Why worry about budget deficits?
Why should we be concerned about continuing federal budget deficits?
The political economic news over the past few weeks has focused on Trump’s “One Big Beautiful Budget Bill.” The legislation is designed to put as much of Trump’s agenda as possible in a single bill that requires only a majority in both Houses to become law. The Congressional Budget Office now projects that the House bill passed in May would increase federal deficits by $2.4 trillion over the next 10 years. Annual budget deficits would grow from $1.9 trillion in 2025 to $2.7 trillion by 2035. The executive-branch Office of Management and Budget claims mandatory savings of $1.7 trillion and $6 trillion smaller budget deficits over the next ten years. However, the OMB fails to consider the bill’s permanent extension of $3.8 trillion in “temporary tax cuts” enacted in 2017 that would otherwise expire later this year.
Democrats claim Republicans are trying to justify continuing tax cuts for the wealthy by cutting health care, food assistance, and other essential services for ordinary people. Texas Democrat Greg Cesar put it, “This is the bill that only really helps the richest Republican donors and leaves all of the voters behind.” If the tax cuts were allowed to expire, there would be no need to cut spending to reduce federal budget deficits.
Some Republicans are concerned that the bill doesn’t cut spending enough to reduce budget deficits. Wisconsin Republican, Ron Johnson, said, "I refuse to accept $2 trillion-plus deficits as far as the eye can see as the new normal. I'm worried about our kids and grandkids, the fact that we're mortgaging their future. It is wrong. It's immoral,"
Budget deficits and the national debt have become flashpoints in political debates. Republicans want to reduce the size of government and cut taxes for individuals and corporations. Democrats want to raise taxes on corporations and wealthy individuals to fund government benefits for low-income and middle-class Americans. Their inability to agree and unwillingness to compromise leave gaps between tax revenues and government spending that inevitably lead to budget deficits and increases in the national debt.
Why should we worry about another ten years of budget deficits? The U.S. has been running budget deficits for the past 25 years. The economy weathered the Great Recession of 2008-2009 and the COVID Pandemic of 2020-2021 and is still growing. From 2010 to 2024, the economy or GDP grew at a rate of 4.6%, including the COVID years. Consumer price inflation averaged only 2.6% during the same period, which included the high inflation rates of 2021 to 2022. So why should we worry about budget deficits?
First, we don’t need to worry about our kids and grandkids having to pay off a $40 trillion national debt. As I have explained in previous posts, Congress could create enough money to pay off the national debt any time it chose to do so. There would be reason for concern about the consequences of putting that much new money in circulation, but not about whether we could pay it off. An offsetting amount of money would need to be removed from circulation elsewhere to avoid inflation somewhere in the economy. However, the debt could be paid off systematically over several years and need not unduly disrupt the economy, as explained below.
Some politicians and economists are more concerned about the interest costs of the national debt than the size of the debt. When interest rates increase, the deficit goes up. Interest claimed about 13% of government spending in 2024, more than for Medicare or national defense. However, 20% of the national debt was intragovernmental debt, meaning the interest was paid to government entities, including the Social Security Trust Fund. The Federal Reserve Banks held another 23% of the debt. The government didn’t start paying interest on FED deposits until the financial crisis of 2008, and could stop doing so at any time. Congress could also create money to pay the interest on the national debt if it chose to do so. The main concern is that interest paid on the national debt has made borrowing an inefficient means of offsetting the federal budget deficit. The government has to borrow seven dollars for every six dollars it spends.
Contrary to popular belief, budget deficits do not cause inflation. The government creates money, or puts new money into circulation, whenever it spends money. However, it takes the same amount of money out of circulation by collecting taxes or borrowing money to offset its spending. For example, tax revenues covered over 70% of total government spending in 2023 and 2024. The government sold government securities or borrowed money to cover the other 30%. Changes in budget deficits from year to year reflect the differences in government spending covered by taxes and borrowing, but the amount of money put into circulation by spending has always been offset by one or the other.
Any increases or decreases in the total money supply result from more or less money loaned by commercial banks, including the small retail banks and credit unions that loan money to individuals. Banks are not limited to loaning out money deposited by their customers. They only need to maintain enough on deposit to cover withdrawals, which typically are a small percentage of total amounts deposited. This is known as “fractional reserve banking.” When banks loan money, they simply create deposits in the borrowers’ accounts. These deposits can be spent as if they were cash. The amount of money the bank has created or put into circulation through lending is the difference between the amount a commercial bank has loaned and the amount it has on deposit.
When borrowers spend money, it is paid to someone else, who typically deposits it in another bank. These new deposits represent new reserves for the recipients’ banks, which are used as reserves for additional rounds of lending, spending, and depositing. When banks reduce their loans relative to their deposits, the process is reversed. Fewer loans mean fewer deposits to use for reserves, and further reductions in loans; less lending, spending, depositing, and less money in circulation.
Even though government deficits don’t increase the money supply, government spending and taxing can cause, or at least accommodate, inflation and deflation in different sectors of the economy. During the COVID pandemic, for example, government spending increased by about 45%, from $5.3 trillion to $7.7 trillion, and has remained above $6 trillion since. Commercial bank deposits also increased by 35% from $13 trillion to $18 trillion. Increases in consumer prices had averaged less than 2% per year before the pandemic, but rose by nearly 5% in 2021 and peaked above 8% in 2022, before dropping back to less than 3% since.
The logical conclusion is that increases in government spending had little, if any, effect on consumer prices before COVID. When COVID disruptions in supply chains restricted the supplies of consumer goods, prices increased, rationing the scarce supplies among those willing and able to pay. When various government stimulus programs put money directly into the hands of individuals and small businesses, more consumers were able to pay the higher prices, which allowed retail prices to rise even higher. Bank loans to those affected by COVID also put more money in circulation. After the supply chain issues were resolved, inflation rates dropped back to less than 3%, but retail prices have remained higher. The government deficits didn’t add to the money supply, but the new money put into circulation by bank loans during the COVID years remains in circulation, supporting higher production costs and keeping consumer prices higher than pre-COVID levels.
Tax policies can also cause or accommodate inflation or deflation in different sectors of the economy. The total money supply, including currency and bank deposits, increased at a rate of 5.9% between 2010 and 2024, adding $30 trillion to the money supply. The GDP increased by 4.6% per year, which also added $30 trillion to the supply of goods and services. It might appear that just enough money was created to accommodate increased production. However, the market value of commercial real estate increased by 80%, or $15 trillion, and residential real estate increased by 100%, or $25 trillion, during the same period. The value of corporate stocks traded on the major exchanges increased by 360% or $36 trillion. Stocks and real estate would have only needed to increase by 50% to keep pace with inflation.
Homes and commercial properties are not 50% more livable or workable than they were in 2010. Corporations are not three times as efficient today as they were 15 years ago. Tax policies during the 2000s left more money in the hands of those who could afford to invest in corporate stocks and real estate relative to those who spent virtually all the money they earned. The FED succeeded in limiting the money supply to keep inflation in consumer prices below 3% and brought unemployment down to 4% after two major recessions. However, the money needed to pay higher prices for corporate stocks and real estate had to come from somewhere. When money borrowed from banks is invested in the stock market or real estate, it is no longer part of the money supply because it can’t be easily converted to cash. However, it takes more money to pay higher prices, regardless of whether it’s real estate or potato chips.
Contrary to common belief, commercial banks aren’t the only financial institutions that create money. Banks often sell loans to other non-bank commercial lenders. For example, homebuyers may get their home loans from a bank but make house payments to a non-bank mortgage company. Non-bank lenders also receive funds from institutional investors, such as pension funds. Non-bank lenders, like banks, can loan more money than they receive from investors or borrow from commercial banks. Non-bank loans account for around 65% of mortgage loans and 40% of paycheck protection loans to small businesses. However, non-bank loans are not considered part of the money supply, and if used to buy stock or real estate, don’t add to the money supply unless sellers of stock or real estate deposit the proceeds in a commercial bank.
Even though the money supply has not increased more than needed to accommodate economic growth and a modest rate of inflation in consumer prices, there has been sufficient money available to fuel inflationary growth in corporate stocks and real estate markets, which increased the wealth of those who were already wealthy. This was a direct effect of U.S. tax policies. Even if all levels and types of income were taxed at the same rate, which they are not, tax cuts would benefit those with the most income the most. In addition, capital gains are taxed at lower rates than ordinary income, which helped fuel the disproportionate accumulation of capital or wealth.
With the national debt approaching $40 trillion, it may at first seem impractical, if not impossible, to pay it off. The total debt wouldn’t need to be paid off because other nations need U.S. dollars to participate in international trade. Government securities are also a safe and convenient means of earning interest on the Social Security Trust Fund. However, the same amount of money put into circulation to accommodate inflated stock and real estate prices would pay off the $40 trillion national debt, with enough left over to allow prices of stock and real estate to keep pace with inflation. The only significant difference is that the government would not remove money from circulation by selling government securities to offset budget deficits and reduce the national debt.
The stimulative impacts of leaving more money in the private sector of the economy would be no different from adding money through commercial bank lending. The FED would need to reduce bank lending enough to maintain a money supply consistent with acceptable levels of inflation and employment. The FED would not need to increase interest rates to discourage increased bank loans, but only keep interest rates and other deterrents high enough to prevent banks and non-bank lenders from increasing loans by using deposits for reserves that would normally have been invested in government securities.
There is no reason for the FED to keep the interest rate charged to member banks near 0% to fund further speculative investments, as it did from 2008 to 2015. The FED might need to reinstate and extend reserve requirements to non-bank lenders as a deterrent to lending for speculative investments in stocks and real estate. Capital gains could also be taxed the same as ordinary income, and taxes could be charged on stock market transactions to prevent speculative investments from “crowding out” investments that increase production, employment, and incomes.
Regardless of the strategy, the FED was able to maintain a stable money supply while nearly $40 trillion was used to inflate stocks and real estate prices. It should be able to do likewise while the government creates money to cover budget deficits and pay down the national debt. Once the debt is paid down, the same process could be used for other government spending. The government could replace Amtrak with a high-speed rail system, transition the U.S electrical grid network to renewable energy, and do other things best done collectively, through government, without increasing the national debt.
The primary reason to be concerned about federal budget deficits is that they reflect an inability to reach a consensus and an unwillingness to compromise on how much to spend collectively, through government, and how much to spend individually. Arguments that we must cut government spending to balance the budget or pay off the national debt are a political tactic to convince people to support unnecessary cuts in government spending on social programs. Arguments that we need to tax the rich to balance the budget are likewise political strategies to convince people to support unnecessary increases in government revenue when the real objective is greater equality of economic opportunity.
Politicians need to start making the case for what they believe their constituents want, either to use more of the nation’s resources and wealth to benefit the common good of society or allow individuals to use more of the nation’s resources and wealth to benefit themselves. The primary reason to worry about budget deficits and the national debt is that they are being used to avoid dealing with the most critical question currently confronting the nation. How much are we willing to share, and how much do we want to keep for ourselves?
John Ikerd
Notes:
Whitehouse: https://www.whitehouse.gov/articles/2025/06/memo-the-one-big-beautiful-bill-improves-the-fiscal-trajectory/
Cesar, TX https://www.npr.org/2025/05/21/nx-s1-5405606/how-democrats-are-opposing-trumps-big-beautiful-bill
Fractional Reserve Banking https://www.investopedia.com/terms/f/fractionalreservebanking.asp#:~:text
Deficits, Debt and Markets: Myths vs. Realities
Charles Schwab https://research.hktdc.com/en/article/MTc0OTY3MDI5MA
Money Supply & Capital Gains: https://fsinvestments.com/fs-insights/money-supply-growth-and-the-implications-for-investors/#:~:text
National Budget Deficits https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/