The Economics of Budget Deficits

Europe is moving closer to another debt crisis, and this one could turn out to be worse than what the continent experienced a decade ago. 

The European Central Bank, with its very low interest rates, has no monetary wiggle room for en masse purchases of government debt. Under a worst-case scenario, which unfortunately is increasingly realistic, Europe is heading for new rounds of severe austerity, with crippling tax hikes and harsh, panic-driven reductions in government spending. 

There is a way to prevent this from happening—scrap all ‘green transition’ policies and focus all political energy on prudent, structural spending reforms across the continent:

• Bring the welfare state under cost control;
• Refocus government benefits on the essential duty of poverty relief, and 
• Get government out of the business of economic redistribution.

Together with tighter monetary policy, this would reassure sovereign-debt investors that Europe’s political leadership, both in Brussels and in member-state capitals, are doing what is necessary to once and for all put an end to the debt-crisis threat.

That is, namely, where the shoe doesn’t fit the current political class’s foot. Barely a decade after the last debt crisis, it is glaringly obvious how elected and appointed government officials have carefully ignored the need for more fiscal conservatism. Looking at the threat of a new debt crisis, investors and taxpayers alike expect nothing more spectacular from their current leaders than a new round of put-out-the-fire austerity packages. 

Fiscal solutions for the long term are too bland and boring to outshine the lure of more ‘green energy’ measures with their arrows pointing straight to the economic stone age. 

So do austerity measures of the kind Europe was subjected to in 2009-2014. The prospect of Europe combining energy-crippling policies with economy-trashing austerity is like a horror movie without a hero.

It is urgent that Europe’s political leadership class take seriously the mounting threat of a fiscal crisis. The very first step toward doing so is to recognize that government must stop taking its budget deficits for granted. For anyone who claims they do, I have a bridge for sale in Brooklyn; since the mid-’90s, budget deficits have been interrupted only by random episodes of fiscal happenstance. 

Eurostat publishes data on government finances from 1995 to 2021. Over this period, 23 of the 27 current EU members have run a deficit for at least 14 years, i.e., more than half the time. The only exceptions are Denmark and Sweden, which have had deficits 13 of the past 27 years, Estonia (12 years), and Luxembourg (5). A total of 20 countries have run deficits two thirds of the time, and six countries have had a deficit every single year: France, Hungary, Italy, Poland, Romania, and Slovakia. 

Before we proceed, let us recognize that deficits in themselves are not bad. What matters is how a government uses its deficits. If the deficits are utilized simply as a funding source for the welfare state’s entitlement programs, then the deficits will help depress economic growth and gradually, yet inevitably, nudge the country toward a fiscal crisis. 

If, on the other hand, the deficits are used as a means to structurally improve the economy, the risk of a future fiscal crisis is moderate, even low. 

The difference between “good” and “bad” deficits becomes even clearer when we take a closer look at the six permanent-deficit countries. They fall into two categories, with three countries that are economically stagnant and three with a recent history of strong economic growth. 

The stagnant economies are France, Italy, and Slovakia. From 2016 through 2021 the French economy grew by 1% per year, on average, adjusted for inflation; the Italian economy only reached 0.3% growth per year; while Slovakia at least climbed to 1.7%.

By contrast, Hungary recorded 3.2% per year, Poland 3.6%, and Romania 3.8%. 

To understand how deficits can be good or bad, we need to distinguish between two types of budget deficits: cyclical and structural. The cyclical deficit varies with the business cycle of the economy: when economic growth is strong, the government budget is in surplus; during recessions, the budget goes into deficit. 

The reason is in the fluctuations of tax revenues, which rise and fall with the growth periods and recessions of the economy. In Figure 1, this is exemplified by surpluses in good times (green) and deficits at the troughs of the cycle (red):

Figure 1

Government spending is for the most part independent of the business cycle, which is why it is illustrated by a straight line. 

The same applies in Figure 2, where there are two alternative levels of government spending. The lower line touches the tops of the cycles in tax revenue, meaning that when times are really good, government can for a short time pay for all its spending out of current revenue. The light red area under this line is a cyclical budget deficit: even though it is never replaced with a surplus, technically speaking it is still a cyclical deficit.

Things change when government spending bumps up to the higher flat line. The dark red area is now added to the budget deficit, which means that there is no point at which government can fully pay for its spending:

Figure 2

The most common cause of a structural deficit is a welfare state that is based on the principles of economic redistribution. By borrowing money to hand out to lower-income citizens, government creates no new economic value. On the contrary, socialist-motivated economic redistribution is a sure-footed way to actually reduce economic growth over time. 

It is relatively easy to identify the structural deficit. Consider Figure 3a, which reports data from France for GDP growth and the budget deficit as a share of total government spending. Figure 3a highlights three periods: in 1 and 3, the economy is growing steadily; at paltry rates, of course (after all, this is France) but it is growth all the same. 

In periods 1 and 3, the French business cycle peaks and budget deficits average 5.5-5.6% of government spending. In other words, even under the best possible economic conditions, the French government can only pay for €95-€96 of every €100 it spends on a regular basis. 

Figure 3a

Now let’s turn to another country that has had budget deficits every year since 1995. Figure 3b applies the analysis from 3a to the Hungarian economy. 

The difference is striking. In period 1, when the economy is growing strongly, the Hungarian government could only pay HUF87 of every HUF100 it spent—in other words, the structural deficit was approximately 13% of the consolidated government budget. There was no trend in the structural deficit, making it a premonition of a major fiscal crisis. 

However, things started changing around 2010, or period 2 in Figure 3b. The deficit starts shrinking, and not just with the recovery from the Great Recession. Around 2015 (period 3), public finances start showing occasional quarterly surpluses; the average deficit for the years 2015-2019 is a low 3.9% of total government spending. 

Figure 3b

Unlike France, the Hungarian economy underwent a transformation that put its budget deficit on a path to structural improvement. Since about 2010, Hungary has taken exceptionally good care of its economy and built family policies, based on conservative values, that have eased the structural strain on government finances.

The result is a phenomenal reduction in the structural budget deficit by almost ten percentage points. If the Hungarian government stays its course, there is a good chance that in the next 4-5 years the structural deficit will be gone entirely.

This would be a remarkable achievement, and there is no reason to believe that it won’t happen. On the contrary, with the strong political mandate from voters to Prime Minister Orbán and his political party, the accomplishments of the past decade are very likely to remain in place. This, in turn, bodes well for the country’s economy and government finances.

Hungary also has two features built into its fiscal policy that help keep the structural deficit in check. The first is an economic-growth rule: when parliament passes the annual budget, it does so based on a forecast of GDP growth that is written into the appropriations bill. If the economy grows in excess of the budget forecast, all tax revenue derived from that extra growth will go toward paying down the budget deficit. 

This feature incentivizes a fiscally conservative parliament to accept budgets only if they are based on a realistic or even modest growth outlook. It could even use the rule to build in permanent deficit reductions: it could, e.g., explicitly state that all tax revenue generated by growth in excess of 3% per year will be used to pay down the debt. 

Either way, the tie between economic growth and the government debt is a nifty feature that forces politicians to consider the economic realities within which they make fiscal policy. It also allows them to track their own influence on the economy; if government spending—and even more so, taxes—start taking a toll on economic growth, the parliament will immediately see the effects in its own budget outlook failing. If growth falls short of the threshold for debt paydown, parliament may find itself having to increase the debt instead. 

Generally, legislatures that have a redistributive welfare state to pay for do not worry too much about having to borrow money (hello Washington?). However, the Hungarian growth rule puts this fiscal irresponsibility rule at the forefront of its policy making, allowing voters and taxpayers to see in plain sight how their elected officials dodge their responsibilities when it comes to budgetary prudence. 

By contrast, when a parliament leans more in the fiscally conservative direction—as in Hungary—it can show voters how it takes its commitment seriously. 

The second fiscal-policy tool that the Hungarians have included in their 2023 government budget is a deliberate effort to spread ownership of government debt to the general public. Without exaggerating the significance of this policy idea, there are noteworthy advantages to it. To begin with, it encourages long-term savings and wealth creation among working families; a government security is among the safest investments one can make, and the Hungarian government is coming closer to being a first-class debtor. In the past ten years its credit rating has improved from negative outlooks below BBB to higher ratings and positive outlooks. 

Furthermore, increased debt ownership among the general public makes government less dependent on foreign creditors. This reduces the risk for debt-crisis spillover effects; if socialist welfare states like Greece or Italy continue to put the European sovereign-debt market in jeopardy, large exposure of Hungarian debt to the global investment community inevitably gives Budapest a serious debt headache.

By contrast, families and small business owners around Hungary are not going to care about a debt crisis in Portugal.

Last but not least, increased ownership of government debt among the general public gives voters and taxpayers yet more reasons to be involved in their government’s affairs. If they sense that their elected officials are spending irresponsibly, they will realize that the money they have invested in sovereign debt will sooner or later be in jeopardy. They can then vote with their bank accounts, forcing government to rethink its fiscal irresponsibility.

The Hungarian success in reducing its structural debt is encouraging for the future. Even if the country will go through a recession in the next year or two, its government stands on solid fiscal footing. The risk for drastic austerity measures is low, at least in the short term. 

France is in a much more dire position. If there is any economy outside the usual suspects (Greece, Italy, Portugal, and Spain) that is in danger of renewed fiscal panic, it is the Fifth Republic. In 2021, France had a debt-to-GDP ratio of 112.5%, ranking it number five in the EU. By contrast, the Hungarian rate stood at 76%.