Deficit Perspectives

President Obama announced a Commission to attach the deficit problem.  Few will be excited by this move, and I agree.

Most people come to a discussion of debt and budget deficits with their minds made up.  People love to take their own experience and use it as a model for how organizations do and should make decisions.  It is the starting point for a beginning social science student.  The key is to learn why organizations do not behave like the individual members.

The basic argument is that you cannot run your family budget at a deficit, so why should the Federal government be any different?  That is enough to carry the day with most people.

I am going to attempt something that is difficult to do, and therefore foolish to try.  I am going to do three things:

1. Outline the public policy viewpoints, the way I might have done many years ago in the classroom;
2. Analyze the political situation and venture a few predictions about the outcome; and finally
3. Explain what this means to us as investors.

Moreover, I propose to do this without bias toward any political or policy viewpoint, and also while citing supporting evidence.  I fully expect those (from all sides) who have an opinion set in concrete will accuse me of bias, so it should be a lively discussion.

The piece is also too long, too scholarly, too boring, and includes too many references.  Since no one will really read the entire article, much less the excellent citations, here is the executive summary:

Obama appoints a commission in a symbolic gesture.  All will shrug.  We will continue to spend to stimulate the economy.  Most mainstream observers think this will work in the short run.  It might lead to later problems.  It is all probably bullish short-term, but we need to keep a close eye on the economic indicators.

Death to Deficits

A strong anti-debt perspective comes from David Merkel.  We like his approach because it is principled rather than overtly political.  Merkel writes as follows:

Debt levels in an economy matter.  They matter a lot.  An economy that

is financed primarily by debt can be like a chain of dominoes.

and...

Economies are more stable when they limit fixed claims and encourage

financing via equity rather than debt.  Imagine what the economy would

be like if interest was not deductible from taxable income, but

dividends were deductible.

Readers know that I am a fan of Merkel's work, perhaps more so when he is analyzing rather than advocating.  He has an advocacy position here, but he puts the case better than other advocates.

Aggressive Partisans

Some commentators are identified with the Obama Administration.  It does not mean that they are wrong, but it is something to keep in mind.  Here are the observations of Robert Reich,  Secretary of Labor in the Clinton Administration and regular liberal presence on talk shows:

1. Government spending needed to offset the continued reluctance

of consumers and businesses to spend. You don’t have to be an

orthodox Keynesian to understand that as long as the private sector is

deleveraging, the public sector has to borrow and spend in order to keep

the economy moving forward.

The current stimulus will peak in a few months. Add in unemployment

insurance payments and outlays for the jobs bill, and the stimulus will

be about $90 billion larger. But this sum is not likely to be enough to

make up for the shortfall in private spending. Consider also that state

and local governments are also slashing jobs and services -- and

raising taxes about $350 billion over this year and next -- and Obama

needs to spend more.

Just look at projected unemployment. Since the start of the

recession in December 2007, the labor market has shed 8.4 million

payroll jobs. Add to these the number of new jobs needed to keep up with

population growth and we’re about 11 million jobs behind the

pre-recession unemployment rate. To fill the 11 million jobs gap,

employment would have to increase by over 400,000 jobs every month for

the next three years, starting now.

Paul Krugman, via Mark Thoma:

Thus Krugman believes the United States has benefitted from the $787

billion

federal stimulus package that was signed into law in February 2009...

Krugman

thinks the legislation helped alleviate the recession’s effects. “We

would

probably have 12 percent unemployment in the U.S. if we didn’t have the

stimulus,” he said. Yet the seemingly long odds against additional

government

spending are leading Krugman to think we may well be headed for a

double-dip

recession — the contemporary counterpart to the slump that occurred in

1937,

just as the U.S. economy was recovering from the worst of the Great

Depression.

And Krugman also calls the fixation on deficits "fiscal scare tactics."

Bill Mitchell, a provocative Australian econonmist, has a strong economic viewpoint.  From his perspective, many of those citing Austrian economics are "deficit terrorists."  In one article he does a rather comprehensive analysis of a John Mauldin weekly letter, concluding as follows:

Anyway, what you soon realise is that the newsletter uses a common ploy

among these “terrorist” types – ask a lot of pointed questions – make it

sound like the sky is falling in, but don’t go into too much detail.

The tactic just turns all the emotional knobs that the author knows will

exploit the ignorance (in these matters) of the readers. Work on the

emotional rather than reasoned and informed plane.

(I'll be happy to highlight any substantive reply from Mauldin, but there has been nothing so far.)

I searched, but it is impossible for me to do justice to the Mitchell arguments with a single quotation.  Another Mitchell article offers an explanation related to another blogger:

The problem is that if I just said “governments can spend what they

like” and left it at that, imagine the reception! I get it anyway, but

at least thoughtful antagonists such as Kid Dynamite do feel the need to

engage and delve a bit more deeply as to why an otherwise smart

sounding character (senior professor, PhD, lots of high quality academic

publications etc) would say something as “stupid as that”.

It is useful and zesty commentary, but prepare to spend some time there.

Classical Keynesians

Joseph Stiglitz (via Mark Thoma) attacks the "deficit fetishists":

Obama

must resist

'deficit fetish', by Joseph E. Stiglitz: ...Don’t give into deficit

fetishism. ... The real risk for America right now is a prolonged weak

economy -

something that a mindless focus on deficits can help ensure. 

The deficit hawks from the banking system went on vacation from the fall

of 2008

through the spring of 2009, while they demanded money be doled out

freely - to

themselves. But now that the public clearly won’t stand for another free

lunch

at its expense, the deficit hawks are back at work, more vocal than ever

about

the need to cut government spending. 

They say it was necessary to the health of the economy to dole out money

to the

banks; but not necessary to the health of our society to make sure

everyone has

access to health care. It was not acceptable to alter the contracts of

the AIG

personnel, even those “key” and irreplaceable personnel who made the

mistakes

that led to a $180 billion bailout, but acceptable to break the social

contract

between America’s elderly and the rest of society, by cutting back on

Social

Security. 

The bankers were short sighted when getting the country into the mess.

But

deficit fetishism is equally short sighted. ...

Barry Ritholtz takes a similar view, criticizing "recent deficit hawks as follows:

How is it that they only learned of the evils of deficits after they

lose power? How very convenient.

The current group of anti-deficit spenders are pro-cyclical, rather

than counter-cyclical. This means that during an expansion, they have no

problem with expanding deficits, running big spending programs, giving

generous tax cuts. During a recession is where they suddenly rediscover

fiscal prudence.

This is ass backwards. During an economic expansion, with employment

gaining and GDP growing is when you should be thinking about saving for

the next rainy day. Counter-cyclical spending means that governments

should watch the budget carefully during the good times, but spend spend

more freely during the downturns. What we are hearing from this crowd

is the exact opposite of what should be.

The Pragmatists

Bob McTeer is a conservative but also a pragmatist.  He does not like excessive spending any more than you, or I, or David Merkel.  The difference is all about timing.

U.S. debt is a problem, but not a crisis. If worse comes to worse, the

Treasury (with the help of Congress) could prevail on the Federal

Reserve to buy its debt at prices more favorable than those demanded by

foreign creditors. If not sterilized, thus neutralizing the impact of

the purchases on the money supply, the Fed would be monetizing the debt

and a pickup in inflation would be the likely outcome. Indeed, that is

what people mean when they refer to “inflating your way out of debt.”

Similar advice comes from James K. Galbraith (HT, James Altucher, now added to our featured sites).  The Galbraith interview is rich with ideas on many themes -- well worth reading.  For today's purposes, this is the key observation:

First of all, it’s very clear that the United States government is not

constrained externally, and it’s clear that quite apart from the

stimulus package, the automatic stabilizers and the financial rescue,

which greatly ballooned the public debt of the United States, have had

no effect on the ability of the United States government to fund itself

and no effect on the interest rates that the government pays. So, it, I

think, follows from that logically and straight-forwardly that we have

nothing to fear from additional efforts as long as they are necessary.

And they’re obviously very clearly necessary. So the question is: what

should be the structure of those efforts?

Political Conclusion

Forming a Commission is a standard operating procedure when dealing with a tough question.  There is widespread agreement about the deficit problem.  The nature of our political system is biased toward greater spending and lower taxes.  Honest observers will see that this has been true regardless of which party is in power.

I have personally been part of such Commissions at the state level, and observed them closely at the Federal level.  I have a number of great stories, but you can all guess the truth.  These Commissions are formed to take the political heat away from the current administration and Congress.  It is an alternative method of forging a bi-partisan conclusion.  Sometimes it actually shows some progress.

For now, it is the President's way of making a symbolic action, while continuing to follow the "pragmatist" course described above.

Investment Conclusion

As investors we need to start with facts.  Here is the most important:

The accepted policy is to reduce deficits through economic growth, not by cutting spending or raising taxes.

If you reject Keynesian economics, you will expect the policy to fail.

Now we have the question of time frames.  The Keynesian stimulus may work in the short term, but lead to future problems.

I cannot tell you what to do, but here is my plan.  I am carefully following economic statistics and corporate profits.  I suspect, but cannot prove, that there will be a positive impact from government policies over the next year.  My crystal ball gets pretty cloudy when I look more than nine months ahead.