Ignore the doomsday books! Deficits won't bankrupt U.S.

Some observers feel that America's 217th birthday will be one of its last happy ones for a while.

Why? They say our budget deficits are so out of hand that we will soon be bankrupt, unable to pay our debts, and unable to keep foreigners from taking all their money out of the country.

I find this analysis untenable -- sheer fiction, a scare tactic that sells doomsday books and attracts listeners to TV shows on the topic.

Now, I hold no great love for the lawmakers who have given us a deficit that will soon reach $4 trillion dollars. The irresponsibility of various administrations and Congresses in allowing government spending to so exceed tax collections that we have reached a deficit of $300 billion a year is unconscionable.

Deficit Feeds on Itself

The financing of this deficit is now the government's third-biggest expenditure -- after entitlements and the military -- and it will soon be No. 2.

The deficit has led to a crowding out of private borrowing and spending that could have helped the economy recover. And it feeds upon itself by forcing the government to go deeper and deeper into the hole in order to pay the. interest on the deficits already on the books.

This may be pretty bad, but is it so terrible that our nation's future is threatened?

Our first evidence that the deficit is not life-threatening comes from the fact that despite 12 years of soaring deficits, we still have the lowest interest rates in two decades and an investing public that trusts U.S. government obligations.

Why is this possible? Don't the huge deficits drain. money from the economy, making credit scarce and boosting money rates?

Just a Movement of Deposits

No. For the money has to be somewhere. Dollars just don't leave the country. They are American bank deposits, basically the bulk of the liabilities of our banking system.

All that deficit finance does is move deposits from the hands of the new investors in government securities to the accounts of those who already own government securities and are entitled to interest payments on them.

Sure, heavy inflation would occur if the Federal Reserve financed the huge deficits by creating new reserves and thus allowing the banks to create new deposit money.

But the Fed is not given to creating inflation. Rather it keeps as its goal protecting the value of the dollar. So most of the deficit finance involves this moving of funds from the new buyers of bonds to the holders of previously issued securities on which interest payments are due.

Now, who owns these bonds? More than $300 billion worth are owned by the Fed itself. What does it do with the interest it earns on them? Once it has funded its own operations, the central bank sends the vast bulk of its income right back to the Treasury as a direct transfer. That certainly doesn't hurt the nation.

Keeping the Flow Going

As for the rest of the bonds held domestically, they too are a part of a loop that keeps money here. The bondholders receive interest, pay taxes on it, spend or invest the rest, and thus keep the interest payments they receive flowing through the economy.

Sure there is a transfer of funds from all the taxpayers and those who bought new bonds as interest is paid to holders of outstanding obligations.

But these banks, insurance companies, and all other investors -- both individuals and institutions -- have sacrificed earlier consumption to buy the bonds. They are entitled to their interest. If they didn't receive it they would be unlikely to invest in U.S. securities again, in which case our economy would really be in a mess.

So domestically paid interest breeds transfer of funds but no actual disaster. The higher the deficit, the more the transfer, but the money stays in the loop.

Nowhere to Run

Even foreign owned dollars do not leave the loop. They can't. They are also merely U.S. bank deposits. As with domestic holdings, foreigners must either spend the interest they earn on American goods and services or reinvest it in other bonds or actual properties like real estate and movie companies. None of these choices should make us unhappy.

The alarmists say "they will take their money and run." Where? When Iran's deposits were unblocked and it pulled billions out of Chase Manhattan Corp., it moved the money down the street to J. P. Morgan & Co.

Sure the budget deficits hurt. But by itself, the deficit will not bankrupt our country unless the Federal Reserve is willing to allow it -- a very unlikely prospect. Deficits can squeeze our interest rates but they can't bankrupt us. So despite all the doomsday books that sell so well at airports, we can wish America a happy birthday and expect to be around for many more.

Mr. Nadler is a contributing editor of American Banker and professor of finance at the Rutgers University Graduate School of Management.

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