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Do deficits matter?

By Karl Smith

The short answer is yes, but more specifically, sort of.

Non-economists generally think of deficits as an issue of responsibility. Deficits mean that we are living beyond our means. This is not good, as it will surely come back to haunt us. This seems intuitive, but is it economically sound.

If there were no foreign trade, then it would be literally impossible for us to live beyond our means. Our means would be all we had. Living beyond them would require some sort of magic. If we didn’t make the things we wanted to consume, then who would?

The fact that we can trade with other nations opens up the possibility of living beyond our means. However, let’s think about how it works. If we are living beyond our means then that implies that we are living off of someone else’s means. For the whole country this can only mean that we are importing goods and services.

Yet, how can running budget deficits lead to us importing more goods and services?

When we go to the store we don’t say to ourselves, “Ah I’ll buy the Toshiba instead of the Dell because the government is running a budget deficit.” No, we choose to buy the Toshiba instead of the Dell because the budget deficit causes the Toshiba to become cheaper in price.

The Toshiba becomes cheaper in price because the dollar becomes stronger which conversely makes the yen weaker and everything priced in terms of yen cheaper. So budget deficits are bad because they strengthen the dollar.

Still, how do you get from a budget deficit to a stronger dollar? Well, the budget deficit either means that the government is spending more than it otherwise would or that taxes are lower than they otherwise would be. In either case, demand for goods and services in the United States is high.

However, in good times when demand rises to quickly the economy begins to overheat and generate inflation. The Federal Reserve wants to stop that, so it moves in and raises interest rates. Higher interest rates cool down the economy, but they also make U.S. bonds more attractive. Foreigners want to buy these bonds, but you can only pay for U.S. Bonds with U.S. dollars. So, first the foreigners have to buy dollars, which raises the price of the dollar.

Now we have a higher dollar, a cheaper Toshiba, more imports and a country successfully living beyond its means. They key, however, was that the higher budget deficit led to higher inflation, which the Fed wanted to choke off.

What if, as today, inflation is already too low? What happens then?

In that case, a higher budget deficit stimulates demand, heats up the economy, inflation rises and then stop. Nothing else happens. The country fails at its attempt to live beyond its means.

What about all the stuff that the government bought or the tax cuts that it gave. Where does the money for that come from? The money comes from the Federal Reserve. If the Federal Reserve fails to raise interest rates and choke off demand, then that means that its meeting demand by printing more money. Indeed, that why the inflation rate rises and that’s why its critically important whether the government is running a deficit when inflation is too high or when inflation is too low.

We might go even further and ask, where do the actual extra goods and services come from? After all, to run a deficit either the government is buying stuff or its giving a tax cut to people, some whom are themselves buying stuff. That means more stuff is bought. Where does that stuff come from?

It comes from combining out-of-work workers with idle factories. That is, unemployment falls and capacity utilization rises. This is again, why it is important whether inflation is low or high. When you reduce unemployment and raise capacity utilization, the economy begins to heat up. As that happens, inflation begins to rise. If inflation was already too high, this will be bad. However, if inflation is too low, this is exactly what you want to happen.

So, deficits do matter. When the economy is strong, they lead the Federal Reserve to raise interest rates, strengthen the dollar and increase imports. When the economy is weak they lead to falling unemployment and rising capacity utilization.

Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at ModeledBehavior.com.

By Karl Smith  | November 8, 2010; 3:01 PM ET
 
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Comments

"If there were no foreign trade, then it would be literally impossible for us to live beyond our means."
.
Not true. The Fed can literally print money. Sure it affects the existing currency in circulation but that doesn't mean it can't happen.
.
The foreign 'trade' in question is hardly trade. Just the purchase of our debt by foreign nations. This simply slows down the period between running up the debt and paying it back. But even without foreign investment we could still live well beyond our means.

Posted by: rpixley220 | November 8, 2010 3:22 PM | Report abuse

This is once of the worst explanations of any concept of economics I've seen. Why is this person writing in the paper again? Imagine this: you can increase the monetary supply without increasing the budget deficit.

Deficits matter because a rapidly increasing portion of our tax dollars are being spent on servicing the debt. This amount is projected to be roughly equal to the defense budget in about 7 years. There's no "sort of" about it.

Posted by: staticvars | November 8, 2010 3:57 PM | Report abuse

Karl:

What a weird column!

You didn't finish your thought:

"So, deficits do matter. When the economy is strong, they lead the Federal Reserve to raise interest rates, strengthen the dollar and increase imports." (which leads to falling exports which INCREASES the trade deficit, which leads to high dollar reserves in countries like China with a high export capacity) "When the economy is weak they lead to falling unemployment and rising capacity utilization." (except in this economy where they have greatly increased the deficit without significantly increasing unemployment or capacity utilization)

Are you sure you're Karl and not Ezra?

Posted by: 54465446 | November 8, 2010 4:00 PM | Report abuse

Someone should have proofed this before it was posted.

"If the Federal Reserve fails to raise interest rates and choke off demand, then that means that [it's] meeting demand by printing more money. Indeed, [that's] why the inflation rate rises and that’s why [it's] critically important whether the government is running a deficit when inflation is too high or when inflation is too low."

...yuck.

Posted by: scrappyhauser | November 8, 2010 4:03 PM | Report abuse

However, in good times when demand rises to quickly the economy begins to overheat and generate inflation. The Federal Reserve wants to stop that, so it moves in and raises interest rates. Higher interest rates cool down the economy,

When I read this passage I thought that mabye the Gov't would be better off raising taxes in that period then the lowering of taxes during the cool times would be more effective.
Of course this is moot because taxes are the new third rail.

Posted by: nathanie1 | November 8, 2010 11:40 PM | Report abuse

You guys are haters. This is a good simple explanation of QE.

Posted by: bmull | November 9, 2010 4:05 AM | Report abuse

When Bush was in office, we were told that they didn't matter.....many business have them

When Obama is in office, they absolutely matter and are KILLING AMERICA

So, it just depends on which party is in the White House

Posted by: Bious | November 14, 2010 5:18 PM | Report abuse

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