Deficits, Inflation, and Living Standards

-- Posted by Neil H. Buchanan

My FindLaw column this week continues my reaction to the Democrats' renewed zeal for fiscal orthodoxy. I have particularly harsh words for President Obama, whose embrace of the Republicans' insane idea to freeze spending during a recession is nothing short of irresponsible.

I go on in that column to offer what I hope is a constructive idea: If we must live in a world where politicians pander to (and thus reinforce) politically contrived fears about deficits, maybe we should revisit how deficits are measured. I suggest that any efforts to create a bipartisan panel to fight deficits should instead be used to create a panel to measure the fiscal deficit in a responsible way. Even though such a panel would surely be populated by the usual suspects who infest Washington, the net result of a semi-public discussion of how to measure deficits would have to be positive. We use the simple-minded cash-flow measure of deficits now. Even alerting the public to the many alternative measures can only be a good thing.

Here, I would like to return to the merits of the arguments for deficit reduction. In my Dorf on Law post last Thursday, I discussed the political pandering question, and I took it as a given that deficits are not per se harmful to the economy. The discussion on the comments board included some very important issues, two of which I will discuss here: (1) Do deficits cause inflation? and (2) Do deficits decrease living standards?

The federal government can finance deficits in any combination of four ways: borrow from domestic consumers, borrow from domestic investors (meaning those who would invest in real plant and equipment, not financial investors), borrow from abroad, or create new money. The latter possibility is what distinguishes the federal government from state governments, as California recently learned again.

Some opponents of deficits assert that deficits are inflationary. (Note: Inflation means sustained increases in consumer prices. That is, a dollar buys fewer goods and services due to inflation. Whether inflation is measured by the Consumer Price Index or any other method, the story here is the same.) The argument is generally that the deficit will be financed by creating new money, which, it is assumed, will surely lead to higher prices.

This assertion is completely undermined by reality. In the 80's, we consistently ran the highest deficits since WWII, but inflation fell from double digits at the beginning of the decade to as low as 1-2% as the deficits grew -- and as we experienced "the longest peacetime expansion in postwar history." In the 2000's, deficits again reached relatively high levels, yet inflation remained muted even during a housing bubble.

More generally, there has been no apparent correlation between the path of deficits and the path of inflation. There is also no known confounding factor that would explain why an actual positive connection between inflation and deficits is not apparent to the naked eye. Deficits have generally not been financed by printing new money. (In the 80's, only about 10% of borrowing was "monetized," i.e., financed by having the Federal Reserve buy Treasury bonds with "new money.") What has been financed with new money has not led to inflation, either. At the very least, we have overwhelming evidence that we can have relatively large deficits and low inflation.

The second concern is that budget deficits cause decreases in living standards. Even if prices are not correlated with deficits, it is possible that the economy will end up poorer because of government borrowing. The usual story, so-called Crowding Out, has government use of productive inputs displacing private use of those resources. If the government borrows from domestic consumers, however, then it has not crowded out something that was going to induce growth. Therefore, even if the government's spending induces no growth at all, it's a wash.

As I have argued many times, even knowing that the government is using resources that would otherwise be used by private businesses to invest in productive capital does not prove that deficits will make the economy poorer. We also need to know whether the government's use of the resources is more growth-inducing or less growth-inducing than what the private businesses would have done with the resources. If the government borrows from domestic investors, the relative rates of return must be compared to know whether living standards have been reduced.

The story changes only slightly if the borrowing is from abroad. As I described in a blog post last Spring, the only thing that changes economically when we borrow from abroad instead of domestically is that we are able to build some of the factories that we otherwise would not have built, but we must then pay some of the profits from those factories to foreign investors. Since there is no shortage of productive investments available to the federal government -- indeed, our continued unwillingness to spend on publicly valuable investments has only increased the number of high-return investments that are available -- there is no necessary connection between higher deficit spending and lower living standards. Deficits and higher living standards can and should go hand in hand.

All of the above analysis, moreover, is true even when the economy is operating at full capacity. When, as now, we face an economy with scads of unused resources -- empty factories and office buildings, millions of unemployed workers, financial capital waiting to be invested -- the connection between higher deficits and higher living standards is direct and obvious. As President Obama is about to prove once again, the connection between lower deficits and lower living standards is also quite direct.

None of this is to say that all government spending is wise or that every increase in the deficit is guaranteed not to lower living standards. I am saying that deficits are not in any way systematically connected to bad spending decisions. Moreover, what Congress does when it decides to reduce deficits too often results in direct harm to real people. An anti-deficit culture leads to bad affirmative decisions such as spending freezes and across-the-board cuts, as well as bad passive decisions such as refusing to finance education or basic research. Conventional wisdom, as is so often the case, has it completely wrong.