Do We Need to Worry about the Deficit?

Like governments around the world, both our provincial and federal governments are beginning to run substantial deficits. Some people are very concerned about that. They say that we are mortgaging our children's future for temporary gain.

Under normal circumstances, I would be as concerned as anybody about these deficits. But most economists regard them as necessary, and I agree.

Other small recessions we have seen over the past decades have been dealt with by the central banks of various countries.

These institutions are responsible for managing the country's money supply. They are allowed to create money, just by declaring that it now exists. Normally, if they think that demand has fallen below the capacity of the economy, they use newly created money to buy government bonds from private investors.

This reduces interest rates, encouraging people to buy houses and cars, and helping businesses to invest. Soon, demand is back up to the point where people can find enough work.

The problem is that, in a very deep recession, this mechanism stops working, because the interest rate on these government bonds becomes effectively zero and can't go any lower. We need another plan.

One possibility is for the government to run a deficit, either by cutting taxes or increasing spending.

If the government runs a deficit, where does the borrowed money come from? Initially, the government will sell bonds to private investors – quite possibly including the people who run your pension plan or mutual fund.

If the story ended there, it would not help much. Large government borrowing would drive up interest rates, which would reduce the incentive for people to invest in cars or houses or factory equipment. This would tend to cancel out the stimulating effect of government spending or tax cuts.

But the central bank is not going to let that happen. It is going to keep the interest rate down through purchasing government bonds using newly created money. So the net effect is that the government owes its own central bank the money it has borrowed to stimulate the economy.

That doesn't seem like much of a problem. So where's the catch? The catch comes if the stimulus works and the financial system starts lending again. We could then find that there is too much money in the economy.

Increasing the money supply expands the economy if it is under capacity, but if we try to push it past the maximum it can produce, we will only create inflation. To prevent inflation, the central bank may sell off some of those government bonds. Then, the government owes the debt accumulated during the recession to private investors again.

Does this mean we have mortgaged our children's future? Let's get one thing straight. We cannot reach into the future, borrow our children's cars and houses away from them, and bring them into the present, however much we might like to do that.

All we can do is create an obligation for future taxpayers to pay those who, in the future, have retirement plans and other forms of saving. Those will often be the same people.

So would it be responsible to just let the deficit grow, even if we don't have a major recession? No. For one thing, if borrowings become too great, we might wind up owing foreigners too much.

It is arguable that the U.S. is now in such a position, with the vast amounts it owes to China and other countries. Owing too much creates the possibility of instability, if people ever start getting nervous about your ability to pay.

In this way, though, Canada is in a much better position because of past prudent practices. Government debt is low. We can afford to spend our way out of this recession.

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