Deficit Spending to Escape a Liquidity Trap, Essay Example

Economic recession refers to a temporary period of general economic decline with a consequent fall in trade, Industrial activity and the general stock market. Economic recession is generally indicated by a decline in Gross Domestic product for two or even more consecutive quarters. Such period is characterized by high unemployment; aggregated income decline and rise in the spending on safety nets. A number of factors, which include, cause economic recession; High interest rates that limit liquidity, increased inflation accompanied by low purchases; reduced consumer confidence hence low spending and a decline in real wages which reduces purchasing power (Eggertsson, 2002). The consequences of recession, mainly is increased unemployment, which reduces government taxes and renders governments unable to sustain pro-poor programmes hence forced to increase its borrowing.

Deficit spending therefore, means the amount by which government spending goes beyond revenue collections over a period or alternatively referred to as budget deficit. This government budget deficit may be caused by recession, which reduces revenue collections. Deficit spending by the government requires that it is financed from other sources for instance from domestic or external borrowing.

There are many views about deficit spending, with some Keynesian economies supporting it as necessary for the continuity of cyclical fiscal policy particularly during recession. However, deficit spending has been viewed to have its advantage and disadvantage to a government in its quest to ensure a stable economic balance. These pros and cons of government deficit spending include;

Advantages

Deficit spending has been viewed as a way of moderating or ending a severe recession. Excessive spending by the government will for example stimulates a number of projects like infrastructure development which will encourage the demand for labour and hence creation of employment a serious consequence of recession. Deficit spending is known to spur economic growth and speeds up country’s recovery from severe recession.

Deficit spending by the government will also create market for the stimulation of business output. Excessive spending by the government has a direct impact on increasing government purchases, which in turn creates a marked output for different business. Increased marked output for business is a key indicator of economic growth that comes with stabilization of different sector of the economy.

Furthermore, a government engaged in deficit spending will allow for a multiplier effect to the general economy (Eggertsson, 2002). This synergetic effect is experienced when government spending is accelerated by deficit spending that, in turn increases business market output that stimulates increased income. High incomes allows for spending by the citizens which finally increase the demand that further improve business output. Such multiplier effect is of great health to the recovery or overall development of country’s economy.

Recession is known to greatly affect the poor most by interfering with their very basic needs making them to be the most vulnerable citizens (Eggertsson, 2002). Deficit spending by government will cushion such disadvantaged part of the population, ensures that they get their very basic needs, and reduces the seriousness of increased poverty levels.

Deficit government spending allows for the compensation for a shortfall in aggregate demand that is typical of an economy under recession. Inadequate government spending will lead to lower purchases that reduce marked output for businesses and therefore lower incomes and overall decline in market demand.

Lastly, deficit government spending allows for control. This is achieved through the reduction of unnecessary investment by government bodies having in mind that they are running on a budget deficit. The need to levy more taxes to try to counter excessive spending will make government and private bodies to stimulate quick pay back hence achieving control of such bodies.

Disadvantages

Excessive government borrowing can have a number of consequences. One of the risks is an increase in government debts (Eggertsson, 2002). The international borrowing, which levy high interest rate that sink a country into huge debts.Also, viscious cycle of borrowing may lead to the piling off government debts, can cause increase in government debts and this is a sign of unhealthy economic development.

Increased demand for borrowing by governments to fund deficit budgets leads to an increase in the interest rates, which discourages borrowing in all sectors of the economy and this stagnated economic development of a nation. Increased interest rates can ‘crowd out’ fixed private spending and the consequent concealment of demand triggered from the deficit.

Deficit spending also leads to low savings in all sectors of the economy at individual and government level during the deficit period. Inadequate savings is very risk in terms of emergencies that may create unintended or expected need for money.

Rising costs is another consequence of deficit spending. This is experienced when the government increases taxes in order to match with its excessive spending forcing the prices to rise than usual and the result of such situations is the drop in standard of living of the citizens with the lower class feeling more pinch of the misbehaving economy.

Increased foreign expenditure is caused by deficit spending, due to the tendency of governments to rely on foreign sources for borrowing.Borrwing in this case might seem to stimulate growth but a closer look reveals lots of piling of government debts due to high interest rates levied on such external borrowing.

In conclusion, borrowing is very necessary in severe recession, as it is appropriate in the recovery and the restoration of a health economic environment. Its tendency to increase the scope of private investment seems to give it a justification; however, its serious consequences like the rise in the interest rates that ‘crowd out’ private investment (Eggertsson, 2002), needs to be considered in making that decision.

Reference

Eggertsson, G. (2002). Committing to being irresponsible: Deficit spending to escape a liquidity trap. Unpublished manuscript, Princeton University.