A government’s budget deficit is the difference between its expenditures and its income in the current period. A government’s income derives, broadly speaking, from the following sources:
(1) Monetary expansion: When a government expands its domestic money supply, the proceeds constitute government income.
(2) Sale of public property: When a government sells goods or services to its citizens, or charges its citizens for use of public property, the proceeds constitute government income.
(3) Taxation: When a government simply takes money from its citizens, the proceeds constitute government income.
If a government’s expenditures exceed its income in the current period (that is, if it is running a budget deficit), it must finance these excess expenditures out of something other than its current income.
One option is dipping into savings. If in the past there were one or more periods during which a government’s income exceeded its expenditures, and if these savings have not already been used to finance past expenditures, then these are available to finance current expenditures.
A second option is borrowing money (in some fashion). Creditors provide money under the assumption that they will recoup this money in the future, together with interest, to compensate them not only for their inability to spend the money in the interim (illiquidity), but also for the risk of not being repaid in a timely manner (default).
If a government pursues this second course, it escapes financing its current expenditures out of past or current income, but must instead finance its current expenditures out of future income. The only further option borrowing provides a government is default, but default is merely taxation of bondholding. If a government imposes a tax on its bondholders, using the proceeds to pay off its contractual obligations to these very same bondholders, it is (in effect) defaulting on said obligations. As proceeds from taxation constitute government income, a plan of borrowing money now to finance current expenditures, but defaulting in the future, is just one more way of paying for current expenditures out of future income.
To run a budget deficit, therefore, is to finance current expenditures out of some mix of past and future income—nothing more, nothing less. The size of the budget deficit relative to current expenditures is simply a measure of the extent to which other generations of citizens must bear the burden of the current generation’s spending. Importantly, running a budget deficit does not by itself imply which kind(s) of income will be exploited to make the needed payments when the time comes.
How, then, ought we to decide upon the optimal size of a government’s budget deficit, other things being equal? The question of interest is how much of a burden the deficit is going to be for other generations of citizens to bear. It is too late to ease the burden borne by earlier generations of citizens. What really matters, therefore, is the magnitude of the obligations being imposed upon future generations.
Besides the size of the budget deficit itself, the only determinant of this magnitude is the interest rate on government liabilities. The higher the interest rate, the greater the burden future generations of citizens will have to shoulder. Whatever we decide the optimal size of a government’s budget deficit to be under normal circumstances, the optimal size of the deficit increases as interest rates fall, and decreases as interest rates rise. In short, the Treasury's demand curve slopes downward.
It is true that the US government's budget deficit is very, very large by historical standards. On the other hand, interest rates on Treasury bonds are very, very low by historical standards. In fact, real interest rates for certain maturities of US debt happen to be negative.
Oddly enough, this makes it possible for the US to profit from cutting taxes. How? Payments for government expenditures must be made at some point. If the US delays these payments, however, it will owe negative real interest on them—i.e., adjusting for inflation, bondholders will have to write checks to future citizens! Reducing the deficit now, when real interest rates remain less than zero, is extremely difficult to justify.
To be sure, interest rates will not stay so low forever. At some point, borrowing costs will likely rise, which will make a more modest budget deficit desirable. Conveniently, though, the current budget deficit has nothing to do with future budget deficits. The US can always cross that bridge when it comes to it. Even if the spike in interest rates occurs rapidly, instead of gradually, the solution will be to rapidly reduce the deficit. No big deal.
One concern many commentators seem to have is that the US political system is developing a bad habit of running large budget deficits irrespective of credit market conditions. This behavior may be tolerable for the time being, it is sometimes said, but when rapid deficit reduction is in order, it likely will not happen—unless, that is, the US changes its ways right now. Whether or not this is so, reducing the current deficit is a seriously sub-optimal way of managing expected future deficits.
A better idea is to institute interest rate-contingent tax rates. Under such a scheme, the government would plan its desired expenditures, together with its desired tax structure, as per usual. The difference is that the quantitative setting of tax rates would be determined by the rates of interest on Treasury bonds. The higher interest rates rise, the higher tax rates would rise. The lower interest rates fall, the lower tax rates would fall. As a consequence, the deficit would rise when interest rates fall, and fall when interest rates rise. Notably, the proposal does not incorporate any controversial fiscal policies—it merely adjusts whatever the political wrangling produces for current conditions in the bond market.
If implemented as a rule (a law that is very difficult for policymakers to overturn on a whim), it would instill confidence in our long-term promise to honor our financial obligations, which would lower interest rates on average. Most usefully, it would pressure policymakers to stop complaining about "the unsustainable budget deficit", and turn their focus towards resolving important disagreements about the composition of US fiscal policy.