Hello,
The budget deficit affects the economy in several ways. (I'm not going
to talk about the effects of policies that can create deficits, such
as tax cuts, but only about the deficits themselves.)
Firstly, large government debts often coincide with high interest
rates, which can push governments toward policies that create
inflation. That hits investor confidence and can possibly lead to a
bear market.
Secondly, whenever the national debt grows, so does the percentage of
tax revenue that must go to servicing it. That means less money for
everything else.
Thirdly, budget deficits mean a decline in national savings. That
means less money for investment in new business.
Finally -- and this is the kind of thing you're interested in -- a
budget deficit impacts international investment flows. For example, in
the 1980s, the budget deficit was partly financed with foreign money.
With more people investing in the U.S., the value of the dollar went
up. In turn, people worried that those foreign investors would rapidly
dump their dollar assets, causing a currency shock, but that didn't
quite happen.
However, economists are still concerned about the effect of the budget
deficit on the currency. If foreign investors feel the U.S. government
cannot control its fiscal health, they might shift their investments
to other countries. That would weaken the dollar and could lead to
higher interest rates here.
Former Treasury Secretary Robert E. Rubin and colleagues summarize the
potential effects of the budget deficit on the economy as follows:
"?The increase in interest rates would reduce investment and interest-sensitive
consumption;
"? The inability of the federal government to control the budget
deficit could be interpreted as a broader failure of the nation to
address its economic problems, and thus prompt a loss of business and
consumer confidence, which would undermine capital spending and real
economic activity.
"? A potentially sharp downward movement in the exchange rate could
cause unexpected shifts in input costs and export opportunities across
different sectors, which could cause short-term economic dislocations.
"? The disruptions to financial markets could impede the
intermediation between lenders and borrowers; uncertainty about the
possibility of substantial inflation could cause creditors to eschew
the long end of the credit market except at extremely high real
interest rates. The effect of the decline in asset prices on bank and
other financial intermediaries? balance sheets could exacerbate the
disintermediation.
"? The drop in asset prices and increase in interest rates could also
spark a wave of bankruptcies, which could further restrain real
economic activity.
"? These various effects can feed on each other to create a dangerous
cycle; for example, increased interest rates and diminished economic
activity may further worsen the fiscal imbalance, which can then cause
a further loss of confidence and potentially spark another round of
negative feedback effects."
So how could a big budget deficit affect you? Well, you could
theoretically lose part of your savings, your ability to afford
imports or trips abroad, or even your job or your business. The key
word there is "theoretically." Some economists are not that worried
about the deficit as it now stands. (See, for example, an article on a
speech by the current treasury secretary at HomeBound
Mortgage [http://news.bbc.co.uk/1/hi/business/3430565.stm]).
Sources: Robert E. Rubin, Peter R. Orszag and Allen Sinai, "Sustained
Budget Deficits," Brookings Institution, Jan. 2004,
http://www.brookings.edu/views/papers/orszag/20040105.pdf.
Douglas W. Elmendorf and N. Gregory Mankiw, "Government Debt," Federal
Reserve, Jan. 1998, http://www.federalreserve.gov/pubs/feds/1998/199809/199809pap.pdf
Steve Schifferes, "Does the US Budget Deficit Matter?" BBC, 2 Feb.
2004, http://news.bbc.co.uk/1/hi/business/3430565.stm.
I hope this answer meets your needs. If not, please request clarification.
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Request for Answer Clarification by
debjaz-ga
on
02 Aug 2004 02:38 PDT
This is just the kind of answer I was hoping for, thanks! I'm
wondering if I can get clarification on one point, though:
>Firstly, large government debts often coincide with high interest
>rates, which can push governments toward policies that create
>inflation. That hits investor confidence and can possibly lead to a
>bear market.
I am assuming here that the above is a concern because history has
shown that a bear market in the past had its origins in just this kind
of condition (would the late 80's be a good example?). Or, would it be
more correct that in the end it's basically ALL just theory, and even
this kind of situation cannot be traced to policies that a consensus
of economists would agree caused it?
You obviously have some knowledge of economics, a very brief summary
of your personal opinion would suffice here. The links you've provided
are quite ample for me to continue researching the general topic on my
own, thanks again, great job!
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