Do Deficits Matter?
Last week we were speaking with a very knowledgable gentleman about financial markets. We expressed GreenPort’s bullish view of domestic equites. We started discussing corporate earnings, multiples, etc., but were quickly cut off. Out came his cell phone. He opened an App that monitors the Federal Deficit. “How does this not concern you? We are 22 trillion-dollars in debt! We are running a current deficit of monumental proportions due to the tax cuts and overspending by the government.” The numbers spun furiously on his debt clock, adding millions of dollars of debt as we spoke. We are hard wired as humans to defend our personal viewpoint, while poking holes in the opposing viewpoint. That’s just how we are made. We consider ourselves fiscal disciplinarians, so it’s really hard for us to dismiss deficits. We dare you to open this link and not be alarmed. http://www.usdebtclock.org Why then aren’t we running for the hills? We base our investment outlook on historical relationships between market returns and economic data. We do our best not to allow ideology and emotion affect our decision making. Sometimes this can be really difficult. Just like each of you, we have personal opinions about what’s going on in the world and what politicians hold what offices. The reason we focus on some issues and not others in our investment process, is that some issues can be proven to impact financial markets, and some can’t. We do our best to understand all issues, but only allow data that has proven itself significant into our investment process. Successful investors need to be unemotional. Some might even say callous. We prefer the words systematic, disciplined, and handsome. As Meatloaf famously sang, “two out of three ain’t bad”. Do deficits and the 22 trillion-dollar national debt matter to stock market performance? Regression analysis would suggest yes, but here’s the shocker. History tells us deficits are unambiguously good, and surpluses are bad, for the economy. There have been seven periods in US history when the government ran surpluses and lowered the national debt. All seven periods were followed by a recession or a depression. Our most recent surplus was during the tech boom of the late 90’s.
We accept, albeit despise, these findings. We believe in fiscal responsibility. We would certainly never suggest that our clients systematically spend more money than they earn. So how can we reconcile these results with our belief system? Simple, we accept economic theory that we also despise. Modern Monetary Theory (MMT) states that not all debt is created the same. We dive into the details below, but for those of you who just want the executive summary here it is; Because the government, unlike individuals, has the ability to create money, sovereign government deficits don’t matter. They can simply print more money to pay their debts. Now for the deeper dive. MMT is not really that modern. It was first introduced in 1905. It proposes that sovereign governments running deficits issued with their own currency, have no risk of default. They can simply make more money to pay their debts. It’s when governments borrow from other countries that debts matter. Here’s the gorilla in the room. This makes sense unless people lose faith in the currency. At what point do these lose faith? We can’t say, but we think we are a long way from that level. Historically what makes people lose faith in a currency is when a government loses it ruling power, or when the currency hyperinflates and effectively makes the currency worthless. There are countless examples of both throughout history. Even today, many less developed nations only transact in U.S. Dollars. Despite having their own currency, they have more faith in the U.S. Dollar. German hyperinflation in the 1920’s is often cited as an example of printing too much money. Following World War I, the Germans printed money to pay of their war debt.
Deficits concern us. If the U.S. Government doesn’t change their spending habits or increase their revenue, we will eventually hit a tipping point. We believe we have a very long way to go before that point. GDP is composed of both government spending and private sector spending. Our Government is running a deficit, but the private sector is running a surplus. This is why GDP can continue to grow despite our public deficit. Here’s the other positive, it’s all relative. Global investors need a currency to store their money in? The next largest currency is the Euro. A currency based on a monetary union that is anything but stable. How about this for our nation’s deficit motto? “We may be ugly, but everyone else is uglier”. Deficits, in particular spending, need to be brought under control. However, there is no evidence that the current deficit and national debt will be the economy’s undoing in the near term. The GreenPort Team