises when the income in the public sector falls short of its expenditures. In this case, it will be necessary to find ways to fund this shortfall. Public deficits can be funded in three ways. First, by printing money – and this would be an exclusive prerogative of the public sector, since private companies cannot, of course, print their own money, nor can individual households. Secondly, by borrowing, that is, by asking the public, households and private corporations to buy debt instruments issued by the government. These include, for instance, treasury bills and bonds. And thirdly, by running down the country’s reserves of foreign currencies.
This monetisation of debt could lead to inflation in the long run, and there are limits to the extent to which reserves of foreign currencies can be used to fund deficits, since foreign reserves would eventually be exhausted. The main channel for funding a public sector deficit is therefore through borrowing.
When the government borrows to fund its deficit, its outstanding debt increases. Conversely, a fiscal surplus would reduce the stock of debt. Remember that deficits and surpluses are flows, whereas debt is a stock. And we can think of debt as a sum of all past deficits that have not been monetised – that is, the government has not printed money to fund them. Now, one should bear in mind that whilst debt is a liability, the public sector also possesses assets. And these include not just physical assets, such as public buildings, infrastructure and public utility plants, but also future tax revenues.
And the ability of the government to raise taxes is fundamental in distinguishing the management of deficits and debt by the public sector from that of a private company or a household. The government can effectively pass legislation to raise revenue by levying additional taxes. And ultimately, the management of public deficits and debt consists of deciding when to raise taxes, whether now or in the future. The government can in principle live forever and need not sell its assets to pay off its debt at the end of each period.
Some proponents of fiscal orthodoxy believe that the government should run neither a deficit nor a surplus and that there should be a balanced budget in each period. However, this cannot always be the case. Where the country suffers from a natural disaster, for instance, it would often be impossible not to run a deficit, both because the government must spend in order to mitigate the consequences of the disaster, and because its tax revenues would have been hit by the negative shock to the economy. It would also be ethically difficult to ask the current generations to bear the full brunt of the reconstruction effort through higher taxes. And similar considerations apply when the economy is hit by a deep recession.
In these cases, it would be morally appropriate to spread the burden of reconstruction across both present and future generations. More generally, public deficits and surpluses are a tool to redistribute resources across generations. If we expect that future generations will be much better off than current ones, for instance, because of significant increases in their standard of living, then one could argue that you’d be morally justified to transfer some of their future wealth to the current generations by running current deficits which will be repaid in the future.