Worrying About The Deficit is Silly

Worrying about the deficit is silly. There is not a day that goes by without hearing someone worrying about the debt/deficit. Whether it is a Fortune 500 CEO, someone on Twitter, a politician, or an economist, there is always worry about the deficit. I say phooey, and here is why.

1) Before I get into the details, let’s have a lesson in some bond history. One of the biggest worries about deficits are that rates will spike up any day now, and they have nowhere to go but up, thus causing a debt crisis from high interest rates. But rates have generally been really low. The precedent has not been high rates. In fact, its the opposite.

This graph is a little old (so the 2.0% bar would be slightly taller), but you get the point.

 

 

 

 

 

 

 

 

 

 

 

 

 

People like to reference the  1970s as where rates are going. Nonsense. That was a major anomaly, not the standard.

 

 

 

 

 

 

 

 

 

 

 

 

 

One other thing people like to reference is that the high debt load is unprecedented and were about to fall off a cliff and face a debt crises. Well, right after the war, US Debt as a percent of GDP peaked at right above 120%, about 20% higher than where we are now.

 

 

 

 

 

 

 

 

 

 

 

 

 

I’m not using the chart to say that the debt:GDP reverses here, just to point out that a high public debt load is not something we have not dealt with. I wouldn’t even worry about a debt crisis even if we broke “new all-time highs”. Japan’s debt load has been growing for over 2 decades, and yet their rates have stayed ridiculously low (won’t post the chart but view this post).

Also, notice how rates have been coming down since the peak in the late 70s, despite debt growing steadily since then? Lastly, anybody who says “we need to run a balanced budget/surplus” clearly does not realize how unlikely that is, given we’ve only had 12 surplus years since 1940 (16%), and only 4 have came in the post-Bretton Woods era (and that was during a time the time of the NASDAQ bubble).

 

2) So, now that we have some history under our belts, let’s understand what the debt is. The deficit  is not shaped by overspending, under-taxing persay. The deficit is shaped by how well the economy does, and mainly, unemployment. You lower it by lowering unemployment (via growth). It’s all a function of how the economy operates (think about it….More people working mean less people on benefits, more people paying taxes, more businesses earning money, etc). We don’t have a high deficit because Obama has instituted policies that overspend. That’s silly. The stimulus is estimated to be 0.32% of the deficit (as a % of GDP) this coming year. The deficit we run is mostly cyclical, and partially, structural.

More evidence that the deficit is cyclical.

 

So now that we have some idea how the deficit functions (not like a household, basically), we should next see how the deficit effects other sectors of the economy. As this chart below shows, The government’s financial deficit, is to the penny, the non-government’s financial surplus. The non-government is made up of the Private (Household and Business sub-sectors) and foreign sector. As you see below, the government’s deficit has allowed the private sector to build a big surplus, which it has used to deleverage (private sector debt) and save during this balance-sheet recession.

This sectoral balance is crucial to understanding the debt. If you say “cut the federal deficit”, you either have some magical way to lower our Current Account deficit (sounds like somebody who wants to devalue the dollar to make exports more competitive…), or you want to shrink the private sector surplus. Neither of which is a good idea. Increasing exports/decreasing imports has the view that exports (and not imports) are a benefit and not a cost. As for the private sector, you either want to shrink corporate profits or you want households to basically have less money. Again, neither sounds like a good idea in a time of a weak economy. If we were overheating, this might be a good thing. But, we are far from that.

 

 

3) So why exactly are rates unlikely to move up and cause a debt crisis?

A) For one, “buyers not showing up” is a myth. We are not in a bond bubble. The $FED controls the rates. They Federal Reserve is the dog walker, the dog is the market. Bond vigilantes are a myth, not invisible or waiting to be unleashed.

B) The Chinese (or foreigners) are not and will never be our overlords. They own a lot of our debt because they receive a lot of our dollars via trade. They could either use those dollars to buy dollar-denominated resources, hold on to those dollars, or store them in treasuries, where they earn some interest. China opts to go in the third route often. China runs a positive current account balance against us. This post does a good job in explaining how it all plays out.

C) We don’t need QE to keep rates low, as evidenced by summer of 2011, when QE2 ended. There were cries: “But who will buy them [bonds]“. What happened? Despite a downgrade, bonds rallied and yields fell to an all-time low. This ignores the fact that yields have been falling for decades now, despite no QEs from the $FED pre 2008. Anyway, even with all this buying, the FED’s share of marketable treasuries has not really spiked.

D) The US is not Greece (a nation which adopted a foreign currency), California (a US State), Walmart ( a corporation), or you/me (a household). The US is the currency issuer of the dollar, everyone else is currency users. Greece uses the Euro. California, Walmart, you/me use the dollar. We don’t issue it. So we can literally run out of dollars. The US government cannot! It’s a simple concept to understand.

4) So what’s the true constraint of debt? The one and only constraint of public debt is inflation. While inflation per say is not a bad thing necessarily, you don’t want high dosages of it. So why am I not worried about possible high inflation from issuing so much debt? This in itself could be another blog post, but to summarize.

A) Wage will likely stay low in the foreseeable future. And if wages are low (and given no strong unionism and high technologization, this is likely), inflation will be low. While not a perfect correlation, this chart shows the strong pattern.

B) In a state of deleveraging, demand for credit remains weak. This indicates the chances of seeing demand-pull inflation low, especially when combined with the low wage outcome.

C) Cost-push inflation always remains a possibility. We can always have a war that disrupts oil production or a major drought. However, it would be hard to see a 70s like scenario in which it remains a prolonged problem. Not saying it can’t happen, but it’s not something I’d be betting on.

D) Hyperinflation from all the FED’s money printing is not a possibility. Hyperinflation is usually triggered by an exogenous, rare event. It is not a monetary phenomenon.

E) The Fed is not even printing money! If they were, the amount of net financial assets in the Private sector would increase. This is not what is happening. They are swapping assets. QE replaces bonds with reserves of equivalent worth. Tell me, is there a difference from $100 million in treasury notes and $100 million in dollars? No. Actually, there is one small difference. The treasuries return some decent interest. So technically, the FED has been making the private sector “poorer”. Now, this isn’t to say that QE does not have any other effects, it for sure does. But it is crucial to realize that swapping reserves for bonds does not increase the amount of dollars in the private sector. And, don’t worry about all those reserves being lent out. That is a myth, banks don’t lend reserves.

5) How do we then structure the deficit and is the deficit a bad thing?

There’s 2 ways you can create a deficit. Increase government spending or reduce taxes. Given our economy is nowhere near “heating up”, increasing the deficit would be a good thing. Now, how we do that is entirely a democratic policy choice. If you think government is horribly inefficient and that free markets work best, then you would support lowering taxes much more. However, if you think government has to play a role in the economy, then you might thinking spending should go up. Personally, I like to see a mixture of both.

And just for what it’s worth, spending is not reliant on tax collection. So more spending does not mean more taxes. This leads me to my next points. The Ricardian equivalence theory is highly flawed. Crowding out is also a highly flawed theory. Government borrowing will not cause interest rates to rise, thus reducing investment spending. Now, government spending can use up resources that might be better used by the private sector, but this is not the same as crowding out. So all in all, the deficit is not a bad thing.

Lastly, the only way to truly shrink the deficit is via growth. Austerity does NOT work. Fiscal consolidation will only make the deficit bigger (as tax revenues plunge and more people collect benefits). Just ask Japan.

 Conclusion

Now that we know what the deficit is, its history, why we need it and why it’s not a bad thing, we can all then agree we need the deficit to be structured better and even to be bigger. Anyway, that’s what we already all support, we just need to stop being fiscal hypocrites.

Tags: $MACRO $FED

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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