Inflation, Deflation and Federal Budgets

In a time when government revenues are much lower and when expenditures are much higher than they generally are normal times, constructing a new federal budget can be a significant challenge. This is especially true when there are wide differences of opinion on budget among the two major political parties, who even in better times seldom agree. We begin consideration of the budget for 2012 with the fact that expenses have exceeded revenues by over a trillion dollars since 2009, and while preliminary consideration of the 2012 budget suggest it could come in only slightly below a one trillion dollar deficit, neither political party regards that as much of a victory.

Two extreme approaches are unlikely to succeed. First, increasing revenues by one trillion is regarded as unlikely. Taking one trillion out of the economy which is only now starting to show recovery would be unwise, especially using it to apply to existing expenditures. Even if the tax code were reorganized to increase simultaneously, it would difficult to increase revenues by one trillion dollars. Removing tax breaks and subsidies that amount to tax expenditures would help, but it’s still hard to get to one trillion. The Congress will try to reorganize the tax code and reduce tax expenditures, but perhaps not before the 2012 elections.

Thus, cutting expenditures will also be necessary. Again, though, it’s unlikely that by reducing expenditures alone we can reach a balanced budget. A one trillion dollar reduction would require dangerous cuts nearly everywhere in the budget, which would have to be cut by nearly 30 percent to reach one trillion in savings. Such cuts might be manageable if undertaken over multiple years, but could not be easily managed if done all at once. Reductions in expenditures can and should be undertaken in most categories. Military expenditures can be reduced by nearly 100 billion dollars in the next budget and perhaps more with time. The Pentagon planners are reassessing the role of the American military in the world and we could see significant additional cuts over the decade. The government’s role in retirement and medical programs that include Social Security, Medicare and Medicade will be reassessed and reduced over time. Social Security is not running a deficit presently but in time, with 85-100 million baby boomers retiring in the next 15-18 years, the numbers of Americans in the Social Security system will begin to exceed those making contributions to it. Decisions will need to be made to address long term solvency of Social security by 2020-2025. Medicare/Medicade expenditures are increasing at a greater rate than any other part of the budget. The nation needs to address health care costs in a realistic way prior to any long lasting or permanent decisions about this area of the budget.

Overall, a safe combination of increases in revenue and reductions of expenditures could allow a reduction of the yearly contribution of the federal budget to the accumulating debt from one trillion per year to one-half trillion per year. Something near or under one half trillion dollar reduction will likely be attractive the Congress after the election. This will be especially so if the job growth trends of the last few months are maintained and are translated into a measurable increase in the rate of economic growth for the year. Such growth, if it occurs, will not make up the other half trillion in the deficit but it will help in heading us in the right direction.

Over the past several years as major deflationary trends accompanied the 2008 crisis—housing, commodity and other prices fell as significant numbers were added to the ranks of the unemployed—monetary policy could afford to be mildly inflationary. Central bankers fear the latter and try to work though the former. Thus, as we move forward, signs that deflation is reducing will be accompanied by efforts to insure than the inflationary effects of monetary policy do not take hold. We are not concerned about inflation at the moment, but it should always be considered and watched for as we move forward.


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