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Do Federal Budget Deficits Matter? Thumbnail

Do Federal Budget Deficits Matter?

We know at the household level, if we engage in “deficit spending,” that bill will eventually come due and we have to pay it. But at the government level, there are a group of economists who have developed a framework for thinking about how government spending and taxation works. And they argue that the government “budget” is much different than a “household” budget. In particular, they suggest the United States may not have to worry about running trillion-dollar annual deficits.

These economists are challenging some of our long-held ideas about federal debt. Their framework, dubbed Modern Monetary Theory (MMT), says we need to stop thinking about the government like it's a business or household that should balance its books at the end of the month. According to MMT, federal debt can be a good thing -- particularly when an influx of cash could provide some relief during a major global crisis.

MMT defined.

That the United States issues its own currency might not seem very remarkable ... until you realize that you can't say the same about any country in the entire European Union.

Add in the fact that the U.S. dollar is still the world's reserve currency (i.e., other countries rely on the U.S. dollar as an international medium of exchange) and MMT argues that Uncle Sam can actually afford to be in the red. Rather than letting the Federal Reserve have so much sway over our nation's economic policy, MMT would free Congress to take a more proactive role in spending first and taxing later. As the theory goes, since our government can always print more money, it shouldn't worry so much about raising taxes in order to pay for essential expenses -- like, say, PPP loans to struggling business owners or another round of Covid-19 tax rebate checks. MMT doesn't consider taxes as a means to generate revenue, but rather as a means to encourage use of the federal currency and to minimize inflation.

The people's surplus.

If you think back to the mid-1990s, you may remember that many folks across the political spectrum were excited that the Clinton Administration balanced the federal budget and even built up a surplus. But, according to MMT, government surpluses are not necessarily good. When our government runs an annual surplus, it means the government took more money out of the economy in the form of taxes than it spent in the form of services and benefits. If the government pulls too much money out of the economy, it might restrict the economy’s ability to grow because households have less money to spend.

According to MMT, it would be better if the government had just injected that surplus money into the economy in the first place to keep people's purchasing power up. Rather than worrying about deficit levels, MMT suggests that inflation should be the key metric governments use to determine when it's time to slow spending. In other words, if inflation is under control, don’t worry about deficits. If inflation starts getting worrisome, then raise taxes to pull money out of the economy and slow things down to get inflation under control.

Crowding out business owners.

2020 has provided something of a case study for how MMT could work. While the CARES Act and other stimulus programs did stabilize the economy during the early days of the pandemic, some folks worry about what's going to happen when the bills come due. The MMT response would be, "Don't worry about it. Spend now, and tax later when inflation gets too high."

Looking through the very narrow window of the last six months or so, you can see why MMT has become more popular. Our federal deficit is now running in the trillions. However, the economy is bouncing back, the markets are doing reasonably well again, inflation is under control, and interest rates haven’t spiked.

I'm simplifying MMT a bit here, but I also think that MMT can oversimplify the benefits of government spending. Generally, yes, it's good that the government can give the economy a shot in the arm when necessary. But when government spending goes up, eventually interest rates do as well (unless the Federal Reserve “controls” them through asset purchases). That can make it difficult for businesses to obtain cost efficient loans, which discourages companies from starting innovative new projects, expanding, or hiring more workers.

I also have some problems with MMT's insistence that paying the bills isn't all that important. The threat of having to raise taxes to “pay for” some new federal benefit acts as a check on potentially reckless use of the federal treasury by politicians who just want to get reelected. If deficits didn’t matter at the federal level, there would be a strong temptation to just keep giving people “free” money beyond the point of its benefit and eventually, inflation would come roaring back. And we saw back in the late 1970s/early 1980s how devasting high inflation can be.

Have a plan, not a theory. 

The key word in the phrase "Modern Monetary Theory" is "theory." It's an interesting idea, but it's still just an idea, not a matter of public policy. No matter what happens in the election next month, our current system of taxing and spending is going to continue, with an assist from the Federal Reserve as needed.

But MMT and competing economic theories are another example of the wealth of tools our country has at its disposal to keep our economy working. We may not always agree on how hard to pull various levers, but the levers are there. And if you have a comprehensive financial plan in place, you’ll be able to make even more personal adjustments that will keep you and your family moving towards your ultimate financial goals.

About Bill

Bill Keen is a CHARTERED RETIREMENT PLANNING COUNSELOR℠ and independent financial advisor with more than 25 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he specializes in providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.

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