Deficit
What is it?
Deficits come in two flavours: budget deficits and balance of payments deficits. A budget deficit occurs when a government spends more than it earns in taxes. A balance of payments deficit occurs when a country imports more than it sells in exports.
A budget deficit is no big deal. Most governments have one and they sustain it by selling government bonds, which cautious investors are usually keen to buy because they're considered a risk-free investment.
A balance of payments deficit need not be the end of the world, either. If a country is importing more goods than it's exporting, it can sustain this by borrowing from abroad. This takes the form of inflows of foreign capital. For example, investors might buy dollars in order to place their money in US bank accounts, to invest in US companies, to buy US government bonds, or simply because they like to hold their money in dollars because it is the closest thing to a global currency.
Deficits go wrong when they cannot be financed any more. A government budget deficit runs out of control when the government can no longer find anyone willing to buy the bonds it needs to pay for its spending - unless it pays a punitively high interest rate.
A balance of payments deficit runs out of control when overseas investors are no longer willing to lend money to the deficit country - unless it pays a punitively high interest rate. This leads to a so-called 'balance of payments crisis', and is usually followed by currency devaluation, which helps. For example, if the US is running a current account deficit of $1 trillion and needs to exchange dollars for another currency (eg, bananas) to pay for it, it will be easier to sell dollars to Banana Republic if half a banana instead of a whole banana can be exchanged for one dollar.
What's it got to do with the financial crisis?
Deficits are big news under the financial crisis. This is because they are a) getting bigger, and b) getting more difficult to finance.
Following the various banking bailouts, government budget deficits have gone through the roof. Over three weeks in September and October 2008, for example, the US government increased its deficit by $1 trillion, putting around 7% of the country's annual GDP on the line to rescue the banking system.
And in the UK, for example, government borrowing is predicted to surge to around 100bn in 2009 - or 6% of GDP.
At present, both the US and the UK are able to finance these budget deficits. As an article points out, the US government is in a position to borrow almost unlimited amounts of cash. Despite its predicament, few people expect the US government to default and US government bonds are still seen as a very safe investment.
When they are sustainable, budget deficits can be a good thing, particularly if the economy is on the cusp of a recession. Fiscal policy theory dictates that by spending money when the private sector is cutting back, governments should be able to get their economies moving again.
Big deficits are a bad idea, however, if countries need inflows of foreign capital to sustain budget deficits, or current account deficits, or both, and investors have lost confidence in their ability to repay. Which countries are in the most worrying state? In October 2008, Nouriel Roubini, a US economics professor who successfully predicted the financial crisis, identified a few. They included:
· Iceland - top of the list due to the failure of its three largest banks, a collapsing currency and an expected $6bn loan from the International Monetary Fund (IMF).
· Hungary - high current account deficit, big government budget deficit. And strong reliance on overseas funding for personal and business borrowing - 60% of borrowing by individuals and businesses is in euros or Swiss francs. If the Hungarian currency falls in value (which it has), these debts become more difficult to repay.
· Bulgaria and Romania - current account deficits (projected to hit 23% of GDP in Bulgaria and 16% of GDP in Romania in 2008).
· Pakistan - the Pakistani current account deficit widened to 8.5% of GDP in 2008, while the budget deficit rose to 7.7% of GDP. In October 2008, Pakistan began talks with the IMF in a reported effort to borrow $10-15bn to offset a balance of payments crisis.
In the worst-case scenario, a country like the UK or the US could face a deficit crisis, with foreign investors unwilling to lend money to cover either the budget deficit or the balance of payments deficit. In this instance, the pound and dollar would plummet. And this could have unacceptable social effects - it would become much more expensive to buy flat-screen TVs from China, for example (or to import food).
In the US, the federal deficit is expected to reach $9 trillion by 2019, largely due to the cost of the 2008 and 2009 bailout spending.
Last updated on 7 September 2009.
