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September 19, 2011

Double Trouble: Weak Currency and High Fiscal Deficit

During times of economic crisis, Central Planning authorities are compelled to intervene. In some circumstances, countries opt to increase government spending, and consequently balloon their deficits. Others attempt to inflate their way out of an economic crisis by printing money and in some cases, using that money to buy government debt. However, marrying these two philosophies can have potentially long term economic consequences.

Weak Currency
When economic times get tough, Central Banks attempt to “prime the pump” by creating money and buying government bonds. This lowers interest rates and is supposed to allow institutions and consumers to borrow cheap. A country that exports could also see increased exports (which promotes economic growth) if currency is created.

For the United States, however, we import much more than we export. Having more dollars in the global market weakens our currency, therefore, it requires more money to make foreign purchases. This leads to increased prices for things we import, such as oil. With major components of our economy being mostly imported, the impact on consumers could be devastating.

Weak currencies can also create domestic inflation. Classic inflation is defined as too much money chasing too few goods. The Federal Reserve has printed trillions of dollars since the financial crisis of 2008, but have we truly seen that great of increase in goods or output. Our employment picture would tell us no. Our GDP growth since then would also tell us no. Despite this, inflation currently sits at 3.6%, the highest in more than three years.

High Government Deficits
Some governments believe they can spend their way to prosperity when a recession hits. By increasing spending (and subsequently borrowing), the government wants to substitute some of the losses from the private sector of the economy, and help spur growth amongst the private sector. Government borrowing also has its costs.

While it may seem counter-intuitive, too much government borrowing inhibits growth. This occurs because in order for the government to borrow money, some type of private entity (or foreign government) must lend it. This steals credit away from private businesses that create jobs and growth. This phenomenon is known as the “crowding out” effect.

Our Current Situation
To date, the Federal Reserve has created at least two trillion dollars (although some evidence shows it may be more than three times that). Meanwhile, the federal government increased its budget deficit from $400 billion per year before the crisis to over $1.5 trillion per year afterwards. The government has easily borrowed $4 trillion as a result of the financial crisis and recession.

We, therefore, are at risk for a combination of price inflation and low/negative growth. We’ve seen oil prices stay historically high and this has transcended into many of the products we use every day. Additionally, the government’s spending spree hasn’t produced any noticeable growth. As noted above, inflation is at a three year high and growth is currently decreasing. We need stable currency growth and stable budget deficits going forward in order to achieve sustainable growth.

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