On Federal Deficits and Debt, Monetary and Fiscal Policy

Abstract

President Biden signed a $1.9 trillion COVID relief package (the “American Rescue Plan”) on March 11, 2021. Without a corresponding increase in taxes, this plan has set off alarm bells for those concerned about the expansion of government deficits and debt. Mainstream economists have raised issues of excessive inflation, “crowding out” of private sector investment, and an unacceptable repayment burden on the young and future generations.The purpose of this paper is to demonstrate that these concerns are based on a misunderstanding of the role played by the deficit, debt, and taxes in the U.S. economy, even a misunderstanding of how certain parts of the U.S. financial system actually work. The paper explores the beginnings of paper (fiat) currency and government bonds in the U.S. and demonstrates that without federal deficit spending, the private sector would lose steam and face a recession. Without federal bonds, the government would lose a lever to control interest rates and inflation, not to mention the private sector’s loss of a risk-free, interest-bearing alternative to cash. This is not to say all deficits (or all government expenditures, for that matter) are good. Some actually do cause excessive inflation, exacerbate wealth disparity or have other harmful effects. These are serious problems and they need to be addressed effectively. Simply raising taxes in an amount to match the spending is an example of an approach with limited effectiveness.The ideal is for large spending programs to be designed to be “inflation neutral,” that is, to include federal revenues (taxes) that are specifically designed to mitigate the inflationary impact of spending, to the extent and place it is expected to emerge. If that is not possible, then increased taxes, while possibly serving political, social, or other purposes, are not the solution to address excessive spending-induced inflation.The problem is, when excessive inflation emerges, the most frequently used tool for addressing it, monetary policy, has the pernicious effect of exacerbating the hurt on the most vulnerable citizens, lower-paid workers and, especially, people of color. This paper will also address deficiencies in fiscal and monetary policies, ideally before they actually become serious.In his press conference on March 25, 2021, President Biden identified the "battle between the utility of democracies in the 21st century and autocracies" as the real threat to the United States, noting that “We’ve got to prove democracy works.” The point of this paper is that only with a proper understanding of how our financial system actually works can our leaders make the best decisions impacting our nation for decades to come.