When the economy is in a severe slump, there is plenty of excess capacity and unemployed workers, and therefore little basis for concern that a deficit is creating more demand than the economy can supply. However, near the peak of a business cycle, when the unemployment rate is already low, a large budget deficit can create demand that the economy is unable to meet.
The consequences of excessive demand are hard to know at this point. One possible consequence is that the Federal Reserve Board decides to raise interest rates. This will reduce demand by reducing housing construction and to a lesser extent lowering public and private investment. It also is likely to raise the value of the dollar, which leads to a larger trade deficit, which will also lower demand.
But suppose the Fed doesn't raise the rate. Fed Chair Jay Powell indicated that he plans to keep short-term rates near zero for the immediate future. In the old days, we would have thought that would create serious problems with inflation, but that is less clear now.
First, the economy is far more internationalized, which means that is easier for excess demand in the United States to simply spill over to increased demand for imports, rather than driving up domestic prices. This is pretty much the story that we see if a single state has very strong demand.
If Ohio were to have a booming economy, it would mostly translate into higher demand for a wide range of goods and services from neighboring states, not an inflationary spiral in Ohio. This is likely to be the case with any excess demand that results from large budget deficits here.
The other major difference between the economy of today and the economy of the 1970s, the last time we saw an inflationary spiral, is that unions are much weaker today. This means workers have far less bargaining power.
While this is a big part of the story of the growth of wage inequality over the last four decades, it does mean that we are less likely to see the sort of wage-price spiral we saw in the 1970s. If we do see a rise in prices due to excess demand, it is likely that workers today will be able to respond by demanding higher wages.
For these reasons, whether or not the large budget deficits that we are now seeing will lead to problems with inflation is an open question. I have argued that it is worth pressing the economy to try to get back to full employment quickly, as well as do many of the positive things included in the American Recovery Act, such as increasing the child tax credit and enhancing the subsidies in the health care exchanges. But there is a real basis for concern about inflation.
The Debt Is Not a Measure of Anything
While deficits are potentially a problem, the debt is not, first and foremost because it doesn't really measure anything. The debt whiners are fond of telling stories about how the debt is a burden on our children, or how the debt can lead to financial crisis and other bad things, but these claims are inventions, not economic realities.
Interest that we pay on the debt can be a burden, but it is dwarfed by other factors like productivity growth. (The impact of 10 years of even modest productivity growth swamps an increment to debt service that we pass onto to our kids from higher deficits today.) Furthermore, debt service burdens at present and the near-term future will almost certainly be much smaller than what we saw in the 1990s.
But there is another aspect to this story that our debt whiners desperately do not want anyone to talk about. Direct spending is only one way in which the government pays for things. We also pay for things, like coronavirus vaccines, by giving out patents or copyright monopolies.
These monopolies can be very costly. In the case of the coronavirus vaccines, they mean that we are paying roughly ten10 times as much for each vaccine as we would in a free market. Vaccines that would likely cost around $2 a shot instead cost us $20. And, they may cost us even more in future years if we need boosters after the pandemic is over.
These government-granted monopolies are effectively a form of government debt. Incredibly, I have literally never seen any of the debt whiners ever mention the hundreds of billions of dollars in rents paid out each year to drug companies, medical equipment suppliers, software companies, or other beneficiaries of these monopolies as part of the burden of the debt. This in spite of the fact that the rents from these monopolies are several times larger than the debt service that we pay out on the official debt.
But let's flip the story over in the hope of teaching something to the debt whiners. Suppose that we looked to replace much or all of the debt that troubles them with new patent monopolies. Imagine that we sold off trillions of dollars worth of patent monopolies to pay off a large chunk of the debt.
If this sounds strange it is important to step back for a second and think of the logic of a patent or a copyright monopoly. While we ostensibly link the award of these monopolies to innovation or creative work, there is no necessary link.
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