Does The Deficit Really Matter?

The U.S. national deficit marked up some interesting news coverage these last few months. First up, was news at the total national debt hit $18 trillion earlier this year. Then, seemingly different news when a May report showed that the U.S. ran its largest budget surplus in seven years during April. What does all of this deficit stuff mean, and does the national debt really matter? (The government often runs a surplus in April; it’s when the majority of U.S. taxes are collected, so it is a larger than normal inflow of funds.)

The Deficit vs The National Debt

It is important to understand some terminology. First, the national debt, is the total amount owed by the United States government. Contrary to popular belief this debt is not owed “to China” or to any other government. Rather, the debt exists in the form of Treasury Bills, Notes, and Bonds (including those U.S. Savings Bonds your grandmother gave you). These all trade as securities on the open market. The Chinese government is free to buy them if it wants, and so are you, and anyone else. Owning these securities entitles you to an interest payment and the repayment of principal on a predetermined schedule. Neither you, nor China, gets any additional rights, no matter how much you own.

The deficit is the amount of money the government takes in, minus the amount of money it pays out. You can measure this over any number of time frames. It is popular to report an annual deficit number. So, the 2015 deficit would be all the money received by the federal government during 2015, minus all of the money paid out.

This number is always negative, unless the U.S. economy is growing strongly and tax revenues are up. This is what happened during part of the Clinton Presidency when the U.S. ran an annual budget surplus, fueled, ironically, by the Internet Bubble of the late 1990s.

So, does the deficit and national debt actually matter?

The answer, is not really, kind of, sort of, and it depends.

First, if you are thinking that someone proved that higher deficits impact the economy negatively, you are kind of correct. However, that paper has since been disproved as it turns out the math relied on for the conclusion was incorrect. In other words, there is no yes, or no on how a large deficit affects the economy.

If you are thinking of comparing the U.S. to Greece, that isn’t accurate either. The problem with Greece is that its economy is separate from Europe’s, but its currency is not. This is not an issue for the United States.

So, what is the actual problem for U.S. deficits?

The real issues come in the form of interest rates and inflation. Assuming the government ran out of people and investors willing to buy Treasury Bonds, it would have to pay higher interest rates. In fact, whenever the government needs to borrow more money, it holds an auction to sell bonds. This sets the interest rates.

However, even though the debt is higher than it has ever been, interest rates are very low. The reason, is the U.S. economy.

Ironically, inflation is low for the same reason. The U.S. economy is not generating higher wages, or greater employment, so inflation is not rising either.

In other words, the economy has much more of an affect on the deficit than the deficit has on the economy.

Theoretically, there would come a point where this would no longer be the case. The catch here, is inflation. As low as inflation is right now, it does exist, and 30 years from now, 18 trillion won’t be worth what 18 trillion is today. In other words, a lot of the debt we have now is getting smaller just by existing longer. As long as the national debt doesn’t outpace actual inflation, nothing really happens except politicians get to excitedly proclaim that they can “fix” the debt.

For long-term investors, and for your own personal financial planning purposes, the debt is a non-issue.