Do Deficits Matter?

How does government borrowing affect the long-term viability of an economy? Is it even ‘moral’ to borrow – if you don’t intend to settle your debts? Strategic Investment’s Dan Denning weighs in with his view on the matter, below…

Do government deficits – and by extension, government debt – matter? I would argue that they do. In fact, over time, they erode the long-term ability of an economy to create wealth…making the pie smaller for all concerned.

Government deficits are unique in the world of debt. The government doesn’t borrow money to create income-producing assets or make capital investment. The purpose of government borrowing is not to create wealth, but rather to redistribute income. And because the government pays off its bonds with tax revenues which it commands from citizens under threat of imprisonment, it’s able to borrow at much lower interest rates than the private sector.

To the extent that non-productive government borrowing crowds out productive, private investment, the economy is in trouble. But how do you measure the size of the deficit? At what size does it begin to matter?

If you measure government deficits as a measure of GDP, they may not seem historically large. But that is not the main issue – rather, the key economic question, in terms of sustainability and capital formation, is how large government deficits are as a percentage of gross saving.

Government Deficits: Crowding Out Private Investment

How much is the government claiming from the pool of available funds? In other words, to what extent is government borrowing crowding out private investment and capital formation?

In the 1970s, the federal deficit was 11% of private saving. By contrast, last summer, the projected federal deficit of $304 billion was just under 20% of gross saving of $1.5 trillion. Today, with this year’s projected federal deficit of $521 billion and gross savings in 2003 (excluding December) of $1.8 trillion, the federal deficit is nearly 30% of gross savings. That is an outrageous ratio.

In short, the higher the debt – and the deficits – the more the government has to go into capital markets. Using its coercion-protected franchise as the “payee of last resort,” it attract funds from savers into its Treasury bills and bonds that otherwise would have gone into corporate stocks and bonds, thereby creating wealth by financing new job-creating enterprises. Instead, the savings, once sucked into the government’s vortex, are mostly squandered in wasteful and ineffective enterprises. (Hey, let’s go to Mars!)

Government borrowing diverts savings away from productive investment and towards simple wealth redistribution. Over time, capital formation slows down…and so does business investment. The long-term ability of the economy to create capital and wealth is hollowed out.

That’s my main economic argument against government deficits. But my most serious bone of contention is moral. The more content we are with regular government deficits, the less responsible we become for ourselves. Borrowing increases actual indebtedness…but it increases dependence, too.

People get used to expecting things to be paid for and provided by the government. Once created and funded, how many government programs have gone away? Very few. These programs develop a constituency of bureaucrats whose paychecks depend on them, and/or taxpayers on the receiving end of the wealth distribution.

Government Deficits: Looking for Your Own Piece of the Loot

The whole exercise in democracy then becomes a shameless debasing game of looking out for your piece of the loot at the expense of your neighbors and friends…and your children and grandchildren.

The root of this argument is that public debt – debt taken out in the name of the people and not by an individual or corporate risk taker – quickly becomes a creature of the political process and winning elections. In time, this becomes corrosive to private morality.

A useful example is provided by the heat wave experienced in Europe this summer. In France, fifteen thousand people who survived the depression and World War II died in their homes or unattended in hospital beds from the heat. Their doctors, neighbors, and children were at the beach, on vacation, confident that the tax dollars they spent were taking care of their loved ones.

When Chirac gave his speech to the nation addressing the human catastrophe, he said that no one person was to blame, but that all of France was to blame. That’s pretty convenient. All of France means not me and not you but all of us. So let’s just do better next time.

Maybe in their private moments the children and neighbors of these people do blame themselves for subcontracting their responsibility to take care of their elders to the government. And then again, maybe they don’t. Maybe the cumulative effect of letting the government become the moral middleman is that you don’t care about anyone but yourself anymore. You care about your job, your leisure time, your life. You work less, have fewer children, and stop believing in God.

It may be a stretch…but I think it all starts the moment we accept that spending more than we earn – as a nation, through our government – is morally tolerable. If it’s not good for a private household to do it, not good economically and not good morally, why would it be better for the government to do it?

Lots of people will claim that only the federal government can and should spend money on things like wars and self defense. Perhaps. But in addition to being controversial, it’s a bit of a red herring. Right now, for instance, are we really in a war in which the bulk of our national resources ought to be dedicated to the military to the same degree as they were in WWII or the Cold War? And even so…it’s the non-military, non-discretionary spending that’s busting the budget anyway.

Government Deficits: 70% of Spending Tied Up

Seventy percent of government spending is locked up in non-discretionary promises to pay for things the government does now, but which used to be done by families, churches, or the private sector. We have cast these promises in political granite and have closed the discussion of whether we ought to or can afford to keep making them.

I would suggest that we not treat our economics as mere mathematics. Economics used to be called moral philosophy. The study of the choices people made with their money couldn’t be separated from whether the choices themselves were “good.”

The market judges “good” by whether the good or service you provide makes things better for people. If it does, you get rewarded for your risk. If it doesn’t, generally, you fail.

Debt isn’t immoral per se. But taking on debt you have no intention of repaying is.

And doing so in the name of the “State” or the “people” may give you the political cover you need to explain away your recklessness. You disguise it as concern for the “public good” or for “society.” But morally speaking, when you sanction it, you’re contributing to the impoverishment of your economy…and the debasement of your own morality.


Dan Denning
For the Daily Reckoning
February 26, 2004

Editor’s note: Dan Denning is the editor of Strategic Investment. He is currently researching the calamitous effects a correction of the U.S.’s “twin deficits” would have on the economy. If you’d like to learn how this relates to you as an investor, and how you might profit from an imminent deficit blow-out, see Dan’s report:

The Other Twin Towers

An expanded version of this article was originally published in a special report, “Does U.S. Government Debt REALLY Matter?” from What We Now Know, a new weekly e-letter from Casey research.

“Excuse me…I couldn’t help but overhear your conversation…do you really believe that the jobs picture will improve? I mean…really?”

“The lesser of your two evil Parisian editors found himself in a fortuitous position on a yesterday’s flight from Paris to Boston (en route for Puerto Vallarta)…”

So begins a cryptic e-mail from Addison Wiggin. Apparently, while making his way to the Supper Club meeting in Mexico, Addison found himself seated next to an economics professor from Harvard…who claimed to be a friend of Ben Bernanke’s…and a neighbor of former IMF chief economist Ken Rogoff…and whose office is just across the hall from the current chairman of the president’s Council of Economic Advisors, Greg Mankiw.

We’ll hear more about Addison’s chance encounter when he hits the ground in the land of tequila and cheap blankets. And since Bill Bonner is making his way back from the sunny climate of Nicaragua himself, we go straight to Eric Fry…on the scene, and on the job…in chilly New York City…



Eric Fry in Manhattan…

– Father Greenspan delivered an inspirational homily yesterday in the halls of Congress. He pronounced the economy free of blemish, praising its many virtues, while turning a blind eye to most of its venial sins…like sluggish employment growth.

– He did, however, caution against the evils of large federal deficits. “As you are well aware,” he intoned, “after having run surpluses for a brief period around the turn of the decade, the federal budget has reverted to deficit…For a time, the fiscal stimulus associated with the larger deficits was helpful in shoring up a weak economy,” the chairman allowed. But the deficits must come down.

– “To date, actions that would lower forthcoming deficits have received only narrow support,” he noted, “and many analysts are becoming increasingly concerned that, without a restoration of the budget enforcement mechanisms and the fundamental political will they signal, the inbuilt political bias in favor of red ink will once again become entrenched.”

– Amen, brother! [More on this subject from Strategic’s Dan Denning, in a guest essay below…]

– But Greenspan did not dwell on the negatives. He ascended Capitol Hill to deliver a message of victory and of hope. “The U.S. economy appears to have made the transition from a period of sub-par growth to one of more vigorous expansion,” he declared. “Real gross domestic product (GDP) rose briskly in the second half of last year, fueled by a sizable increase in household spending, a notable strengthening in business investment, and a sharp rebound in exports…Overall, the economy has lately made impressive gains in output and real incomes, although progress in creating jobs has been limited. The most recent indicators suggest that the economy is off to a strong start in 2004, and prospects for sustaining the expansion in the period ahead are good.”

– The Faithful embraced Father Greenspan’s assessment of the economy as gospel truth and responded to his message by chasing lustily after stocks. The Dow Jones Industrial Average gained 35 points to 10,601, while the Nasdaq Composite rose nearly 1% to 2,023.

– Inspired by Greenspan’s message, the dollar soared heavenward as well, gaining 1.5% against the euro to $1.250. We would not be surprised to see it drift a little higher…but the ill-fated greenback’s divine inspiration is temporary at best. [Ed note: In the long term, these bursts of “inspiration” are merely even better opportunities to sell the dollar. Now is the time to lock in your position – before the dollar resumes its decline in earnest.

– The dollar’s impressive rally took a lot of shine off of the gold market. The tarnished metal tumbled $8.70 yesterday to $396.10 an ounce.

– In a world so free from blemish, so devoid of macroeconomic iniquity, gold is irrelevant. If there are no demons, evil spirits or looming financial disasters to ward off, why lug around a relic like gold…especially when the relics at the Federal Reserve insist that inflation does not exist?

– Notwithstanding Chairman Greenspan’s inability to observe any inflationary pressures in the economy, a very visible bit of inflationary pressure is gurgling up from the ground right beneath him. Crude oil for April delivery tacked on $1.10 to close at $35.68 per barrel – the loftiest price in nearly a year.

– And there seems to be a bit of inflationary pressure in the semiconductor sector as well. The Semiconductor HOLDRs Trust (SMH:Amex), which bounced 1.5% yesterday, has doubled over the last 12 months. But SMH investors may be interested to know that there is a lot of air under this thing. The P/E ratio of SMH’s top 10 components is a hefty 82.4. Furthermore, as options pro Jay Shartsis observes, “Corporate insider data from Crosscurrents for these stocks revealed that over the past six months there have been 239 sellers and three purchases…None of this seems to bother Wall Street analysts who maintain opinions on the group, as 51.2% of their recommendations are buys and only 6% are sells (with the rest holds, presumably).”

– Wall Street loves ’em…So consider yourselves forewarned.


Back in Paris…

*** First Mankiw, then Gramlich, now “Father Greenspan,” as our New York editor calls him…what’s going on? Not only did Sir Alan own that burgeoning federal deficits are a problem that must be addressed – he even proposed cutting Social Security and Medicare payments. That’s the third reasonable economic statement made by a policy wonk in the past week.

Of course, as we noted yesterday, there is no constituency for a balanced budget in the country. But at the very least, it looks like there may be some lights on in the U.S. capitol.

Naaah…what are we thinking…that would be too much to hope for!

*** Below, Dan Denning resumes the subject of federal deficits, government debt, and the shadow they cast over the U.S. economy…

The Daily Reckoning