Europeanization Is No Vacation; the Federal Budget Deficit Is Making Us Poorer

The Washington Times (Washington, DC), July 29, 2010 | Go to article overview

Europeanization Is No Vacation; the Federal Budget Deficit Is Making Us Poorer


Byline: William B. Conerly, SPECIAL TO THE WASHINGTON TIMES

Many people are worried about the United States' federal budget deficit and our accumulating debt burden. While it's true that the federal budget deficit was recently reported to be lower than it was this time last year, it is nonetheless still dangerously high. Last year, the federal budget deficit reached a record $1.4 trillion. Public debt is currently more than $13.3 trillion, and that number is growing.

The level of discourse is usually simple: We're going bankrupt. But what is the specific threat that the federal government's huge debt burden poses?

Of the three potential effects of the budget deficit and growing public debt - inflation, a debt crisis or tax hikes - higher taxes leading to slower growth is the most likely consequence.

In regard to inflation, budget deficits are inflationary only if the central bank accommodates the deficit and buys back the debt with newly printed money.

The crucial question is whether the Federal Reserve will stick with the anti-inflation doctrine started in the 1980s or whether it will help the Treasury by inflating the currency. Inflation helps the Treasury by lowering the real, or inflation-adjusted, amount of the debt. This is typically done in countries where the central bank is controlled by the government. The U.S. Federal Reserve, in contrast, has substantial independence.

Recently, the Fed has radically increased the monetary base, also called high-powered money. This consists primarily of bank reserves at the Fed. However, the link between the monetary base and the money supply (which includes currency in circulation as well as checking accounts and savings accounts) is looser than historic norms. Think of a car with a slipping clutch. The motor is revving up, but the axle is moving slowly. One fear is that the clutch will suddenly take hold, and then we are off on a wild ride.

If the Fed tightens the money supply by pulling bank reserves out of the system, it can prevent inflationary pressures. This requires a delicate not-too-much, not-too-little balancing act, however.

A debt crisis is also a potential consequence of the massive budget deficit. When a country is in a debt crisis, it runs a large deficit year after year. …

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