Tuesday, July 14, 2009

Reflections on a Trillion Dollar Deficit

Yesterday the Treasury Department announced that as of the end of June, this year's federal budget deficit exceeded one trillion dollars. And the fiscal year doesn't end until October 1. Remember, this is the deficit we're talking about, not the total debt. So in the last nine months we've added an entire trillion dollars to the debt that we are passing down to our children and grandchildren.

To put this in perspective, in just the last nine months we have added nearly 10% to the ten trillion dollar national debt that taken 233 years to accumulate. Not only does this deficit represent the highest deficit ever recorded in terms of dollars, but it also represents the highest percentage of gross domestic product (13%) since the end of World War II. The spending is expected to accelerate over the next few months, with government sources anticipating the final deficit this year to exceed 1.8 trillion dollars.

What are they thinking?

There are only four ways to pay for deficit spending: 1) Borrow money by issuing government bonds; 2) Print more money; 3) Raise taxes; 4) Cut other spending. Let's take a quick look at each of these approaches.

Borrow Money. This is what the government has been doing this year. They have been able to sell bonds to companies and foreign governments in order to bankroll the deficit. Ultimately, however, this will lead to rising interest rates because the fed will eventually have to increase the interest rates on the bonds in order to attract new customers. Rising interest rates will have a devastating impact on the real estate market, which has already taken its fair share of lumps.

Print Money. This a very dangerous option. If the government prints money to pay its bill, the result will be high inflation, putting the country into a prolonged economic malaise like we had in the 1970's. The other effect will be a loss of worldwide confidence in the dollar, possibly impacting its status as the world's reserve currency.

Raise Taxes. This is a short-sighted solution. Economically, tax increases are contractionary. This means that raising taxes historically stifles economic growth. A recent exception to this was the Clinton tax hike, where tax increases were followed by economic growth. This was likely due to the fact that the tax hikes occured during the internet boom, which fueled tremendous economic growth entirely unrelated to the tax increase. Of course, that growth turned out to be the tech bubble which burst at the end of Clinton's second term. There is wide agreement that tax increases during a recession are a bad idea and would ultimately prolong the recession by preventing both businesses from growing and jobs from being created.

Cut Spending. This is the logical place to look to solve the problem. Our trillion dollar deficit was generated by the two stimulus packages, the first by Bush and the second by Obama. As long as we stop doing more stimulus and do not add any more expensive new legislation, such as health care reform, next year's budget deficit naturally will be much lower.

That's the beauty of it. We don't even need to actually cut spending to solve the problem. All we need to do is prevent Congress from enacting any new spending. Unfortunately, over the last several years, Congress has not demonstrated any ability whatsoever to fiscally reign itself in. In fact, the current Congress has shown itself gleefully willing to approve any and all new spending, no matter what the cost, as long as it carries the emergency misnomer of "stimulus."

They just need to take a deep breath and put away the checkbook for a while. The economy will recover just fine without them.

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