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Q: What are the effects of the federal deficit on the American economy? ( Answered 5 out of 5 stars,   2 Comments )
Subject: What are the effects of the federal deficit on the American economy?
Category: Business and Money > Economics
Asked by: debjaz-ga
List Price: $10.00
Posted: 30 Jul 2004 15:10 PDT
Expires: 29 Aug 2004 15:10 PDT
Question ID: 381495
We hear a lot in the main-stream media about how large the current
deficit is, but basically nothing about why the average American
should care about it. How does it affect ME? I'm sure it does, or
eventually will, but I'd really like to have some specific examples or
possible scenarios. Any researchers who are lay economists out there?

I heard something interesting a few months ago while watching PBS,
Frontline I think, about someone's theory that the federal deficit is
affecting the price of gas we're paying at the pumps today. In a
nutshell, it said that the deficit was undermining confidence in the
U.S. stock market, so there was less foreign investment in the market.
As a result, the value of the dollar is lower overseas, which
means that OPEC nations actually have to charge more per barrel of oil
to make up the difference. I'd be curious to hear any thoughts about

Thanks! -- A WannabeInformed voter in Seattle, WA
Subject: Re: What are the effects of the federal deficit on the American economy?
Answered By: mwalcoff-ga on 31 Jul 2004 13:50 PDT
Rated:5 out of 5 stars

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

"? 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

"? 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 []).

Sources: Robert E. Rubin, Peter R. Orszag and Allen Sinai, "Sustained
Budget Deficits," Brookings Institution, Jan. 2004,

Douglas W. Elmendorf and N. Gregory Mankiw, "Government Debt," Federal
Reserve, Jan. 1998,

Steve Schifferes, "Does the US Budget Deficit Matter?" BBC, 2 Feb.

I hope this answer meets your needs. If not, please request clarification.

Search strategy:

budget deficit effect economy

budget deficit national savings

budget deficit dollar confidence

budget deficit capital inflow

federal reserve budget deficit

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!

Clarification of Answer by mwalcoff-ga on 02 Aug 2004 04:58 PDT
Thank you very much for your comment, although I must say that my own
economics background is really not comprehensive enough to provide an
expert opinion.

Some people do draw a link between Reagan-era budget deficits and the
1987 stock market crash. See:

But others disagree. See:

So you could make a case that, as you say, "it is all just theory."
The budget deficit might affect the market, or it might not. There are
no sure things in the stock market. If there were, everyone would know
exactly where stocks prices should be, and investing in the stock
market would be like investing in Treasury bonds!
debjaz-ga rated this answer:5 out of 5 stars and gave an additional tip of: $10.00
Very succinct, well thought out answer. It's great to know this
resource is available, thanks!

Subject: Re: What are the effects of the federal deficit on the American economy?
From: neilzero-ga on 01 Aug 2004 20:40 PDT
The government is doing a balancing act with the defict and debt
including some lies to help keep confidence high. a major disastor
such as a major USA city totaled by an asteroid hit, would likely
produce a confidence loss of major proprortions which would ripple
though the finances of other countries as well as the USA. It could
take decades to recover the present standard of living, and many
marginal employees would be unable to find employment.   Neil
Subject: Re: What are the effects of the federal deficit on the American economy?
From: neilzero-ga on 02 Aug 2004 14:38 PDT
I agree with Mwalcof. Interest rates go up because the government is
bidding against other barrowers for the money available to be loaned.
The stock market goes down, because people sell stocks to buy USA
securities that are paying high interest. Bonds go down because buyers
are looking for yeild to maturity at least as high as treasury notes.
People have large on paper losses which become real if they sell
stocks and bonds. A significant world wide loss of wealth can occur
due to large USA deficits, except for the few investors who guess the
drops in advance and make money by selling short. Typically the short
sellers also loose as they guess wrong.
 The Federal Reserve Bank moderates at least slightly by allowing
member banks to barrow more money than usual, and at an attractive
interest rate. In theory they can loan unlimited money by starting the
printing presses, but this is scarry to investers both at home and
abroad. If investors get too scared they will invest in prescious
metals, works of art and land rather than buying the debt offered by
the USA. Uncle Sam could pay 30% interest on half the money they owe
which could take nearly all of the falling tax receipts. The USA would
then have to defalt on many or most of the contracts outstanding at
the time. The USA could become a third world country in a few days in
worst cases. Nearly everyone almost everywhere will loose big and long
term if the USA collapses to third world status. Please rebut,
embellish or comment.   Neil

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