Deficits are fine so long as inflation is kept in check
Unemployment has dipped below 4 percent, the lowest since 2000. At the same time, the federal budget deficit this year will top $700 billion. Could there be a connection? Yes, there is. Our low unemployment is the result of our high budget deficits, plain and simple.
Why? Because it takes a lot of total spending to utilize all our enormous economic resources. When total spending is too low, as it’s been until recently, we are not fully using our economic capacity, and many people can’t find jobs. When we run budget deficits, we are adding more spending than we are taking out in taxes, and low unemployment is the result.
Of course this is something that we can overdo. At some point, high spending from any source can cause the demand for workers with special skills to hit bottlenecks, and wages in some fields will begin to rise faster than we would like. This will eventually translate into higher prices. But we aren’t there yet! There is hardly any inflation in the economy. Deficits at the current level are exactly what the economy needs.
You frequently hear that these high deficits will “crowd out” private investment because government borrowing will compete with the private sector for the limited supply of savings. This is simply not so; there is no “limited supply of savings.”
When banks make loans to businesses for investment, the banks are not drawing money out of their depositors’ savings and loaning it to borrowers. When a bank makes a loan, it creates the money out of thin air by electronically marking up the borrower’s deposit account in exchange for the borrower signing a loan agreement and usually pledging some collateral. That money didn’t exist before, and it won’t exist anymore after the loan is repaid.
This is the major reason why government borrowing cannot “crowd out” private borrowing and investing. There is no limit on the ability of banks to create new money for investment — so long as they have new credit-worthy loan applicants. It’s true that banks must, in this country, keep roughly 10 percent of their deposits as “reserves” with the Federal Reserve system. But the Federal Reserve always makes sure banks have enough reserves to equal or exceed that requirement by buying bonds from the banks in exchange for reserves. This keeps the interest rate at the level desired by the Fed. At the moment and for the foreseeable future banks have far more reserves than 10 percent, so they don’t have to worry about meeting their reserve requirements.
The Federal Reserve can also create new money, and it does so every time it buys bonds from the private banks.
These are the reasons why government deficits cannot physically crowd out private investment. We are a sovereign country that borrows in its own currency. We can never run out of our own money; we can never go bankrupt; we don’t ever have to worry about foreign or domestic “bond vigilantes” holding us hostage and demanding exorbitant interest rates. The Federal Reserve and private banks can always create new money to finance budget deficits or to refinance the national debt, which has never been and will never be paid off.
But don’t we have to worry about inflation?
Yes, we do. That’s exactly what we should worry about, but it’s the ONLY thing we have to worry about.
As I said above, if the government runs too big a budget deficit, it will cause some wages to rise too fast because the economy is putting too much strain on the workforce, especially in specialty areas. We should always insist that Congress and our economic officials manage the government budget in a way that keeps inflation down to reasonable levels, like 2-3 percent.
But until we see signs of significant inflation — more than 3-4 percent — there is no problem with running big budget deficits. They are keeping our economy humming.