Deficits Will Matter

Recently by Gary North: Assessing What Ron Paul Has Accomplished

The defenders of supply-side economics have regaled conservatives with this slogan, “deficits don’t matter,” from the late 1970’s until today. As far as I can determine, this was the only idea to come out of the supply-side movement that was ever agreed to by the mainstream Keynesians and Chicago School economists. They all agree: Federal deficits don’t matter. Someday, yes, but not yet. Not now. Don’t worry. Be happy.

According to a recent article by Dr. Brian Riedl of the conservative Heritage Foundation, deficits do matter. They are going to matter a whole lot more over the next decade. They are going to matter to people who are dependent on the Federal government for handouts. That is a large number of people. He writes:

The Office of Management and Budget has released its annual mid-session review that updates the budget projections from this past May. They show that this year, Washington will spend $30,958 per household, tax $17,576 per household, and borrow $13,392 per household.

Think about that. For every American household — about a hundred million — the Federal government will spend $31,000.

Wait a minute. The typical American household makes about $46,000 a year. Are we to believe that the Federal government will spend, in the name of the American people, $31,000 per household? That each household will be taxed — income taxes, Social Security taxes, corporate taxes, etc. — $17,000? That is what the figures say. Dividing $46,000 by $17,000 is 37%. Can that be possible? Add to this another $13,000 in debt. That is what the government’s statistics report. Anyone who thinks an extra $13,000 in household debt doesn’t matter is living in la-la land. This includes economists.

We all know by now that this year’s deficit was expected to be $1.8 trillion. Because the banks aren’t borrowing government bailout money as rapidly as expected, the deficit is expected to be about $1.5 trillion. Officially, the fiscal year ends on September 30.

There is debate between the White House and the Congressional Budget Office about whether the deficit between now and the end of fiscal 2019 will be an extra $9 trillion (White House) or $7 trillion. Let’s compromise: an extra $13 trillion. That’s the way official Federal budget estimates usually are: low-ball.

The assumptions undergirding both sets of estimates assume that Social Security will not go into a deficit until 2017. It is likely that it will go into deficit before the next election, or possibly the year after. A few politicians are admitting this, but they are not getting a hearing. ( Rising unemployment threatens the program’s income from FICA payroll taxes (“contributions”). Meanwhile,

The 22 percent spending increase projected for 2009 represents the largest government expansion since the 1952 height of the Korean War (adjusted for inflation). Federal spending is up 57 percent since 2001.

Bad as Bush was for Federal spending, it’s getting worse, fast. Next year is the final year for the Bush tax cuts. In 2011, the old system will go back into operation. This will be a major tax increase.

Then Medicare spending will rise as a result of Bush’s prescription subsidy bill. This is a permanent fixture of American politics.

Will there be savings? Of course not. Savings and government are antithetical concepts.

President Obama claims that “we have already identified $2 trillion in savings over the next decade.” This is not true. The President first creates a fantasy baseline that assumes the Iraq surge continues forever (which was never U.S. policy) and then “saves” $1.5 trillion against that baseline by ending the surge as scheduled. It is like a family “saving” $10,000 by first assuming an expensive vacation and then not taking it. Another $1 trillion in “savings” is actually tax increases (in other words, savings for government, not taxpayers).

There is now no political escape from an escalating burden of taxation and borrowing.

The assumption of supply-siders, Keynesians, and Chicago School economists is that the economy can grow its way out of any existing Federal debt. It can grow its way out of all future debt presently scheduled. There is no threat to the economy by increased Federal debt.

They are wrong. There is a major threat: the other phenomenon they all deny.


Austrian School economists have long argued that the principle, “you can’t get something for nothing,” applies to capital markets. If the government absorbs a trillion dollars of investors’ money, that money cannot go to the private sector.

The Establishment economists look at past interest rates and conclude that government does not crowd out private investing. Interest rates do not always rise when government borrowing increases.

They substitute statistics for logic. They refuse to accept the principle that money lent to the government cannot simultaneously be lent to the private sector.

Keynesians dismiss the Austrian view. Why? Because they believe that money borrowed by the government will be spent by the government, then by the recipients. This will expand the economy. Theirs is demand-side economics.

Supply-siders dismiss the Austrian view because they believe that government intervention in a time of economic crisis is warranted. They are all Keynesians when a recession hits. They think the government will cut back on spending when the recession ends. Then, once again, deficits won’t matter. But they matter in recessions. They are seen as good. They don’t matter in boom times.

Chicago School economists dismiss deficits if the stock market does not collapse. They believe that the market forecasts accurately. If the market goes up when deficits go up, then, by definition, deficits are good. Things will work out. No problem.

Austrian School economists argue from the logic of scarcity. There are no free lunches. There is no free capital. When an investor buys a government debt certificate, he is deciding against investing in a private firm. He also decides not to lend to a private consumer. The government allocates this money so as to further the government’s agenda. That agenda is clear: to expand the power of the government over the private sector.

Over time, this allocation of capital reduces the productivity of the private sector. The private sector must pay higher interest rates, or offer more profitable opportunities, than the government does. People who want safety buy government debt. People who want to accept risk and uncertainty do not. Over time, those who want safety outbid those who want more risk. Why? Because the amount of capital available to the risk-takers declines compared to the risk-avoiders. Corporate retained earnings become the main source of new capital. But these earnings decline as government regulation increases.

The reality of crowding out is evident to those who pursue the logic of economics, meaning the logic of scarcity. Scarcity is progressively overcome by economic growth. Economic growth depends on these factors: (1) increased thrift per capita; (2) increased capital per capita; (3) increased retained earnings; (4) a lower rate of interest that comes from greater future orientation among investors; (5) a profit-and-loss system that eliminates the inefficient producers/investors.

The expansion of civil government erodes all five factors. (1) Thrift falls when people trust the government for their future income. (2) Capital investment in private ventures falls as the government absorbs invested funds. (3) Retained earnings fall as a result of reduced capital and increased regulation. (4) Interest rates rise because of reduced concern about the government-guaranteed future. Present-orientation increases. (5) The profit-and-loss system fails because the government bails out the biggest, least efficient firms, above all large banks.


We have moved into an era of reduced economic growth. This is the product of the previous five factors, but the one that is most obvious today is the increase in the size of the Federal government’s debt. There is no organized political opposition. There is no sense of urgency. The slogan, “deficits don’t matter,” repeated over and over for a generation, has undercut any sense of concern over the escalating deficits.

The decline of concern has been bipartisan. No national political leader has arisen to make opposition to spending and debt his battle cry. Ron Paul was the one major exception in 2008, but his candidacy was something of a Don Quixote affair. He was not going to win.

In our generation, “deficits don’t matter” has replaced “we owe it to ourselves” as the slogan of preference among defenders of big government. Defenders of limited government have adapted it: “deficits don’t matter this year, because of the recession.” When the recession finally ends, defenders of limited government always find other challenges than deficits. Why? Because they want to make money or else get elected. The phrase, “deficits do matter,” raises a key question: “Which deficits matter most?” We all know the answer: Social Security and Medicare. These are politically untouchable.

So, we are unable to stop the rising tide of Federal debt. It cannot be reversed. The government is debating whether the deficit will be $900 billion a year or a mere $700 billion. Both figures would have been laughed off by both parties as fantasyland scare tactics in August 2008. That is how fast and how far the terms of acceptable political discourse have shifted in just one year: early September 2008 to today.

The Federal government will absorb ever-larger percentages of our productivity. We will find capital ever more expensive in the private sector. Companies will not be able to borrow.

This is already the situation. Look at the chart of bank lending to business. Loans have gone negative — more businesses paying off old loans than other businesses borrowing to expand production.

We are seeing the capital starvation of businesses.

Next, there will be bank failures. These will be smaller banks, of course. The big banks got their bailout. One serious estimate is that 1,000 more banks will go under before this cycle is over. This estimate comes from a man whose firm buys bankrupt banks.

These banks are local banks. They are the source of funding for local businesses that do not have access to large pools of capital.

There are few economists who are predicting rapid and robust economic growth next year. Most have accepted the reality of this recession. It has been a major one. It is not over. Unemployment will rise through next year.

If we take seriously the effects of the crowding out effect of Federal deficits, this recovery could be delayed for years. The government has become a gigantic gullet. I keep thinking of the plant from outer space in “Little Shop of Horrors.” It kept absorbing more blood. It could not be satisfied.


There is nothing on the political horizon that indicates a change in business as usual in Washington. That is because the source of opposition to deficits has been undermined for four decades. The economics profession remains unconcerned at all times about deficits. The investment community favors large deficits, for it knows that big businesses are the prime candidates for bailouts. Investors want to defer until Judgment Day the unwinding of the bubble economy.

When Bernanke, Geithner, and other high officials assure the public that the Federal Reserve will unwind its huge increase in the monetary base, once the economy starts growing again, investors dismiss any suggestion that this proposed unwinding will be a replay on steroids of Bernanke’s mild reduction of growth in the FED’s balance sheet, 2006—2007. That created the worst recession in post-World War II history.

Why does anyone believe that the FED will be able to shrink the monetary base without creating a far worse recession than we have experienced so far? The federal funds rate is barely above zero. Bernanke says it must be kept there for a lengthy period of time. Banks will get used to this state of affairs. Then the FED will allow rates to rise. What then? Steady economic growth? If that were possible, why didn’t we get that in 2008? Why did Bernanke’s slow monetary base growth result in the crash of 2008?

Investors and politicians want to believe in pixie dust. Clap, and Tinker Bell won’t die. Bernanke and Geithner tell us all to clap. The fund managers clap frantically. CONCLUSIONIf we believe the Federal Reserve’s statistics, it has begun to sell off its assets. It is shrinking the monetary base.

On the other hand, if we are to believe the president of the Federal Reserve Bank of New York, the Federal Reserve has been lending the commercial banks’ excess reserves to the government. The FOMC is using the commercial banks’ money to buy T-bonds and Fannie Mae and Freddie Mac bonds. The FED is paying the banks 0.15% for overnight money and is then lending the borrowed money to the Federal government to buy bonds at 2.5% or more.

Third, the Federal Reserve is taking on some interest-rate risk in terms of its balance sheet. The excess reserves have an overnight maturity. These liabilities are being used to purchase longer-term assets. In principle, if short-term interest rates were to move up very sharply, the cost of funding could eventually exceed the return on the Fed’s assets. The bigger our balance sheet, the greater the amount of interest-rate risk we are assuming.

Here is one more reason why the government needs to audit the FED.

This much we know: the Federal deficit is not going to come down to pre-2008 levels in the next decade. Deficits will matter.

September 3, 2009

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North