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American Enterprise Institute: America's Dangerous Budget Deficit Dance

January 15, 2021
Image for American Enterprise Institute: America's Dangerous Budget Deficit Dance

Article by Desmond Lachman in American Enterprise Institute

At a time when the U.S. budget deficit has reached a record 15 percent of GDP and the national debt has exceeded 100 percent of GDP, there seems to be a growing consensus in academic and economic policymaking circles that in today’s world of low-interest rates, budget deficits no longer matter. How quickly these experts have forgotten the country’s earlier inflationary experience with budget deficits in the 1970s.

Now that Democratic victories in the Georgia Senate races seem to have removed the political obstacles to yet another round of large-scale budget stimulus soon, it will not take more than a year or two to find out how dangerous the present loose thinking about budget deficits will have proved to be.

America’s painful experience with inflation in the 1970s should be a cautionary reminder that irresponsible budget-thinking could be taking the country down the path to higher inflation once again.America’s earlier inflationary experience should also be reminding everyone how undesirable high inflation has proven to be. High inflation interfered with the efficient functioning of the economy. It also proved to be the cruelest of taxes on the economically most vulnerable part of the population.

The main reason to fear that large budget deficits and high public debt levels would likely lead to higher inflation is that they would make it politically difficult for the Federal Reserve to raise interest rates when the economy fully recovers. 

If it were not to raise interest rates to prevent the economy from overheating, then higher inflation would result. Yet if it were to raise interest rates, then it would be putting the government on a path to ever-increasing budget deficits and ever-rising public debt levels as the government’s interest costs would rise.

Yet another way in which large budget deficits could lead to domestic inflationary pressures would be by creating the conditions for a dollar crisis. 

The dollar depreciation that might result could add to domestic inflationary pressure. 

Long run inflationary expectations, as measured by the difference between inflation and non-inflation linked bonds, have now risen to over 2 percent for the first time in two years. Meanwhile, since its March 2020 peak, the U.S. dollar has now depreciated by more than 12 percent.

One has to hope that Janet Yellen, Joe Biden’s nominee for Treasury Secretary, is mindful of the inflation risks associated with an overly expansive budget policy. One also has to hope that she is able to restrain Biden and a Democratically-controlled Congress from fiscal irresponsibility as it frames a budget response to the current slowing in the U.S. economy. If not, then Americans should brace themselves for ....

To read this article in American Enterprise Institute in its entirety, click here.

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