Why the Deficit Matters

The U.S. economy is limping along, looking healthier one day and suffering a setback the next.

But one economic indicator never gets any better: the soaring federal budget deficit.

Everyone knows big deficits are bad. They mean the government is spending more than it takes in, building an ever-larger debt that must be repaid with interest. But the various ways that deficits do their damage are not always clear to laymen.

Alan Levenson, chief economist for T. Rowe Price (Stock Quote: TROW) explains in the firm’s fall newsletter that a larger deficit means the country is saving less, reducing the amount of money available for investments that improve productivity. Higher productivity is key to an improved standard of living.

Because the government takes in less than it spends, it must borrow the difference by selling bonds and paying interest to bond investors, Levenson adds. As investors put increasing amounts of money into safe government bonds, they put less into private investments such as corporate bonds. To compete, corporations have to offer higher yields. That can drive interest rates up on everything from mortgages to auto loans to credit cards.

The government’s growing need to borrow makes it more dependent on foreign investors. If the government tries to sell more bonds than foreign investors really want, the imbalance in supply and demand tends to drive the dollar’s value down relative to other currencies. That makes foreign goods more expensive for U.S. consumers.

But Levenson notes that the worst has yet to happen, despite these forces. Interest rates, for example, remain very low and the dollar has not fallen as far as many experts thought it would.

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