How does a national budget differ from a household budget?

Question

We are often told by pundits that "Country X cannot spend more than they take in in revenue, because a house that makes A and spends B will always collapse if B>A". Essentially the siren calls of a balanced budget as promulgated by the talking heads.

Sadly, despite even conservative economists like Friedman citing a k-percent rule and the necessity of inflation (since the number of people demanding money seems to continue rising), many entry level students get hung up on this concept.

Essentially, what I'm asking is:

What are the key functional differences between a household budget (or other simple toy model) and a national budget and what's the best way to communicate this to people with only a passing familiarity with economics?

I'm looking for a way to effectively communicate to group of first year students that beyond just the ability to control the supply of money (monetary policy), and control income and spending more readily than an individual or household (fiscal policy), economic policy really has nothing in common with the ability to balance a checkbook, and the dramatic oversimplification is a disservice to the dismal science.

Answer 1

If you think about it, there is really not much difference between a government budget constraint and a household budget constraint.

Both have uncertain income streams, which are labor and capital income for the household, and mostly tax revenue for the government. On the other side of the constraint, you will find consumption and saving for the household. The government will spend most of its income on (public) goods and transfers to households (social system).

Both can move income inter temporally using borrowing. However, neither can run a permanent deficit where it is "not expected to ever pay back", something that is typically referred to as a No-Ponzi-Game condition. As an implication, the "life-time budget constraint" will have to hold for both:

sum of all expected future income = sum of all expected future expenditures

I'm pretty informal here, you would typically rather derive "present value" of these constraints, but latex is not yet allowed here, and I'm already writing much.

What should government debt be used for?

We typically assume that households and governments have concave utility, they prefer consumption processes that are second-order dominating. Hence, they want to engage in smoothing of consumption over fluctuations.

Since all debt has to be paid back eventually, there is limited use of government borrowing. Most typically, one wants to stabilize consumption and output over business cycles, by financing consumption in busts and paying back in booms. Also, given an interest rate r, investments that promise a higher return than r can be financed through debt, as the government will not violate consumption smoothing.

Potential Difference

One potential difference is the commitment. Developed governments are typically more trustworthy, they are more likely to pay back there debt. Hence, they can borrow at cheaper interest than most households. As a conclusion, they can use debt more aggressively than households for the two purposes consumption smoothing and investment, as emphasized above.

tldr: Besides that, they're very much alike. Note also the Ricardian Equivalence, which is not at the heart of this question, but very much related.

Answer 2

A toy model is less useful here, as the only mathematical constraint is that both must adhere to the no-ponzi condition - i.e. that whilst you might be a borrower/saver in any individual period, you cannot finance your consumption merely by planning on borrowing more every year into the future.

Yet aside from this constraint, various aspects of economic theories give rise to the following differences:

1. Since households have diminishing marginal utility from consumption within a period, households aim to smooth consumption through their life cycle. Within-household incomes generally follow a predictable hump-shaped cycle. Your income is likely to be low at the start of your life, higher in your mid 30s to 50s, then decline in your 60s and thereafter. Households will take on high debts in the early stages of their lives, then aim to become net savers in the middle of their careers, then draw down on those savings at a later stage of life. It is therefore not uncommon for a household to get into debts of up to ~5x annual incomes.
2. Following on from the point about debt in (1), households can generally finance much larger debts (proportional to annual incomes) than governments can. A rule of thumb for mortgage serviceability in many countries: a household can borrow at a level where repayments to pay down the loan over 30 years are worth approx 30% of their current income at cycle average interest rates. Governments will extremely rarely run budget surpluses worth 30% of revenues, and thus will find it harder to sustain debts that are of a similar scale relative to their revenues.
3. Household incomes are more risky than government incomes - consider that a large recession might reduce an annual income by up to 90% for 5-10% of households, though this would only be a 4-9% reduction in incomes for a government. For this reason, governments are also less likely to find themselves credit constrained than households.

These points refute two common (though opposing) arguments made regarding fiscal policies. Firstly, it refutes the argument that governments should not run deficits. Point (3) argues that governments have dependable incomes, and therefore deficits may be appropriate. On the other hand, point (2) demonstrates that a government cannot sustainably run debts which are comparable in proportional terms to a household's mortgage - despite having a more diversified revenue base than an individual household.

Answer 3

Imagine you are trying to fill a bucket with a hole in it. It's obvious you will never get the bucket filled if the hole allows more water to leave than you have power to put into it with a hose. That's your household budget. The hole = your expenditures. The hose = your income. The water level in the bucket = savings. Simple enough.

National economies are not like buckets, though. It doesn't make sense for a national economy to have "savings", or "income". If I spend money at Wal-Mart, that's an expense for me but income for them. If someone else buys one of my paintings on Ebay, that's an expenditure for them but income for me. Everyone is better off presumably, but as far as the amount of money goes, it's zero sum. A better analogy for a national economy is an interconnected series of pipes where no water enters the system and no water leaves the system. In this completely closed system, we can't add any water, but what we can do is make the water flow faster. Then everyone gets the water that they need with a fixed supply. Because mild inflation allows the real GDP of an economy to grow at a faster rate than it would otherwise be able to, in this analogy, inflation is like widening the pipes.

Incidentally, there IS a pretty good counterpoint at the national level for the household analogy, but it's not government spending. It's actually the aggregate trade imbalance with other countries, as that money leaves and enters the system in a way that government spending does not.

Answer 4

1. Governments can raise taxes.

Governments can compel a large swathe of the population to give it unrequited transfers known as taxes. Households cannot.

2. Governments can print money (at least those that enjoy monetary sovereignty).

Governments can print pieces of paper that will be gladly accepted as payment for goods and services. Households cannot.

Note though that this power is not a widow's cruse. The limiting factor, constraint, or trade-off is inflation. See this discussion: Smith (2014).

3. People die.

There is thus a (literal) deadline at which a person's assets and debts must be resolved. A person cannot remain in debt forever.

In contrast, there is no obvious deadline for governments. A government can be in debt for pretty much forever:

• The US has been in debt every year since its founding (TreasuryDirect.gov — the debt came close to zero in 1835–36).

• The UK has been in debt every year since at least 1694 (Ellison & Scott, 2017, Fig 1).

Yes, a high and rising debt is undesirable.

However, if say a government consistently maintains a 40% debt-to-GDP ratio for 200 years, then most economists would consider this perfectly healthy and sustainable. In contrast, it is not generally possible for an individual to be in debt to the tune of 40% of her annual income for 200 consecutive years.

4. Governments can borrow at much lower interest rates (thanks to the above factors).

On 2019-01-31, the US government's average interest rate was 2.574%. This is lower than the rate at which most Americans would be able to borrow and certainly much lower than their credit card interest rates.

5. Government budgets directly influence economic growth.

When an individual decides not to buy a new fridge, this does not affect her income. But when government cuts spending, this likely reduces national income, which, by the way, also tends to reduce the government's own income (i.e. tax revenue).

Conversely, when an individual buys a new fridge, this expenditure does not increase her income. One individual's expenditure adds to others' income, but not to her own.

But when government increases spending (on anything other than imports), this does result in increased national income. A country's expenditure is its own income.

When an individual suffers a fall in income, it may be prudent for her to cut back on her expenses. In contrast, when a country suffers a recession, it is not usually prudent for its government to reduce spending.

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Every family in America has to balance their budget. Every small business. Should we expect anything less from a great nation? (Jeb Hensarling, 2011.)

The above is a common piece of rhetoric used by pro-balanced-budget politicians. There are two mistakes.

First, as already alluded to above, we have the fallacy of composition: What is true of the parts need not be true of the whole.

Second, the premise is not even true. Many families and businesses do not have balanced budgets and are in debt.

This though is not necessarily a bad thing. An individual in law school, a family that's just bought a home, and a firm that's just built a factory may all be in debt, but we do not ipso facto disapprove of them.

Likewise, if a government spends its money on productive and legitimate uses (and not mostly on fireworks and bridges to nowhere), we should not condemn it simply because it is running a deficit.