Element 3.6: Avoid Excessive Spending and Deficits

“The attractiveness of financing spending by debt issue to the elected politicians should be obvious. Borrowing allows spending to be made that will yield immediate political payoffs without the incurring of any immediate political cost.”⁽⁹²⁾

When government’s spending exceeds revenues, a budget deficit results. Governments generally issue interest-earning bonds to finance their budget deficits. These bonds comprise the national debt. An annual budget deficit increases the size of the national debt by the amount of the deficit. In contrast, when government revenues exceed spending, a budget surplus is present. This allows the government to pay off bondholders and thereby reduce the size of its outstanding debt. Basically, the national debt represents the cumulative effect of all the prior budget deficits and surpluses.

Prior to 1960 the consensus among economists was that, while debts typically increased during wars, it was the responsibility of governments to run budget surpluses to pay down these debts as quickly as possible. There were major debt reductions in the United Kingdom in the century following the Napoleonic Wars, in France following the Franco-Prussian War, and in the United States following the American Civil War.⁽⁹³⁾ UK government debt stood at 20% of GDP at the start of the 20^th century but rose to over 200% of GDP by the late 1940s due to the two World Wars and the Great Depression. Following the World War II the country followed conventional economic wisdom and brought its debt down to 25% of GDP by 1990.

The English economist John Maynard Keynes (pronounced “canes”) wrote a prescient essay in 1936 in which he claimed:

“Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or later, it is ideas, not vested interests, which are dangerous for good or evil.”⁽⁹⁴⁾

Starting with the latter part of the 20^th century Lord Keynes himself became that “academic scribbler.” In 1936 he published a theory that provided both an explanation for the length and severity of the Great Depression and a remedy for preventing such events in the future. During the 1940s and 1950s, the Keynesian view swept the economics profession, and it soon dominated the thinking of intellectual and political leaders. According to Keynesian analysis, government spending and budget deficits could be used to promote a more stable economy. Keynesians argued that rather than balancing the budget, the government should run budget deficits during periods of recession and shift toward a budget surplus when there was concern about inflation.

The first part of that advice was easy for politicians worldwide to follow, but somehow the second half was never internalized. Spending now is easy for voters to see, while paying later is not so saliant.  By 2023 cumulative budget deficits in the UK had raised the ratio of national debt to GDP to over 100%. Freed from the balanced budget constraint, politicians have consistently spent more than they were willing to tax. Exhibit 21 shows a trend over the past 19 years, from 2005 to 2023, where governments of advanced economies consistently ran budget deficits each year. Emerging market and developing economies began experiencing budget deficits from 2009 onwards. For emerging market and developing economies, the budget deficit averaged 2.8 percent of GDP, whereas for advanced economies, it averaged 4.3 percent of GDP during the same period of 2005–2023. Unsurprisingly, deficits were more pronounced during recessions, particularly during the financial crisis of 2008–2009. It's worth noting that advanced economies were more affected by the financial crisis, exacerbating their deficits. Exhibit 21 also illustrates that some developing economies mirrored this trend of budget deficit dynamics. Ukraine stands out as an exception, however, experiencing a dramatic increase in its budget deficit after 2022 due to Russia's invasion. This continued war has led to the deficit reaching nearly 20 percent of GDP by 2023.

Deficits inevitably drive the national debt higher. In advanced economies, the general government gross debt, measured as a percentage of GDP, soared from 76 percent in 2005 to 112 percent in 2023. Similarly, in emerging market and developing economies, it rose from 41.5 percent to 67 percent over the same period.⁽⁹⁵⁾

In Albania, government debt amounted to 62.9 percent of GDP, while in North Macedonia it stood at 51.6 percent. In Armenia, the figure was 48.7 percent, followed by Georgia at 39.3 percent, and Ukraine with the highest at 98.6 percent of GDP.

Source: IMF, www.imf.org.

The political attractiveness of spending financed by borrowing rather than taxation is predictable. It reflects what economists call the shortsightedness effect: the tendency of elected political officials to favor projects that generate immediate, highly visible benefits at the expense of future costs that are less visible. Legislators have an incentive to spend money on programs that benefit the voters of their district and special-interest groups that will help them win reelection. They do not like to tax, because taxes impose a visible cost on voters. Budget deficits and borrowing allow politicians to supply voters with immediate benefits without imposing higher taxes. Thus, deficits are natural outgrowths of democratic politics unrestrained by commitment to a balanced budget.

The unconstrained political process plays into the hands of well-organized interest groups and encourages politicians to increase spending to gain benefits for a few at the expense of many. For example, each member of a legislature has a strong incentive to fight hard for expenditures beneficial to his or her constituents. In contrast, there is little incentive for a legislator to be a spending “watchdog,” for two reasons. First, such a watchdog would incur the wrath of colleagues because a spending restraint would make it more difficult for them to deliver special programs for their districts. They would retaliate by providing little support for spending in the watchdog’s district. Second, and more important, the benefits of spending cuts and deficit reductions that the watchdog is trying to attain (for example, lower taxes) would accrue equally to voters in the other districts. Thus, even if successful, the constituents of the watchdog’s district will reap only a small fraction of the benefits.

Perhaps the following illustration will help explain why it is so difficult for the parliaments of all countries to bring government spending and the budget deficit under control. The Verkhovna Rada (parliament) of Ukraine has 450 deputies. Imagine these 450 people dining together, each knowing that they will only pay for a fraction of the total bill. With such a small share, no one feels compelled to order conservatively. Why not order shrimp appetizers, steak and lobster entrées, and a lavish dessert? Even if one person's extravagant choices push the bill up by €45, their individual share of the cost would be 10 cents (1/450th of €45). It seems like a great arrangement! Of course, he will have to pay extra for the extravagant orders of the other 449 diners, too. But that’s true no matter what he or she orders. The result is that everyone ends up ordering extravagantly, driving up the overall cost for all, with little added value relative to cost.⁽⁹⁶⁾

The incentive structure outlined here explains why deficit finance is so attractive to politicians. During 2007–2023, EU countries deficits pushed up their debt by about 22 percentage points, reaching 84 percent of GDP.⁽⁹⁷⁾ Moreover, the benefits promised to senior citizens under the social protection programs are far greater than the payroll tax revenues that provide their financing. These unfunded liabilities are another form of debt. Social protection represented the largest area of general government expenditure in 2022 in all EU member states. It stood at 19.5% of GDP, the largest being in France and Finland—about 24 percent of GDP.⁽⁹⁸⁾ As the proportion of the working population shrinks and the number of those retired expands,⁽⁹⁹⁾ spending on social protection will outstrip the revenues for financing it, further complicating the debt liability of the federal government.

What will happen if the EU member governments (or any other country) do not bring their finances under control? Let’s remember that just like people, governments must pay interest on the money they borrow. As a nation’s debt gets larger and larger relative to the size of its economy, there will be repercussions in credit markets. Extending loans to the government of a country with a large ratio of debt to GDP is risky. As a result, the highly indebted government will have to pay higher interest rates. In turn, the higher interest costs will make it even more difficult for the government to keep within its budget or to keep taxes, a less popular way to raise money to finance government spending, at reasonable levels.

If the debt continues to rise relative to income, investors will become more and more reluctant to buy the bonds issued by a country’s treasury. Eventually a financial crisis will result—either outright default by the government or financing the debt by money creation and inflation. In either case, the impact on the economy will be destructive. This has occurred in many countries, such as Greece, Venezuela Sri Lanka, and Zimbabwe, that have failed to control government finances. No country is immune to the laws of economics.

The bias of the political process toward debt financing and unfunded future obligations is a time bomb. If it is not corrected, it will result in an economic crisis: debt obligations that cannot be met. Efforts to meet these obligations with higher taxes or money creation will lead to inflation, a severe reduction in income, or both. Control of government debt, both the outstanding national debt and the unfunded promised benefits, is unlikely to happen without a change in the political rules to make it more difficult for politicians to spend and promise more than they are willing to tax. There are several ways this could be done. The country’s constitution could be amended to require the government to balance its budget. Or a constitutional amendment could mandate that spending proposals and increases in the government's borrowing power require either a two-thirds or three-fourths approval by the legislature. Or the current year’s spending might be limited to last year’s level of revenues. Proposed constitutional rule changes of this kind would both improve the efficiency of government and avert a future catastrophic debt crisis.

We do not mean to imply that all government debt is harmful. Just as a business may responsibly borrow money to invest in productive assets, so may a government. Examples might be building a road or bridge where the debt can be repaid through tolls, or more abstractly, support for scientific research that has broad externalities. Unfortunately, much government debt throughout to world today is undertaken to pay for current consumption at the expense of future generations. Without a solid understanding of the economic consequences of excessive debt it is far too easy for politicians to “bride” current voters with goods and services today, knowing that the bill will not come due until long after they (the politicians) are out of office.