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Making sense of deficit, national debt and inflation

At the dawn of February 2022, the US national debt climbed above $30 trillion, a figure 25 times the value of all US currency in circulation. At the same time, inflation reached levels not seen in nearly 40 years. The situation has been worsened by the recent war in Ukraine.

While some inflation was inevitable as the economy recovers from its pandemic, the current rate has set off economic alarm bells. With many Americans already feeling the brunt of price hikes, and looking for trusted professionals to answer clients, be it losses, debt, inflation, and what the Federal Reserve can and can’t help. Well, now is a good time to take a deeper look at it.

Federal government budget deficit and national debt

Some commentators have mistakenly referred to the “$30 trillion deficit”, adding to the long-standing confusion between deficit and debt. a government deficit Occurs in a year when expenses exceed revenues. If the federal government takes in $750 billion in taxes during a particular year but spends $925 billion on programs, the US Treasury has a deficit of $175 billion for that year.

National loanOn the other hand, measures the cumulative effect of losses over time. Let’s say, for example, that the US starts a decade without any national debt. Throughout the decade, the federal government runs an average annual deficit of $150 billion. Every year, the government meets its obligation to pay interest on the borrowed funds, but does not pay any principal. The end result is a national debt of $150 billion X 10 = $1.5 trillion.

The last time the federal government had zero debt, Andrew Jackson was sitting in the Oval Office. The current $30 trillion national debt represents the end result of 185 years of government borrowing, overseen by 39 different presidents.

Is it true that foreign powers own the US national debt?

Governments need to borrow money to bridge the budget deficit gap. A common belief popularized by many politicians holds that the US government is primarily kept afloat by foreign lenders. However, this claim is more provocative than accurate.

For a number of complex reasons that get to the heart of what money really is, the US Treasury just doesn’t take out loans. Instead, it issues government-backed securities, mostly Treasury bonds (longest maturity), T-bills (shortest maturity), and T-notes (intermediate). These securities are sold for less than their face value, which they receive on maturity. Therefore, the cash amount in a matured bond tends to yield a larger interest payment on the initial investment.

The American public—which includes individuals, trusts, mutual funds, and companies—holds the majority of these securities. Foreign governments, notably China and Japan, have a minority stake, but this fact reflects their own economic strategies more than American desperation. Oddly, agencies within the US government have the same national debt as other nations.

The concept of giving US government money to a US government agency is a bit mind-blowing, but there is logic behind it. Some agencies have revenue streams outside the general federal budget. For example, Social Security taxes (the primary component of FICA taxes) go directly to the Social Security trust fund. The revenue going to the trust currently exceeds annual benefit payments, so the Social Security Administration buys Treasury securities to obtain an investment return on the surplus.

Adding to the complexity, since 2009, the US Federal Reserve has also held some of the securities that make up the national debt. By law, the Fed cannot keep a profit. As a result, when the Fed settles Treasury securities, it surrenders any profits back to the Treasury. The Congress has often taken advantage of this swirling budget circle to make the deficit less visible.

Do deficit and debt really cause inflation?

With both the national debt and inflation rates crossing worrying milestones, politicians and analysts are both quick to add. However, as I discussed in a previous article on Milton Friedman’s Economic Theories, the relationship between deficit, debt and inflation is far from simple.

While ballooning federal deficits and skyrocketing debt have been the norm over the past 35 or more years, inflation has remained largely the same for much of that period. Thus, any claim that rising national debt naturally drives prices upward does not hold water. In fact, Friedman said that the primary driver of inflation is not the state of the federal budget per se, but the overall size of the money supply.

The link between debt and inflation lies in the fact that government spending can increase the amount of money flowing through the economy. For example, stimulus payments released during the pandemic put money directly into consumers’ pockets. People with more money want to buy more goods, and if demand increases during times of tense supply, prices tend to climb faster. Thus, the pandemic created a perfect inflationary storm.

In short, the current bout of inflation has little to do with the total national debt, but likely stems in part from specific, recent deficit spending. Slowing credit growth will not necessarily reduce inflation, but reducing the money supply almost certainly will. The Fed will play a central role in that process.

Monetary Policy and Inflation

Efforts to change the money supply make the US monetary policyOne of the primary tools available to tackle inflation. In sluggish economic times, the Fed seeks to increase the flow of money, a process known as quantitative easing (QE). When an excess of economic activity drives prices upward, the Fed goes the opposite way with quantitative tightening (QT).

Historically, interest rates have been at the heart of monetary policy. Lower rates encourage consumer and business lending, leading to higher spending, which in turn sends more dollars through the economic pipeline. Therefore, interest rate cuts have often acted as a powerful QE tool. Conversely, the Fed may follow QT by raising interest rates. Saving money becomes more attractive than borrowing, so people and businesses snatch money.

Problems with this traditional form of monetary policy arise when interest rate changes will have adverse side effects. In our current economic situation, for example, the need for QT may make a rate increase of some amount unavoidable. However, with many businesses still struggling to recover from the slowdown of the pandemic, borrowing is very difficult, which could hit the national recovery. This concern has prompted many economic experts to turn their attention to the Fed’s balance sheet.

Federal Reserve Balance Sheet and Its Meaning

In recent years, the Fed has become a regular buyer of Treasury securities. This practice has made it possible to inject money into the economy at a time when interest rates were already at historic lows. Holding these securities increases the Fed’s balance sheet, which is basically an inventory of assets and liabilities. Currently, this inventory includes more than $2 trillion in Treasury bonds, T-notes and T-bills, as well as trillions more in mortgage-backed securities.

The Fed now proposes to shrink its balance sheet by selling a portion of its Treasury holdings. Given the value of those securities, a sell-off would enable the Fed to liquidate a large amount of currency without a major interest rate bump. In theory, at least, this 21st century QT strategy could control inflation without dragging down the economy as a whole.

For the balance sheet reduction approach to work, there must be an interested buyer for the Fed’s securities. This could mean that more national debt is going into foreign hands. Furthermore, no amount of QT will fix a broken supply chain, which almost all experts see as an important step in bringing inflation under control.

Why the Federal Reserve Can’t Reduce the National Debt

The swirling debates about deficits, debt and inflation fuel misconceptions about what the Federal Reserve’s action can achieve. In particular, some reports have incorrectly described shrinking the Fed’s balance sheet as a way to reduce the national debt.

In fact, reducing the Fed’s balance sheet and other QT strategies is anti-inflation Measures, not anti-debt measures. For one thing, the Fed has less than 10% of the national debt. More importantly, selling those securities would not change the national debt even a penny; This will simply transfer the ownership of the loan.

So, while QT actions may hold great promise for easing current inflationary growth, we cannot look to the Fed for help with loans. Only Congress can resolve this issue, and any realistic approach involves difficult choices.

How We Can Actually Pay Off the US Federal Debt

Ultimately, the only way to reduce the national debt is the same way individuals get themselves out of financial trouble: by paying off the principal. And the only entity that has the power to do so is the one that controls our national purse strings, namely the Congress.

Deficit spending requires additional borrowing, making payment of principal impossible. Therefore, Congress would first need to create an annual budget with more revenue than it spent. The Treasury could then use each year’s surplus to buy back securities without issuing new ones.

Unfortunately, historically the only strategy that has been effective in turning deficit into surplus has not gained much popular appeal. Bottom line, the government should increase revenue, reduce spending, or both. Voters often express support for spending cuts, yet their support quickly evaporates when the cuts affect a program they hope to one day benefit from.

Similarly, raising taxes would increase immediate revenue, but citizens are not quite ready to contribute more to the federal treasury. More importantly, by reducing disposable income, tax increases could ultimately overwhelm the economy, resulting in lower wages and Less federal revenue over the long term.

Still, any credible debt reduction plan will necessarily involve some combination of austerity measures and targeted tax hikes. Economists have suggested some methods to reduce the bite of these functions.

Conclusion: An unknown frontier and an uncertain future

Almost all experts agree that the current level of inflation in the US is unstable and should be brought under control soon. Conversely, opinions differ widely as to whether the rising national debt actually poses an imminent economic threat. Historically, many economists saw 77% of annual GDP as the clear cutoff line for debt stability. He believed that debt above that level would inevitably spiral out of control, crushing the country’s economy for decades.

By that standard, the US should be in real trouble, as our $30 trillion debt is more than 130% of the country’s current GDP. The fact that the US is doing quite well, all things considered, has made many analysts reconsider conventional wisdom. The researchers arrived at the figure of 77% mainly by studying the often tragic fate of developing countries whose currencies do not have the global influence of the US dollar. Meanwhile, Japan’s debt sits at over 200% of GDP, and no one sees the Land of the Rising Sun as a place of economic ruin.

The truth is, we don’t know how high the national debt is, and that kind of uncertainty is inherently uncomfortable. By the time we get to know the actual extent of the debt, the country would have passed a point without any economic gains.

In any event, linking current inflation with the long-term problem of increasing government debt will not help either issue.

This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.

Harvey Bezozzi is a CPA and CFP, More information can be found here

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