As yields on U.S. Treasuries of all maturities approach or exceed 5 percent, it’s worth revisiting one of modern monetary theory’s most famous conceits: the view that “deficits don’t matter.” In this framework, deficits are unlikely to cause inflation, and if they happen to do so, taxes can always go up to restrain it.
Putting aside microeconomics (jerking around taxes to manage the business cycle would have enormous long-term efficiency costs), this claim contains a kernel of truth, but not one that MMT advocates grasp. From a growth perspective, deficits indeed need not “matter”—growth in one area of the economy is offset by contraction elsewhere.
That’s because fiscal policy has an unfortunate consequence if used stimulatively outside of a large recession: a phenomenon called “crowding out.” In a deep recession, the economy has lots of spare production resources. Workers, factories, and buildings sit idle, and government borrowing to stimulate economic activity is unlikely to thwart activity from elsewhere. Further, a sharp downturn is accompanied by a decline in investment, meaning interest rates are generally low, and government borrowing won’t put much upward pressure on borrowing yields. Monetary policy may be ineffective in getting the economy out of a rut if it’s already fired all its bullets and policy rates are near zero, opening space for fiscal policy to play a role.
If the economy isn’t in a sharp recession, though, and has no unused resources, then whatever activity government stimulates is likely to be drawn from reduced activity elsewhere. If everyone is already employed in productive work and no one is idle, any worker engaged in government-directed activity is necessarily forsaking the work he or she would otherwise be doing. “Deficits don’t matter,” indeed—not because they enable unlimited spending to solve all society’s ills with no consequences, but because in the absence of a severe downturn, they cannot boost growth.
This dynamic has hobbled the effectiveness of the Biden administration’s fiscal policies. Legislation like the so-called Inflation Reduction Act directs vast sums of money—now estimated by analysts at the University of Pennsylvania and Goldman Sachs at more than $1 trillion—toward climate-focused investments like electric vehicles and alternative fuels.
But with unemployment below 4 percent, the borrowing-funded IRA investments have necessarily pulled activity and investable funds away from other sectors that private individuals and firms would otherwise like to be engaged in. This diversion of funds away from the private sector raises the cost of capital, as firms and households compete over lower levels of available funding. There’s only so much savings—and if the government absorbs it, then the rest of us must pay more interest to get a piece of what remains.
Consider housing. Average mortgage rates have more than doubled from levels of around 3.5 percent before the pandemic to 7.5 percent today. For many individuals, rates can exceed 8 percent. Combine soaring mortgage yields with the massive run-up in home prices, and housing affordability stands at a record low. Many families will now find homeownership, or even switching homes, out of reach. Residential investment, rather than boosting economic growth, has declined for nine straight quarters, and it is no coincidence that the decline started right after the American Rescue Plan was enacted, borrowing soared, and interest rates began rising.
Put these pieces together: families can’t buy homes because mortgage rates are high; mortgage rates are high because profligate fiscal policy is absorbing such a high percentage of available loanable funds in the global financial system. Homebuying has been crowded out by electric-vehicle battery factories. If you can’t afford a house at the new mortgage rates, this is why.
This is just one example—because of the rise in interest rates, credit costs have increased across the economy. Households, firms, and entrepreneurs now have to pay significantly higher rates to access funds. Conversely, activity favored by the IRA’s fiscal agenda receives subsidies, so the increase in funding rates doesn’t affect it as much. Government-favored activity is booming, with the explosion in private nonresidential investment standing in sharp contrast with residential investment. The relative stagnation in bank lending for commercial and industrial activity, unchanged over more than three years, reveals that declines in unsubsidized lending have offset growth in subsidized lending.
These distortions are affecting the entire investment landscape and will reverberate through the economy for years or decades. Venture capital funding fell 35 percent in 2022 from the year before—a larger drop than took place after the Global Financial Crisis—thus halving the investment in start-ups. According to data from Bloomberg, total year-to-date investment-grade bond issuance in the U.S. is down $19 billion from last year, despite nominal GDP growth of 6 percent over a year ago. And home mortgage applications are at their lowest level since 1995, though the economy roughly doubled over this time.
Redirecting credit toward government-sponsored activity while starving parts of the private sector will have long-term consequences. Households and businesses invest because they believe that the investment will yield returns. Such good investments are not being made, though, because they cannot obtain the credit to do so, and because at higher interest rates fewer projects will break even. Meantime, most of the government-sponsored activities cannot survive without the subsidies, which means that they are uneconomic and likely to collapse when the subsidies disappear or get reduced.
The result of this deficit-fueled activity is a supply side of the economy that is heavily distorted, resulting in materially worse long-term productive capacity and economic growth, as well as increased vulnerability to inflation on positive demand spikes. The sooner we reverse the subsidization of uneconomic sectors and get our fiscal house in order, the sooner American households and businesses can resume investing in the future.