Almost every year, the US government spends more than it receives in taxes, fees, and other forms of income, resulting in the growth of federal debt. Opponents of deficit spending claim that we are saddling our children with a debt burden that will lower their standard of living as they struggle to pay interest on the debt.
Some economists, however, see no such danger in current deficit spending. Modern Monetary Theory (MMT) claims that a country which controls its own currency can always meet its debt obligations in that currency simply by creating more money, such as when the Federal Reserve Bank buys bonds from the US Treasury. Bond purchases make funds available for the Treasury to spend on anything, including interest on the national debt.
Although MMT dismisses the importance of accumulated national debt, it accepts that annual deficits can be a problem if they’re too large. Government deficits inject money into the economy and this can cause inflation. People who receive this money typically want to spend most of it. If the economy at full employment can’t provide all the goods and services that people want to buy, demand exceeds supply, and prices go up.
High inflation is economically harmful. People on fixed incomes and those with savings see declines in their income and wealth. Private savings, which could be used for productive investments, are reduced because people prefer to spend their money right away rather than see its value decline. In the long run, interest rates increase as well because lenders and investors want returns that more than match the value of the dollars they’ve lent or invested. High interest makes borrowing expensive, thereby reducing investments that promote economic growth.
High interest rates affect federal deficit spending, as well, because the government must spend more money to service its accumulated debt. In order to avoid large annual deficits that threaten even higher inflation, the federal payment of high interest must be offset through reductions in payments for defense, healthcare, infrastructure, environmental protection, and other important programs. Thus, a growing public debt would be a problem if inflation and interest rates were to climb. So, MMT endorses deficit spending, but not so much as to cause significant inflation.
Fortunately, the Fed can influence interest rates. It sets the Federal Funds Rate, which is the interest rate at which banks lend their excess reserves over night to other banks. This affects the banks’ cost of borrowing and thereby the price (interest rate) that they charge when they lend money to others. In general, when the overnight rate is low so is the interest rate on mortgages. Currently (February 2021) the Federal Funds Rate is at or near zero.
Another way the Fed influences interest rates, including the rates the government has to pay on the national debt, is through sale and purchase of bonds on the open market. Public and private entities issue bonds to raise money. Bonds have a fixed monetary return, not a fixed interest rate. That return equals a higher interest rate when the bond’s price goes down, and a lower interest rate when it goes up. (A $5 payout on a one-year bond yields 5 percent interest when the bond costs $100, but only 4 percent interest when the bond costs $125.) The Fed can lower interest rates by buying bonds on the open market, thereby increasing their price (supply and demand) and lowering their interest rate, which lowers other interest rates in the economy.
But all this depends on annual deficits not being so high as to trigger significant inflation. How do economists know whether a given level of deficit will trigger such inflation? Reputable economists differ about the impact on inflation of the $1.9 trillion package proposed by the Biden administration as Covid-19 relief.
What’s more, factors out of federal control may influence the inflation rate. Some economists think that low inflation during the last few decades resulted from the Chinese offering inexpensive production, and technology allowing the use of inexpensive services from India. But China will have fewer workers in the future, and they’re expected, like Indian workers, to demand higher wages as their countries become wealthier. In addition, politically motivated retreats from globalization may also create inflationary pressures. Increased domestic production may provide good jobs, but it usually increases costs.
In sum, because we can’t count indefinitely on low inflation, and therefore low interest rates, we should be concerned about the accumulated total of national debt to avoid interest payments consuming too much of federal budgets in generations to come. Deficits should be geared toward emergencies (wars, pandemics), programs that promise to reduce government spending in the future (early childhood education, more efficient healthcare), and infrastructure improvements that promote economic growth (energy, transportation) to reduce the size of the national debt relative to our means of servicing it.
It seems to me that there is also the issue--not a danger, maybe, but a concern--of how national debt instruments effectively redistribute wealth. Payroll taxes taken from people living hand-to-mouth get used to pay the interest to people who have parked their excess money in government bonds and notes. Foreign governments buy U.S. bonds, and American tax money goes to them, as a sort of unbudgeted foreign aid to countries who have enough money to lend us some of it.