All Commentary
Friday, February 1, 1985

The Deficit Connection

Mr. Ross is an Oregon commentator and writer especially concerned with new developments in human freedom.

From the man-in-the-street, to economists, to politicians, to academics, nearly everyone seems worried about federal deficits.

During Presidential campaigning, Walter Mondale called deficits “a travesty”; in more reserved tones, Ronald Reagan called deficits “a problem.”

Distinguished professors write grave tracts warning of deficit repercussions “in the out years” (i.e., in the longer run). In an informal television tabulation of my own, in a single week over 100 interviewees and speakers from different walks of life were quoted making disparaging comments about deficits.

That deficits seem destined to be with this nation for awhile is hardly disputed. Even the more optimistic forecasts project several hundred billion dollars in deficits added to the national debt before the end of the decade. Some estimates push a trillion dollars.

While most people regard deficits as bad, there is considerable controversy over whether deficits are connected—that is, whether they must lead—to higher prices, to what current political jargon terms “an inflationary environment.”

Many analysts, such as economist Fred D. Kalkstein, warn or imply that deficits are ultimately connected to higher prices via interest rates. Accelerated borrowing to pay for the deficits pushes up interest rates, and the borrowing tends to temporarily dampen or “hide” the effects of extraordinary levels of monetary growth.

(M1 money supply—primarily currency in circulation and checking-type accounts—averaged over 10 per cent annual growth from mid-1982 to mid-1984, the highest sustained two-year rate since World War II; M2 and M3, much broader money measures, also showed abnormally rapid growth.)

“The longer the combination of disinflation [meaning less rapidly rising prices] and high interest rates persists . . . [a]t some juncture,” wrote Kalkstein, “the money will begin to flow from our shores . . . the dollar will fall . . . and the inflation inherent in the Fed’s monetary stimulation will come home to roost.” (The Wall Street Journal, 31 July, 1984.)

Other economists remain sanguine about deficits.

For instance, in an August 31st Wall Street Journal letter Hoover Institution Senior Research Fellow, Milton Friedman, said, “I do not regard the deficit as a major issue or cause for concern.” Coming from the man who has been one of the nation’s more popular and vociferous—although less than consistent—modern opponents of inflation, this was quite a statement. While Friedman has many times contended that higher money growth and higher taxes lead to price increases, he apparently found no worrisome connection between deficits and higher prices.

Purported gold standard advocate, Congressman Jack Kemp, is another leader of the camp which takes a relatively benign view of deficits.

Kemp even went so far as to say that the way to handle deficits is through much more rapid monetary growth; he thus proposed to “fight” deficits by inflation—although, as can only be true in the bizzare world of political double-think, Kemp steadfastly stated that this actually amounts to a policy of combatting inflation.

Anti-Deficit Magic

There are many who share Kemp’s view that with enough economic growth, deficits will eventually “take care of themselves.” If this sounds strangely similar to the old (but apparently not yet worn out) notion that monetary stimulus (i.e., inflation) is a good play for prosperity, read on . . .

On its own terms, how would this “modern” notion work its anti-deficit magic?

To use a sports analogy, perhaps as a skilled slalom skier averts obstacles, growth will bypass all the impediments of (ever-increasing) government interferences in the economy and skim along joyously unabated for the next several years. But in order to make a continuous uphill run possible, our growth-skier will be endowed with a jetpack containing a clever mixture of “supply-side” and Keynesian doctrines. So powerful, yet controllable, will this mixture be, that the skier will not only effortlessly avert obstacles and speed ever higher, he will be able to tow a bobsled full of happy, taxable workers and producers behind him.

In short, through this enormous economic ingenuity, growth will permit continued expansion resulting in the U.S. Treasury’s ultimately taking more revenue from more freshly employed workers and profitable companies. Under this view, the new revenue would supposedly be used to pay for what are now deficits.

Naturally, if somehow this wonderful theory did not produce quite enough growth-generated taxation—if growth proved a little too sluggish—it might be “necessary” to raise taxes outright.

Sound economics says higher taxes would inhibit growth, but—perish the thought. Economic history suggests the accelerated money supply portion of the jetpack’s fuel would be unstable and likely explode into higher prices, but—perish the thought.

In “answer” to these “dangerous” thoughts, the public is treated to an interesting argument: 1. It will not be necessary to raise taxes if the Federal Reserve “cooperates” and doesn’t, as Kemp put it, “flirt with deflation,” i.e., if the Fed keeps pumping up the money supply. 2. The money supply will not be volatile if there’s enough growth to “absorb” the new money. Hence, one point conveniently supports the other: More money is needed for growth, which will then justify the money supply increases. This argument deserves an economic “Circular Reasoning Award.”

Actually, most economists now accept the view that monetization of debt eventually leads to higher prices. But this does not get to the core of the matter at hand. For what if deficits were entirely financed by borrowing or taxation—i.e., without monetization?

Political Factors

This question forces us to refocus on a broader context, to include in our economic view at least some of the major machinations of modern politics. Politics is inextricably intertwined with any economy and the nature of political favor-brokering is inextricably intertwined with a full understanding of the connection between deficits and higher prices.

Without getting into the “I’m honestly coercive” arguments from the morally smug advocates of “open]y” higher taxes, let’s move on to those advocates who believe that if deficits are financed out of existing supplies of money, inflation (by which they mean rising prices) cannot rear its ugly head to strike at America’s pocketbook. In other words, if the Fed does not add greater quantities of money to the economy and the government only borrows or taxes to meet its overspending, there is no “inflationary impact.”

How would this work?

The borrowing portion of the argument holds that those who lend to the government would have lent the money to someone anyway; whoever gets the borrowed money will in some fashion spend it.

For example: if a savings and loan is lent money, the firm relends the money to a homebuyer, who then spends the money in the housing market; if a car manufacturer is lent the money—perhaps by sale to the public of corporate bonds—the company uses the money to purchase what it needs to make automobiles.

So, what’s the difference if the government is lent the money—through sale of Treasury bills, notes, or bonds? Doesn’t the government then turn around and spend the money just as the savings and loan or car company would? Isn’t this just a “macro-economic” reshuffling of the cards?

No, it is not. But the argument rests on an interesting premise—out of the same epistemological grab bag that so reliably gives us levitation, clairvoyance, and mental spoon bending. The premise is that government can, in theory, reliably spend money for purposes which are productive, for instance, delivery of mail, road maintenance, dam construction, courts of law, police, and so on.

Marking the Deck in Favor of Government

But despite the theory, often motivated by desperate binges of Rooseveltian political nostalgia (i.e., of how Roosevelt “pulled us out of the Depression,” which he did not), most government money in fact goes into nonproductive—or at best, far less productive fields—than does money which is left in the private economy. And this is an important clue to discovering the deficit connection to higher prices. This is where we begin to get involved in political machinations. Increased lending to government is not a question of reshuffling the economic deck, but of marking the deck in favor of government growth.

(Incidentally, Roosevelt knew of the unproductiveness of government spending, but he was the “Great Communicator” of the emerging Keynesian liberals and successfully exploited a combination of public ignorance about economics and disguised appeals to something for nothing in order to shift blame from government to the bleeding and battered remnants of 1930′s business, thus terribly prolonging, rather than relieving, the Great Depression.)

The reason most government-directed money tends to end up in unproductive ventures is precisely because it is politicized money, money governed mainly by the whims of politicians rather than by the judgments of markets. In most of today’s studious tomes of economic analysis, this fact is at best given token treatment. (To his great credit, Milton Friedman gave the subject prominent, if incomplete, treatment in Tyranny of the Status Quo.)

Not only does government lack the foresight and standards by which to rationally prejudge what is or is not productive (the most fundamental practical reason for having free markets), but no matter how it acquires its money, government does not really have to suffer failure in the marketplace.

Witness the Postal Service, which has historically been a money-losing operation, and yet grows larger and continues to require government subsidies or abnormal price hikes for its services year after year. As of this writing, the postal primates are engaging in a new round of typical government monkey business, demanding a 23-cent first-class stamp as well as steeper rate hikes for some other classes of mail. If the Postal Service were truly private, investors and users would long ago have relegated it to the marketplace junkyard.

Even worse, look at the various “entitlement” programs. The agencies which disburse money for all manner of purposes, ranging from medical care to food stamps, have conspicuously limited connections to the marketplace. For instance, as economist Alan Greenspan noted in a column (WSJ, 4 September, 1984), Medicare and Medicaid operate under hundreds of price controls—controls which virtually divorce consumers of medical services from true medical costs.

The Ticket to Success

Modern political history shows that regardless of the money it squanders, if an agency is popular with politicians, it will survive—and grow. The prevailing, though seldom admitted, standard of what is good becomes what is approved; what is good becomes what those in power say is good; a pat on the head from a politician becomes more precious than profits, more prized than prices; politics, not markets, become the agency’s “ticket to success.”

When one discounts expenses for the legitimate government functions of defense and courts of law, all the rest, a majority, amounts to redistributing purely politicized money, coercively gathered from millions of individuals, to special interests selected by the favoritism of those in power.

Despite decades of glorious campaign rhetoric from both major parties to the contrary, government continues to grow and now comprises about one-quarter of the total economy (GNP), up from about one-fifth just four years ago.

As men ranging from Bastiat to Smith to Mises to Hazlitt have illustrated, it is a political rule of thumb that regardless of how it gets it, the more government gets to spend the more it becomes accustomed to spending.

I admit it is hardly an attractive analogy, but government’s appetite is much the same as that of a growing pig; the more you feed it, the bigger it grows and the more food it demands. And remember that it doesn’t matter at all to the pig’s metabolism how you went about getting the food; the animal will grow just as well on borrowed food as it will on food gathered by “legitimate” means.

Just as increased taxes lead to increased inflation and expand the government’s appetite, so does a bor-rowing-financed deficit. Each year of deficit spending accustoms politicians to a new, higher level of spending—spending to redistribute to powerful supporters, whom the politicians hope will constitute a grateful voting majority.

Given the outlandish modern political appetite, taxes, inflation, and borrowing reinforce each other. When one becomes insufficient, politicians switch to another.

This is precisely why we see so many demands for “standby” (higher) taxes and why Ronald Reagan—with ample Congressional “encouragement”—signed several tax increase measures in the three years after signing into law near the beginning of his administration a personal income tax reduction.

As sad and disgusting as it may be, in good times or bad times for the citizenry as a whole, politicians want only good times for themselves. This is why no matter how badly the economy is doing, the politicians refuse to cut overall government spending. They make cuts in some programs, but others increase; they accept a change of diet, but squeal in protest at a reduction of diet.

The Inflation Tax

When the economy slips into recession, and people are not able to lend the government enough to take care of deficit spending, the government resorts to increased taxation or inflation.

Of course, higher taxes are extremely unpopular during recessions, so inflation commonly be comes the answer to deficit financing. But because the effects of inflation are usually not seriously felt for about two years after it begins, higher prices are put off to times of prosperity. During such times, because people are at least temporarily better off, they are more generous—including toward government; therefore, it is during economic recoveries that taxes are normally raised and fresh borrowing is begun, firing up government’s share of economic activity to an accelerated, higher level.

Eventually, exploding prices and an updraft of taxation create a mushroom cloud of malinvestment and the deadly economic fallout begins to mutate and kill healthy growth—and recession returns. This gloomy scenario always comes about when government takes more money from the private sector.

Perversely, as we had during the early 1980s, the new round of recession usually occurs as prices are still rising. Price increases may slow, but in a fiat-money economy, even during recession, prices seldom actually decrease. In modern vernacular, we get “disinflation” but not general “deflation.”

Almost any form of financing government’s deficit-growth provides more incentive for government to expand—and that expansion leads to inflation. Deficit-borrowing thus becomes just one of several forms of government financing leading to inflation.

In sum then, always it is into the process of steadily increased political confiscation of wealth that the question of borrowing-financed deficits must be figured. Financing deficits through borrowing is not a contextless phenomenon. To return to my earlier analogy, borrowing to fi nance deficits is a time-tested way of making Government-the-Porker fatter and increasing its appetite.

How to regain control and put the porker on a diet is really another subject—outside the scope of this essay. But until our profligate politicians awaken to the dangers of def-icits-no matter how financed—a provocative bumper sticker might be: IF YOU LOVE DEFICITS—OINK!

  • Mr. Ross is an Oregon commentator and writer especially concerned with new developments in human freedom.