A Brief Note on Deficits

I’d like to take a moment to add something to Bill Mitchell’s excellent article “Iceland proves the nation state is alive and well” found here: http://bilbo.economicoutlook.net/blog/?p=33707 which, I feel, would make an excellent learning opportunity for the general public concerning deficits and the economy.

In the section “The public deficit supported growth until private domestic expenditure was strong enough”, we note from the chart that at the start of the Global Financial Crisis in 2008, Iceland was running a pretty large deficit in order to counter the collapse of the economy. As the years move ahead, we see the deficit gradually reduce until we reach 2015 where it is almost non-existent. Today, Iceland’s unemployment rate is very low and the economy is doing great.

Your typical political enthusiast (right or left, doesn’t matter) who received his or her’s economics education from TV, would conclude that Iceland reduced its deficit and so, the unemployment rate fell and the economy improved. Therefore, we must reduce the deficit.

Such a conclusion, though it is held as “common knowledge” is, in fact, pure nonsense. The reality is that the economy collapsed, then Iceland responded with a budget deficit. Afterwards, the economy began to improve and then the deficit reduced automatically as the economy continued to improve.

How?

When unemployment falls and the economy improves, tax receipts increase.

Didn’t think about that, did you.

As tax receipts increase over time, they gradually eat away at more and more of what government is spending and so, automatically reduce the budget deficit.
Hopefully, this is an eye-opening moment for some fiscal conservatives out there. If not, I’ll explain it the following way (using positive numbers so as not to confuse):

(10 – 4 = 6)

Where 10 is government spending minus 4 in taxes equals a deficit of 6. Now then, let’s put more people to work with that 6 and watch tax receipts gradually increase:

(10 – 5 = 5)
(10 – 6 = 4)
(10 – 7 = 3)
See the deficit reducing?
(10 – 8 = 2)
(10 – 9 = 1)
And so on until we arrive at a balanced budget:
(10 – 10 = 0)

Where government spends 10 and taxes 10.

Better rethink the popular talking point “we’ve gotta reduce the deficit!” and along with that, all of the balanced budget amendment nonsense.

You’re welcome.