There is much confusion about federal budget deficits. Many people, whether liberal or conservative, believe that the federal government will go bankrupt “soon” because of its habit of deficit spending. There are multiple US debt counters, both online and IRL, that put this notion in the starkest possible terms. Here’s one:

https://www.usdebtclock.org/

The attention the national debt has received is indicative of a deep sense of fear that pervades much contemporary thought about the role of the federal government. But is it warranted?

First a couple of basic facts:

• Congress– and only Congress– has the power to issue currency, as stated in Article I Section 8 of the US Constitution. So the financial constraints on the federal government cannot be meaningfully compared to those of a family, or a business, or even a US state.
• The federal government issues treasury bonds whenever it expects to spend more than it receives in revenue. But that’s just a policy that was established by Congress. It’s not a fiscal necessity.¹
• The federal government will always have the ability to pay for any programs or policies adopted by Congress. So said Alan Greenspan before Congress when he was asked to testify before it by Paul Ryan in 2005.²
• Congress has paid down more than 20% of the federal debt 7 times in the past– and every time the result was either a recession or a depression.³

Here’s an example that will serve to explain the impact of deficit spending on the US economy.

Suppose that Congress decides to spend $100 billion on infrastructure improvements without raising revenue. That would result in negative $100 billion on the government’s ledger. But every ledger has two sides. So there must be a positive $100 billion somewhere else. Where would that be?

To figure that out we need to understand what the government would do with its $100 billion of newly issued currency. To improve infrastructure it will need to go into the private sector to purchase infrastructure improvement services. That is, the government will be writing checks to individuals and companies that can provide the required services. (The government could opt to have the US Army Corps of Engineers perform many of these services, but let’s ignore that case.)

So the result would be a positive $100 billion deposit to business accounts in the private sector.

Now imagine that after a couple of years of infrastructure improvements the deficit hawks win out and Congress decides to balance the federal budget. Doing so would add a positive $100 billion to the government’s ledger, bringing its balance to zero. But that positive $100 billion would have to be offset by a negative $100 billion in the private sector.

What does that negative $100 billion represent? That is Uncle Sam reaching into the bank accounts of private citizens and businesses to extract $100 billion. Exactly who will pay that $100 billion would depend on other government policies, such as tax policy. But the net effect is that the private sector will see $100 billion in liquidity evaporate. That is the recipe for a recession.

What about inflation? Doesn’t government spending always result in inflation? Didn’t Milton Friedman win the Nobel Prize for that insight?

Let’s go back to our example of a $100 billion spend on infrastructure improvements, and let’s imagine that at that time the national economy is running at 100% capacity. Every business is fully booked, and there is 0% unemployment nationwide. Now Congress jumps in and requests bids for $100 billion of infrastructure improvement services. In this case it’s pretty likely that the bidding service providers will offer their services for a premium price– which means that prices for such services will generally tend to go up.

But would that affect the general consumer? For general consumer products such as home electronics and groceries– no, probably not. But the increased demand for infrastructure services would likely put upward pressure on the cost of building new housing, since most housing foundations require excavation, grading, and cement footings. So there would very likely be a modest side effect on the Consumer Price Index.

When Congress funds new weapons systems for the US military, such purchases are relatively unlikely to affect the CPI since consumers can’t purchase warplanes or submarines at their favorite retail outlets. But there may be side effects. Weapons systems may require the use of specialized materials, such as rare earths, that might also be used for some consumer products, and the government induced increase in demand could result in an increase in prices for some categories of consumer goods.

All of the above analysis would be different if the economy were not running at full capacity. In that case it might be that businesses that provide the required services are hungry for work and therefore wouldn’t bid their services at premium prices.

Now let’s consider a different case. Imagine that Congress decides to buy flat screen TVs for every classroom in America. Since the government doesn’t have flat screen TV manufacturing facilities in its tool set it would have to go to the private sector to purchase flat screen TVs– and the increased demand would almost certainly put upward pressure on the prices of consumer electronics. That would definitely affect the CPI.

The point is that the impact of government spending on the nation’s economy depends on the state of the economy at the time of the expense and on the specific sectors of the economy that would be impacted by the increase in demand generated by the government’s requirements.

The primary constraint on government spending is inflation. So long as we are keeping an eagle eye on inflation, so long as we don’t allow inflation to spin out of control, government spending is not in and of itself a crisis. The accumulated “debt” of the federal government is simply a record of the funds that Congress has allocated for the good of the nation and it will never need to be repaid.

I underwent a massive re-think of my understanding of the federal deficit when I read “The Deficit Myth” by Stephanie Kelton. Ms. Kelton is a world class economist whose book clearly articulates the true nature of the federal deficit. I heartily recommend her book for those interested in a deeper dive. Most of the above is based on her book.

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Notes:

1 “The Deficit Myth” by Stephanie Kelton, Chapter 4

2. “The Deficit Myth”, pg. 180-181

3. “The Deficit Myth”, pg. 96

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