Last week’s announcement that the federal budget deficit will reach $455 billion this fiscal year (which ends on September 30), brought predictable denunciations from the Democratic side of the aisle. It’s not so much that Democrats care about deficits — after all, they are the party that invented deficit spending — they just want to score points against the Republicans.
I don’t blame them. In their shoes, I would do the same thing. I wrote many a press statement denouncing Democratic deficits during the Carter administration, when I was a young Republican staffer on Capitol Hill. Although I never thought deficits mattered very much, I knew that there were many people out there who did. So, lacking anything else to say, we Republicans attacked Carter’s deficits.
The problem was that although most people think deficits are terrible, they are even more opposed to any measure that will actually eliminate them. Huge majorities were against tax increases or any particular cuts in spending to bring deficits down. Thus, while Republicans felt good about themselves for being fiscally responsible, they gained no electoral advantage whatsoever.
It wasn’t until 1980, when inflation and interest rates both reached double-digit levels, that the deficit issue had any electoral potency whatsoever. That is because there was a plausible case to be made that deficits were inflationary, as well as raising interest rates by crowding out private borrowers from the market.
The problem is that it just wasn’t true. Inflation is exclusively a monetary phenomenon. It results when the Federal Reserve creates too much money. That is the one and only cause of inflation — meaning a sustained rise in the general price level. Individual prices go up and down continuously. But the overall level of prices cannot rise unless initiated or accommodated by the Fed.
Inflation was also the principal cause of higher interest rates at that time. Borrowers knew full well that the debt repayments they received in the future would be reduced, in real terms, by inflation, so they demanded an inflation premium in interest rates as compensation. Long-term rates in particular rose percentage point for percentage point with inflationary expectations. Thus, if a mortgage rate would have been 4 percent with zero inflation, it would be 12 percent if 8 percent inflation were expected.
Therefore, both inflation and high interest rates resulted from the same basic cause: Federal Reserve policy. Whatever impact deficits may have had was very small by comparison.
Some argued that deficits were inflationary because the Fed was monetizing the debt — in effect, paying it off with printed money. If so, this was a counterproductive strategy, because interest rates rose faster than the deficit. The inflation resulting from faster money-supply growth raised interest rates, rather than lowering them, by raising inflationary expectations. Higher interest rates raised the Treasury’s borrowing costs, which made the deficit worse. Thus, except in the very short run, printing money to pay off national debts just doesn’t work.
Of course, some countries do resort to the printing press to pay their debts and in such cases deficits are inflationary. But the Federal Reserve is an independent institution that operates as it pleases. Administrations can influence it, but they can’t control it. Consequently, there is no direct linkage between deficits and inflation in the U.S.
The notion that deficits raise interest rates is more plausible, but the evidence doesn’t support it. Since 2000, the budget has gone from substantial surplus to substantial deficit, yet interest rates have fallen steadily over that period. The reason is that whatever impact deficits may have on interest rates is small relative to the impact of other factors, such as the business cycle, Fed policy, and exchange rates.
Politically, the main importance of the deficit is that it undermines the case for tax cuts. Indeed, every Democrat running for president next year would reverse already-enacted tax cuts, at least in part. They want the higher revenues to pay for increased spending, rather than deficit reduction. But higher deficits make their case easier.
One problem is that current deficits have very little to do with tax cuts. If all the tax cuts over the last three years were magically rescinded, we would still have a deficit of almost $300 billion, due to the economic recession and higher spending for national security. Moreover, economic growth would be slower and unemployment would be higher — substantially so according to a Treasury Department study.
In the end, the deficit is more of a metaphor than something real. Republicans use it as a shorthand way of saying spending should be lower, while Democrats use it to imply that taxes should be higher. One’s preferences in this regard will largely determine one’s perception about the importance of deficits at any given time.