Why the Deficit Matters

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The U.S. economy is limping along, looking healthier one day and suffering a setback the next.

But one economic indicator never gets any better: the soaring federal budget deficit.

Everyone knows big deficits are bad. They mean the government is spending more than it takes in, building an ever-larger debt that must be repaid with interest. But the various ways that deficits do their damage are not always clear to laymen.

Alan Levenson, chief economist for T. Rowe Price (Stock Quote: TROW) explains in the firm’s fall newsletter that a larger deficit means the country is saving less, reducing the amount of money available for investments that improve productivity. Higher productivity is key to an improved standard of living.

Because the government takes in less than it spends, it must borrow the difference by selling bonds and paying interest to bond investors, Levenson adds. As investors put increasing amounts of money into safe government bonds, they put less into private investments such as corporate bonds. To compete, corporations have to offer higher yields. That can drive interest rates up on everything from mortgages to auto loans to credit cards.

The government’s growing need to borrow makes it more dependent on foreign investors. If the government tries to sell more bonds than foreign investors really want, the imbalance in supply and demand tends to drive the dollar’s value down relative to other currencies. That makes foreign goods more expensive for U.S. consumers.

But Levenson notes that the worst has yet to happen, despite these forces. Interest rates, for example, remain very low and the dollar has not fallen as far as many experts thought it would.

That’s because other factors have created a reprieve that will probably be only temporary, he says. Americans have been so alarmed by the falling values of their investments and homes, and by the poor job market that they have started to save more. That has helped offset the reduced saving caused by the deficit.

At the same time businesses are spending less in housing construction, plant and equipment purchases, helping to offset the overall need for foreign investment.

Also, even though the U.S. does borrow substantially from foreigners, government bonds are considered so safe that they remain the top choice for foreign governments that need to invest currency reserves. This high demand means foreign investors will settle for low yields on those bonds, helping to keep interest rates low.

But the mitigating factors cannot stand up forever if deficits remain large, Levenson says, warning of growing costs of Social Security, Medicare and Medicaid as the population ages.

If the U.S. fails to reduce its deficits, says Levenson, the government’s need to borrow will eventually drive interest rates up and “depress income growth in the U.S.”

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