The Real Meaning of the Deficit

I think there is a lot of confusion about the real meaning of the deficit. There is a lot of talk about the need to balance the budget, the need to pay down the deficit, to make the 'hard choices' – but no-one really talks about the why. There is some ambiguous talk about deficit vis a vis the future, but no specifics at what is at stake.

In simple terms, as long as others are willing to purchase and hold U.S. Dollars, thereby funding the deficit (or holding it in terms of bonds), the dollar remains strong, e.g., its purchasing power remains great. However, if conditions were to change, if others' confidence starts to falter, and U.S. Bonds are not seen as the low risk instruments that they are today, it would signal a weakening of the U.S. Dollar, and the purchasing power of the dollar would likewise fall.

A falling dollar translates, here at home, to inflation, as the amount of goods or services that can be purchased with a given amount drops. Everything starts to cost more, from food to clothing, services to labor.

Inflation isn't necessarily good, although it impacts different people differently. To truly understand the demagoguery surrounding the deficit, one needs to ask the question: Who will be most impacted by inflation?

The answer, of course, is lenders. Bankers. Wall Street tycoons. Anyone who lends money and derives their income from the resultant payments sees their income fall. And, if their money is tied up in a long-term, fixed rate instrument (think a 30-year fixed rate loan at 4%), there is a huge risk that such an instrument's yield will drop to near (or possibly, below) zero if inflation climbs high enough – that the payment flow is actually negative.

Now, a debtor or borrower is in almost the opposite position. While there was likely some initial pain as their income dropped relative to the goods and services they wished to purchase, since labor (i.e., wages) are a form of service and hence increase their cost along with inflation, labor typically sees their income keep pace with inflation, and the resultant pain is from the fact that there is no growth in their wages. Conversely, as inflation takes hold, the amount relative to their pay that their long term debts require is dropping, laborers are seeing an actual increase in their standard of living as a greater amount is free to purchase other goods and services!

So, who really cares about the deficit? Not likely you or I. In fact, it has been suggested that one of the best ways forward would be for America to gradually inflate her way out of the problem of a high deficit, and that the consequences are orthogonal to the current horror stories told about a high deficit.

So, the next time someone tells you it is imperative that we balance the budget and begin serious efforts to reduce the deficit, ask them “Why?”

And if the answer isn't because they have substantial money tied up lending to others at low interest rates and a future inflation risk may lower their income, they either have no clue or are lying to you.

And in either case, they have no credibility. So why listen to them?