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When the government engages in deficit spending, all other things being equal, this results in the bank system getting more reserves

Yep - in the current monetary system (where the US dollar is not pegged to gold), the dollar derives its value because it is the only thing the private sector can use to extinguish its federal tax liabilities. IMO, we need to run a long-term average federal budget deficit in line with long-term GDP growth rates (say ~3%) because that is the supply level that the private sector requires in additional currency and banking reserves to meet its need for the government's money. Whenever we dip below that level (or worse go into a budget surplus), we court US dollar deflation.

One way to think of deflation is that the US dollar strengthens vs gold (i.e., less supply of dollars vs demand for dollars causes gold to 'buy' less US dollars). So as they say in sports broadcasting, let's go to the replay and look at some data for the US budget deficit as a % of GDP during the surplus years of 1998-2001 and compare it the average gold price for that year.

(Deficit) (Deficit)
Fiscal /Surplus US GDP /Surplus
Year ($B) ($B) % of GDP Gold


1994 (187.8) 7,476.7 -2.51 384.0
1995 (144.3) 7,799.5 -1.85 383.8
1996 (110.5) 8,287.1 -1.33 387.8
1997 (2.7) 8,788.3 -0.03 331.0
1998 46.3 9,325.7 0.50 294.2
1999 105.9 9,926.1 1.07 279.0
2000 218.9 10,472.3 2.09 279.1
2001 81.7 10,701.3 0.76 271.0
2002 (204.2) 11,103.8 -1.84 309.7
2003 (400.2) 11,816.8 -3.39 363.4
2004 (378.3) 12,562.2 -3.01 409.7
2005 (297.6) 13,381.6 -2.22 444.7


The US dollar strengthened by 40% (compared to gold - but it wasn't just gold, look at oil and just about any other currency/commodity vs the dollar during this time) as the Federal budget went from deficit to surplus and stayed there for 4+ years. The US economy tipped into recession and the Federal budget started to go back into deficit. And sure enough, the dollar weakened again (gold rises back to $400/oz).

If you extend this data out into present day, the rough relationship continues to hold. I think TransverseSlice is correct and deficit spending is quite misunderstood even by the 'experts' because it feels so counter-intuitive to how households, firms and even state and local governments have to behave. That's not to say that deficits should be irrelevant, but "paying down" the Federal debt will bring on deflation. So be careful what you ask for.

wabuffo
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