What is the budget deficit and why does it matter?

A friend of mine used to say that talking about public finances gave him MEGO – “My Eyes Glaze Over”. But in reality many of the basic ideas underlying public finance are quite simple, and even interesting. Understanding these concepts is valuable because they tell you how well your country is doing and what might happen next.

A friend of mine used to say that talking about public finances gave him MEGO – “My Eyes Glaze Over”. But in reality many of the basic ideas underlying public finance are quite simple, and even interesting. Understanding these concepts is valuable because they tell you how well your country is doing and what might happen next. 

In this article, I’ll be talking about the “budget deficit”. What exactly is it, and why is it important? 

Put simply, a government incurs a budget deficit when it spends more money than it collects in a given year. That’s all there is to it. The companion terms are budget surplus – when a government collects more money than it spends – and a balanced budget (when the two numbers match). 

Let us look at an example. In round numbers, the South African Treasury expects to collect R1.3 trillion in 2020/2021, while it expects the government to spend R2 trillion. This creates a shortfall of some R700 billion.  

The size of the South African economy is about R5 trillion, meaning that the deficit equates to about 14% of the size of the entire economy – an astronomical figure.  

To put it in historical perspective, such deficits have previously only been incurred after the two world wars and in the late 1980s, when apartheid was collapsing and the government had run out of money. As with previous record deficits, this year’s 14% deficit is partly also a result of anomalous circumstances, in this case the Covid-19 pandemic and the resulting shutdown of the economy. 

When faced with a budget deficit, governments need to get money from somewhere to cover the shortfall. The most common way to do that is by borrowing money.  

To borrow money, governments issue and sell “bonds”. A bond is a promise to repay borrowed money after a specified period of time, plus interest. For instance, if you bought R10,000 of 5-year fixed rate South African retail savings bonds, currently on offer at 8%, the government would promise to pay you 8% or R800 per year for 5 years, before repaying you the full R10,000 at the end of the 5 years. 

So far this is all straightforward. Now let us take a look at what happens over longer periods than just a single financial year.  

Budget deficits are far more common than balanced budgets or budget surpluses, and it is easy to see why. Governments make themselves popular by spending lots, for example on free public transport, free housing, free schooling, free healthcare, welfare and so on. Conversely, they make themselves unpopular by taking a lot of money out of the economy in the form of taxes, duties and levies.  

Because governments want to be popular, allowing them to stay in power for longer, they commonly spend more than they earn, meaning that they have to borrow year after year after year, creating a growing mountain of national debt.  

When that mountain becomes very large, it starts to pose a danger. In South Africa, the value of the accumulated debt in 2020/2021 is equivalent to 80% of GDP – that is the total value of all the goods and services produced in South Africa, in a year. It is expected to climb to 89% of GDP in 2025/2026, and even that may be optimistic. 

When the debt burden reaches such high levels in countries with low economic growth, like South Africa, then the institutions that lent money to the government start worrying about whether it will in fact be able to repay them. They worry that the government may default, in other words refuse to repay its debts, violating the terms of its repayment promises. 

The risk of default is assessed by credit ratings agencies such as Fitch, Moody’s and Standard & Poor’s. Debt issued by governments which are considered very trustworthy and therefore very unlikely to default is referred to as investment grade. Debt issued by untrustworthy governments is referred to as being speculative, or, in popular parlance, junk status.  

Currently, all three of the major credit ratings agencies rate South Africa’s debt as being speculative, meaning that there is some degree of concern about the government’s ability to repay its debt. 

To compensate lenders for this risk, the government has to offer them higher interest rates – meaning that its debt becomes more expensive. The risk then is that the government enters a so-called debt spiral, where the rising levels of debt and debt interest become unsustainable, eventually leading to a debt default. 

Another risk of high debt levels is that the government has to divert a growing part of its revenue away from its actual mandate, such as paying school teachers and police officers, building roads, hospitals and schools, and funding grants for the needy – and instead has to spend money on servicing its debt. South Africa’s debt-service costs in 2020/2021 total around R270 billion, which are spent on repaying borrowed money, plus the interest on loans currently outstanding. 

Those R270 billion are being paid to people wealthy enough to lend money to the government, rather than the poor South Africans who really need it. To give you an idea of the scale of the debt-service costs, in South Africa they now exceed spending on the police, the defence force, courts and prisons, and home affairs (R209 billion).  

To get out of the debt spiral, the government has to stop borrowing so much money every year. And to do that, it can do three things: spend less, collect more, and lower the interest rates it has to pay on the money it borrows. None of these things is easy. But nor are they impossible: none other than the South African government managed to turn a 7.1% budget deficit in 1992/93 into a budget surplus of 0.9% in 2007/08. In the same time period, it halved the country’s debt burden from a high of 49.5% of GDP in 1995/96 to 26% in 2008/09. During the same period, the three major credit rating agencies changed their assessment of South Africa’s debt from speculative to investment grade – meaning that the government could borrow money more cheaply. It was a remarkable achievement. 

All of this took place against the backdrop of a growing, job-creating economy, giving the government lots of scope for action. Today, however, the situation is dramatically different, with an economy in the doldrums, crippling debt, sky-high deficits, astronomical unemployment and more and more spending demands on the fiscus – for bailing out state-owned enterprises, funding free tertiary education, saving the country’s crumbling infrastructure, paying the country’s high-earning civil servants and so on. 

The situation can only be turned around through hard, growth-creating reforms which the government is unwilling to undertake. They include abandoning the pursuit of expropriation without compensation, instilling accountability in the public service, rejecting race-based policies and reforming the labour market and the education sector wholesale. Such reforms could spark a quick turnaround in South Africa, as investor confidence is restored and the country benefits from cheap international money, investors looking for returns, and what may turn out to be a commodities boom. 

However, it is more likely that the government will turn to two other solutions first: it will try to leverage private savings for public spending, for example by obliging pension funds to invest a portion of their members’ savings in government projects; and if that source is unavailable or runs dry, the government may well turn to printing money to pay off its debt. However, despite what adherents of Modern Monetary Theory (MMT), a currently fashionable economic delusion, may believe, you can’t get something for nothing. There is always a price to pay, and in the case of a rapid expansion of the money supply, that price comes in the form of inflation (either monetary devaluation or the emergence of asset bubbles, which create terrible devastation when they burst). 

In conclusion, after reading this explainer you should now know: 

  • What is a budget deficit?
  • What is government debt?
  • Why is it dangerous for a government to have lots of debt?
  • How can a government safely reduce its debt burden?