We have already seen that equilibrium in the circular flow of income does not require that the government should balance the budget (set G = T) necessarily. However, if it choses to run a deficit with G > T (as has been the typical pattern of government policy in the UK and many other countries), then the implication of the circular flow of income is that there must be offsetting 'imbalances' in either or both of the BoP current account (X - IM) or the domestic capital market (S - I) since S + T + IM must equal I + G + X for an equilibrium.

For instance, in a major depression, I is less than S, in which case a budget deficit (G greater than T) can result in the excess of savings over investment being "mopped up" by the government (borrowing this excess of savings to fund the budget deficit).  This is the essence of the Keynesian policy for recovery from the 1930s Great Depression, when investment fell because of the general negative sentiments following the stock-market crash, and savings increased as people feared growing unemployment and falling incomes.

In practice, a considerable fraction of Government Spending and Taxation is now closely linked with national income - via automatic stabilisers.  G grows as Y declines (economy in recession), due especially to unemployment and social security spending - see chart below.  Taxes should increase as Y increases, and fall as Y falls (as has been the case since 1990, with a lag - taxes are paid in arrears).  This relationship, however, did not hold in the 1980/81 depression, because the Government (under Mrs. Thatcher) was actually increasing tax rates at this time to slow the economy down and reduce the (substantial) inflation at the time.

If G goes up and T goes down during a recesssion, then the Budget is likely to be in deficit during recessions, and will only be in balance or surplus during the booms (as in 2001 - with a substantial budget surplus because of increased tax revenues, as well as rather restricted government spending).

Thus, government deficits are not necessarily always all bad. "Forcing the budget to balance every year is bad economics" - the Economist, 12.2.1994 - Economic Focus, p 79. Counter- cyclical budget deficits (surpluses) can help prevent economies getting stuck in recession or generating serious inflation.

Does this mean that, over the full cycle, the budget should balance (G = T over the full cycle)?  Or should it be allowed to be in continual deficit, with G > T, so that the government can provide the services and investments the electorates require?

The question of how big budget deficits should be depends on the answers to two further questions:

1. Is the deficit (which increases total public debt) being used to build up national public capital (investment in Health, Education, Transport, Communications etc.)
2. Can the build up of public debt be tolerated, and more importantly, serviced in the future (ie can we afford to pay the interest of the increased levels of public debt)?

• the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending. It is met when, over the economic cycle, the current budget is in balance or surplus; and
• the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things equal, a reduction in public sector net debt to below 40 per cent of GDP over the economic cycle is desirable." (Though why 40% is such a 'magic' number remains unclear)
  

• The key problem with the Golden Rule - only borrow for capital spending - is to identify capital spending:  which parts of government spending count as current and which as capital or investment - for instance, what is a new building and equipment for the Department of Social Security?  what is increased spending on education or health? The government statement goes on to define capital spending as "growth enhancing" but this, too, is far from unambiguous.
• The major issue under the Sustainable Investment Rule is why 40% is a critical level for public debt. Italy's net public debt has been as high as 110% of GDP, the US's is about 40%.  But, if capital spending is really growth enhancing, then presumably a higher debt ratio now can be justified on the grounds that the additional growth in the economy in the future will reduce the debt burden.