Fiscal Deficit

Fiscal Deficit arises when a government's annual expenditure exceeds its annual revenues (excluding money received from new borrowings).

Government is essential to any organized society. What varies between countries is the desired level of government activity, but any society with a government (of whatever form, from autocratic king to modern democracy) needs to pay for the activities undertaken by its government. A Fiscal Deficit arises when a government’s annual expenditure exceeds its annual revenues (excluding money received from new borrowings). The Fiscal Deficit relates to a specific period, usually a year, whereas the Federal Debt relates to the accumulation of annual deficits.

Government is like any other business or household, receiving income and making expenditures and like any other business; government cannot operate in deficit indefinitely as eventually creditors will lose faith in the country’s ability to honor its obligations.

In order to fulfill its obligations to its citizens, government raises money through direct and indirect taxation and this money is then spent in fulfilling what the nations politicians perceive as being the functions and responsibilities of government. Conservatives generally believe in a smaller role for government in the nation’s economy and this, in theory, should lead to less government expenditure and reduced deficits or fiscal surpluses. Left leaning politicians believe in a larger role for the state which must be funded through higher taxation or Fiscal Deficits as higher levels of government activity in the economy mean that this increased activity must be paid for by someone, as a wider role for government cannot be undertaken without additional expenditure. Over the short term the decisions regarding the size of the Fiscal Deficit or Surplus are primarily political.

Managing the Fiscal Deficit requires deft handling by the government as, on the revenue side there is always a limit to the level of taxation which a population is prepared to accept. Governments must operate within this acceptable level and attempt to ensure that it does not discourage the entrepreneurial efforts of its citizens through charging too much tax. On the expenditure side of the equation government must ensure that almost unlimited wants (for better education, more police, better healthcare etc) are met to a level which the populace deems to be acceptable. It is against this background that the government must plan its finances which are further complicated by the vagaries of the economic cycle which, in depressed times result in reduced revenues (less profits mean less taxes raised) for the government and often increased expenditures through additional unemployment benefits and social welfare payments.

Fiscal Deficit and Gold

Although monetary policy often seems to be more important, fiscal policy may also be a significant driver of gold prices. When a fiscal deficit arises, it undermines the confidence in the economy and thus spurs safe-haven demand for gold. To a large extent, this is because high fiscal deficits increase federal debt. And high indebtedness triggers worries about inflation, as, historically, public debt was often monetized which resulted in high inflation. There are also worries whether the government will be able to meet its debt payments, or it will be forced to cut its spending or increase taxes, which could hamper economic growth.

The best example of the impact of fiscal deficits on the gold market may be the U.S. in the 2000s. President Bush created a twin deficit and significantly deteriorated the fiscal position of the country (as one can see in the chart below), which erased the investors’ faith in the U.S. dollar and triggered a rally in gold, confirming that it may be a hedge against fiscal deficits.

Chart 1: Gold price (green line, left scale, P.M. fixing) and U.S. fiscal surplus/deficit to GDP (red line, right scale, in %) from 1969 to 2016.

On the contrary, during the Clinton era gold was in a bear market, as Bill Clinton achieved a fiscal surplus, which strengthened the U.S. dollar. The above chart shows thus that there is a negative correlation between the fiscal position of the U.S. federal government and the price of gold (about -0.56). However, a lot depends also on other factors, such as, the Fed’s monetary policy, the level of inflation and real interest rates, etc.

We encourage you to learn more about the gold market – not only about the link between fiscal deficits and the yellow metal, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.