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or more)—unless taxes are raised. The costs of funding programs for the aging baby boomers will only put further strains on the budget.
Granted, deficits by themselves need not present a problem. Deficits are of course only one side of a country’s balance sheet. On the other side are assets. If a company borrows money to make high-return investments, no one is worried—so long as those investments do in fact yield returns.1 Our soaring deficit is not a concern if the money is spent on education, technology, infrastructure—all investments that historically have yielded very high returns, far higher than the interest rate the government has to pay—because then the returns to our society are far greater than the costs. But, if the money is spent on wars in Afghanistan or Iraq, poorly designed bailouts for banks or tax cuts for upper-income Americans, then there will be no asset corresponding to the increased liabilities, and then there is cause for concern. This seems to be the road we have been heading down for the last eight years and, disappointingly, are to too-large an extent continuing to travel.2
And with it there will be strong incentives to reduce the burden of the debt through inflation because inflation reduces the real value of what is owed. It means the government will pay back its debt with dollars that are worth less than they are today.3
This is how we come to another threat to the dollar: inflation.
THE STRENGTH of the dollar is determined by the laws of supply and demand, just like the value of any asset. The demand for a currency is based on the return to holding the asset relative to other assets, e.g., the interest rate received from a dollar asset, like a Treasury bill, plus the expected capital gain or loss. Demand today (and thus the value today) depends critically on expectations about the value tomorrow, but the value tomorrow will, in turn, depend on expectations of the day after. Prices are inexorably linked to expectations of the future, both near and far. If investors, or even people as a whole, believe that sometime in the future there is going to be high inflation, then those who hold dollars will be able to buy less with those dollars. The demand for dollars then—and now—will decrease, and hence (holding everything else constant) so will the value of the dollar at the present moment.
As market participants have watched the U.S. deficit rise dramatically and the Federal Reserve effectively print money seemingly without limit, fears of that very kind of inflation, not now, but sometime in the future, have grown. The fear is not of immediate inflation; there is so much excess capacity and unemployment that deflation is in fact more a worry. But the longer-term concern is that if and when the economy recovers, inflationary pressures will grow.

THE FEAR from some debt holders (China in particular) is that the U.S. government will purposely try to raise inflation—or be soft in resisting it, for the obvious reasons. I would normally think these concerns to be exaggerated. “Inflating” away debt is not painless. And if the Fed tried to do so, our foreign creditors would immediately demand higher interest rates—the only way to collect the real value of what they are owed.
The Fed, of course, right now wants to keep interest rates low because it is worried about the recovery. The only way to offset our foreign debt holders’ demands of higher interest rates would be to start buying u