“Deficits don’t matter,” except when they do. Congress and the Biden administration are in one of their periodic fights about lifting the debt limit, with threats about “defaulting” on the debt. The Constitution requires that the government pay all of its legal debts (that is, principal and interest to bondholders) but not necessarily the expenses of running the government, including defense and welfare. Tax revenue greatly exceeds required debt payments, so there is almost no chance that the government will default because bondholders are first in line.

The framers of the Constitution wrote that Congress has the power “to coin money, [and] regulate the value thereof,” and “No state shall … make anything but gold and silver coin a tender in payment of debts.” Before 1933, citizens could demand gold and silver in exchange for government bonds and banknotes. President Franklin Roosevelt refused to redeem the bonds in gold coin, offering only paper currency instead. His actions were upheld by the courts, thus paving the way to unending inflation. In 1971, President Richard Nixon “suspended” the promise to foreign governments to redeem dollars they had for gold, effectively ending a formal tie to gold. If the government reduces the value of the currency through inflation, it is, in effect, defaulting (but not legally, according to the courts) on its promise to pay bond and currency holders what they thought they were buying.

The government can run modest (i.e., smaller than the rate of growth of the economy) deficits forever without resorting to inflationary practices, but that is not the current situation. When the government spends more each year than it receives in revenue (taxes and fees), it makes up the difference by issuing bonds. The bonds are auctioned off to big banks, which in turn may sell them to the Federal Reserve, other government agencies, foreign governments, various private institutions and individual investors.

If the Fed wishes to hold down interest rates and increase the money supply to spur economic growth, it can buy many bonds from the banks in exchange for Federal Reserve notes (money), which in turn encourages the banks to lend more to private customers. After a lag, much of this added money growth usually results in higher prices, aka inflation. At the beginning of the pandemic, the Fed greatly increased the money supply — by about 40% — to offset the increased government spending and government-mandated lockdowns (which reduced supply), causing the current inflation.

If the government continues to run big deficits, as it is currently doing, and if the Fed stops buying many of the newly issued Treasury bonds, private parties or foreign governments will buy them (because of the increased interest rates). If private parties buy more government debt, they will do so by reducing their intended savings and investment (productive capital formation) and consumption, thus slowing economic growth and job creation.

As noted in the opening line, deficits don’t matter, except if the accumulated debt keeps increasing as a share of gross domestic product — causing a real increase in the size of debt payments as both a share of government spending and as a share of GDP. At some point, the deficit spending begins to spiral out of control, ending up in both inflation and negative economic growth.

Debt reaching 100% or so of GDP is problematic — and that is where the U.S. now finds itself (123% of GDP, up from about 49% at the end of the Reagan administration). There are many real-world examples of unsustainable debt burdens. The Greek debt burden is about 200% of GDP, and their real incomes are now about 40% lower than they were 15 years ago. The Italian debt burden is about 150% of GDP, and real incomes have dropped about 20% in the past 15 years.

Most official and private forecasters are projecting a continued and rapid increase in the U.S. debt burden, causing it to rise from 180% to 220% of GDP in the next 25 years (without a major war or other catastrophes). This will almost certainly cause a major decline in real per-capita incomes, the beginnings of which are now occurring. The responsible thing to do would be to reduce government spending, but approximately two-thirds of spending goes for Social Security and Medicare/Medicaid payments — and most politicians are in denial about making the necessary changes.

Knowing that the government fiat currency will almost certainly be debased at a more rapid rate, prudent people will seek out ways of preserving wealth through real estate ownership, acquiring gold and silver, and financially liquid forms of base metals such as copper and aluminum that will retain long-run value and can serve as money substitutes.

The good news is that when the government fails to provide sound money, it is perfectly legal and proper for private parties to agree on forms of payment for goods and services, whether barter, use of foreign currencies, metals or other commodities, etc., and such contracts are enforceable in the courts.

So, do not despair. When government fails, private entrepreneurs will emerge to fill the void. Inflation will have destroyed the value of the government debt, and a new government can emerge with a clean slate, as we saw in many of the former communist countries.

• Richard W. Rahn is chairman of the Institute for Global Economic Growth and MCon LLC.


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