In the long run, an economy’s output
is determined by its productive capacity, which in turn, is partly determined
by its stock capital. When deficits reduce investment, the capital stock grows
more slowly than it otherwise would. Over a year or two, this crowding out of
investment has a negligible effect on the capital stock. But if deficits
continue for a decade or more, they can substantially reduce the economy’s
capacity to produce goods and services.
The flow of assets overseas has similar
effect. When foreigners increases their ownership of domestic bonds, real
estate or equity, more of the income from production flows overseas in the form
of interest, rent and profit. National income - the value of production that
accrues to residents of a nation falls when foreigners receive more of the return
on domestic assets.
Budget deficits by reducing national
saving must reduce either investment or net exports. As a result, they must
lead to some combination of a smaller capital stock and greater foreign
ownership of domestic assets. Although there is controversy about which of
these effects is large, this issues is not crucial for the impact on national
income. If budget deficits crowd out capital, national income falls because
less is produced: if budget deficits leads to trade deficits just as much it
produced, less of the income from production accrues to domestic residents.
In addition to affecting total
income, deficits also alter factor prices: wages (the return to labour) and
profits (the return to the owners of capital). According to the standard theory
of factor markets, the marginal product of labour determines the real wage and
the marginal product of capital determines the rate of profit. When deficits
reduce the capital stock, the marginal produce of labour falls, for each worker
has less capital to work with. At the same time, the marginal product of
capital rises, for the scarcity of capital makes the marginal unit of capital
more valuable. Thus, to the extent that budget deficits reduce the capital
stock, they lead to lower real wages and higher rate of profit.
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