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How does the federal deficit affect me?

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Q: I’m a college student and am confused about something. How exactly does the federal budget deficit affect me as a civilian just try to live my life and pay my bills?
— Sara Jasnow, Smithtown, N.Y.

A: You have every reason to be confused. There’s been an awful lot of hand wringing and doomsday predictions about the swelling federal budget deficit — despite very little agreement among economists about whether there’s really any reason to worry. Even those who are worried are a little fuzzy on just why.

The conventional argument against federal budget deficits is that they raise interest rates and “crowd out” other borrowing, which, in turn, makes it more difficult for the U.S. economy to grow. Here’s (in theory, anyway) how:

Say you decide to start a business when you graduate from school, and you need to borrow money to get it started. If your friends and family have put their savings in all those Treasury bills sold by the government to pay for the deficit, there’s less money lying around to invest, so you’ll have to pay someone a higher rate to get them to lend you money. That higher interest rate cuts into your profits, making it harder for your new business to survive and grow. (Even if you don’t plan to start a business, the job you’ll be looking for when you graduate could depend on some other business borrowing money to expand, create a new job and hire you.)

But it turns out the real U.S. economy hasn’t studied economics. Since 2000, the budget surplus has flipped over to huge deficits (no one’s really even sure just how big they are) mostly due to big tax cuts and increased spending on the Iraq war. Meanwhile, interest rates have actually fallen during that period. (The reasons for that are even more confusing, but if you want to dive into that question, check out this excellent paper by Sylvain Leduc at the Philadelphia Fed. He concludes that rates only rise if people are worried about future deficits)

So if the current budget deficit hasn’t raised interest rates and it doesn’t seem to be hurting the economy, why are some people — including Fed Chairman Greenspan, who knows a thing or two about economics  — warning that deficits are so bad? The answer is that deficits may rise and fall, but they can’t keep rising forever. So, as Greenspan warned this summer, things may be OK for now, but he’s worried about looming Social Security and Medicare costs from the “inevitable retirement of baby boomers starting in 2008 and beginning to accelerate in 2011 and 2012.” In other words, you may be able to carry your credit card balance OK today, but if you think you’re going to need to buy a new car tomorrow, you’ve got a problem.

It’s also important to look at where the money is coming from to pay for the federal budget deficit. If Uncle Sam borrows from you and me, and we buy Treasury bills with savings from our paychecks, that’s not such a bad thing. The interest we earn on those T-bills goes back into the economy and keeps it growing. And eventually we can cash in our T-bills and buy more stuff.

But what’s happening now is that more and more of those T-bills are being bought by people outside the U.S. — who are making more and more of the stuff we buy. That means 1.) Americans aren’t saving as much as they used to and 2.) we’re basically financing our appetite for imports with debt held by foreigners. In other words, the American economy is running up its credit card with money borrowed from the rest of the world.

That’s OK for now: much of the money foreigners lend to us goes right back to their economies when we buy stuff made somewhere else. So they like to keep lending, and we like to keep borrowing. But the trend is not sustainable. It could take decades, but sooner or later Americans will have to 1.) pay cash for what we buy from abroad and 2.) pay back all those foreigners who lent us money.

If that happens gradually, there’s no reason to think it will hurt the U.S. economy. But if the process happens too quickly — if for example, the dollar plunges and foreigners decide they’re not that interested in buying T-bills any more — that wouldn’t be good. A rapidly falling dollar could spark inflation (because you have to use more dollars to buy the same German car or Asian-made cell phone.) And the solution to inflation is higher interest rates. Which, once again, makes it harder for you to open up that new business or find one that’s hiring.