Tuesday, December 28, 2010

Why does the deficit even matter?

What if you could take, say, $15,000 and go back in time about 25 years.  Or, better still, go back in time about 50 years.  50 years ago $15,000 bought a hell of a lot.  In Syracuse, NY you could buy a split level 3 bedroom home for just over $15k.
The same type of home today is just over $100,000.  
Or maybe going back even further to 150 years ago when the federal government was giving away homesteads of 120 acres or more for 5 years work and $200.  To back when a good week's work paid $7 and you'd be lucky to clear $350 in a year.
Because back then $15,000 was some serious money.  That was the type of money that would make place someone in the "super rich" category.  Today it's really not that much.  The average household brings in that much in just under a half year's work.  But back then a person could work his whole life and never see that much money in some parts of the country.

So what?

Well, the "so what" has to do with the notion of inflation.  You can't go back in time with today's money.  The technology doesn't exist, for one thing.  For another, you'd have to be very careful about which dollars you bring back.  You wouldn't want to go trying to spend bills printed in 2005 in 1850.  They'd look funny and have a counterfeit date on them.  Plus your debit card wouldn't work.

But you CAN buy things with today's money and pay for them in the FUTURE, which is sort of like going back in time with tomorrow's money to pay for things today.  So the principle is kind of the same.  We do this with debt.  We take out a loan--like on our house or credit card--on the assumption that we'll have more money in the future to pay off the balance.  In the case of the house, we assume the value of the house will increase and in the case of the credit card we just assume we'll have some extra cash laying around to pay off the balance--somehow.

These assumptions are based on 2 things.  One is that we'll be making more money due to greater productivity.  The other is that we'll be making more money due to general inflation.  We may not think of the other much at all because inflation is a sneaky little bug that most of us don't even notice in the short run, but we all notice over the long run.  How many times have we heard our parents (or grand parents) tell us about going to a movie, getting a tank of gas, and grabbing a burger for under $5?  Yea, that doesn't happen any more.

The thing about inflation, though, is that it's been largely kept in check over the last 10 or 20 years.  Why?  A large part of that has to do with a very, very activist Fed working diligently to manage interest rates and keep inflation under control  Another very large part of that has to do with imports from China.

What?!?

Yup, imports from China.  A lot of the stuff we buy--most of the stuff we buy--comes from China where it's cheaper to produce things.  That's one way to keep costs, and prices, down.  And one way to control inflation is to keep prices down.  So, as we make more money due to greater productivity inflation usually eats away at those greater earnings.  But over the last 10 or 20 years, inflation has been remarkably low.  Of course, earnings gains for much of the population have also been remarkably anemic over that same time frame, but we haven't noticed because prices for everything seemed to be flat or only slightly increasing.

That is, until right around 2003.

That's about the time we saw gas prices spike up, food prices spike up, commodity prices on all sorts of inputs spike up and general panic and chaos ensued.

THIS is why the deficit matters.

One of the reasons we keep getting cheap stuff from China is because their currency is pegged to ours.  That causes much anger and consternation in the US Government, but that's not real anger, just political posturing.  You see, they'd like it if China allowed their currency to float because that would allow the dollar to become devalued against the yuan--which means inflation--and it would make it easier for the US to pay back a lot of the debt with tomorrow's much, much more abundant money.  However, that would also trigger run away inflation here in the states because all that stuff from China that is so damn cheap, that has been keeping our inflation in check, and keeping our flat wages tolerable, because we don't notice that our wages have been flat because prices have also been pretty flat, will suddenly be no longer cheap.

American businesses will redeploy capital into other nations that can manufacture stuff cheaply.  China's economy will be in tatters.  The US economy will be completely freaking out.  Everything will be upside down and backwards.

And as long as we're running trillion dollar deficits, China can't allow their currency to float against the dollar, because their cheap currency--fixed in price against our currency--maintains a very, very positive trade balance in China's favor, which sends dollars their way.  All those surplus dollars have to go somewhere, and luckily for them there's a government that spends dollars like they're going out of style.  The US sells debt, and those dollars that China is stacking up from trade go right back to the US in exchange for the debt.  And all that debt creates interest payments, that go right back to China.  China uses those interest payments to purchase commodities and fuel their own industrial expansion.  That industrial expansion puts a strain on the environment, sure, but also puts a strain on those commodity prices like corn, milk, beef, and, yes, oil.  When the price of oil goes up, the price of everything goes up.  And when the price of everything goes up, we get inflation.  Usually inflation would make it easier to pay off our debts.  However, in this case it doesn't work because when our currency gets devalued--that is, experiences inflation--China's currency gets devalued because they're pegged to currency.

And they can't unpeg their currency until we fix our deficit problem.

THAT'S why the deficit matters.
I know.  It's a complicated mess.  But in the middle of the complicated mess is a thing that we can control, and that's the out of control spending.  Get that under control and a lot of the complication goes away.

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