Deficient Thinking

Story Outline:

• America's budget hit another record milestone this year—$3.1 trillion—prompting fears of a growing budget deficit.
• Most investors fear deficits because they assume they hamper stock return.
• Historically, the reverse is true—budget deficit extremes have led to superior market performance.

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It's election season, so prepare yourself for candidates—red, blue, and green—to make hay out of this particular news item.

Bush Boosts Defense Spending in $3.1 Trillion Budget
By Roger Runningen and Brian Faler, Bloomberg.com
https://www.bloomberg.com/apps/news?pid=20601087&sid=a803RNWQqYpE&refer=home

Three-point-one trillion. Trillion with a T that rhymes with P which stands for political hot air. Yes sir, we got trouble right here. But is it really a big deal? We're comfortable saying, from now until the end of time, because of inflation, budgets will keep getting bigger. Though, as a percent of GDP (the correct way to view large numbers), this year's budget growth is unalarming. But it's not the budget that troubles people. It's the deficit—projected to hit $410 billion this year. Time to panic?

Not really. First, deficit projections are rarely right. Consider, when the 2003 tax cuts were passed, hysterical headlines cried the deficit would spiral out of control. Instead, it shrank. Maybe we shouldn't get too exercised over deficit projections. And even if it's true—do big deficits hurt us? Most folks believe, from the depth of their beings, budget deficits are bad for markets, the economy, and our mortal souls. Why? Because deficits add to debt, and most everyone believes government debt is an albatross—slowing stocks and hindering growth.

Is that right? No one is saying, "Hey, budget deficits are awesome!" So this is a good time to check if something is true or if the world has fallen prey to a powerful myth. This is an easy one to check—the data is all publicly available. Plotting past budget balances as a percent of GDP since the end of World War II, we noted extreme highs (surpluses) and lows (deficits). Then we checked subsequent 12-, 24-, and 36-month stock returns. You'd expect surpluses would have led to great returns, but the opposite is true. Budget deficit extremes had the better results—by a wide margin. Following deficit extremes, markets averaged 21.6% over 12 months, compared with -1.8% for the surpluses. After 36 months, deficits averaged 35.1% returns but surpluses just 10.3%. Seeing just that, a rational person would conclude buying big deficits is a superior strategy to buying big surpluses. Even more amazing: It's the same thing globally—Germany, UK, and Japan all experienced superior stock returns following deficit extremes.

And it makes good financial sense. You can reference any Corporate Finance textbook for lessons in leverage and optimal capital structures to discover there's an appropriate debt level for every firm—and extrapolate those same lessons to a federal level. You can also check America's history for times we've had as much, more, or less debt as a percent of GDP to know our current debt load likely isn't troubling. (Having no debt, as we did when President Jackson paid it all off, had disastrous results. We suffered a bank panic and one of the worst depressions in our nation's history.)

But here's another way to see this: Newly lent money in this country changes hands about six times in the first year. Six times! You borrow to buy a car. The dealer takes that money, pays the manufacturer and his employees. The manufacturer pays its employees, buys raw steel, and pays lobbyists. All the employees buy groceries, clothes, and home entertainment systems. The grocery store . . . you get it. Every time money changes hands, it moves our economy along.

It's the same thing with government debt. Yes, our government does really stupid things and we prefer if you or GE or Apple or Lindsay Lohan or even someone less responsible made that first spend. But still, money gets borrowed and spent on dumb government things. Useless bridges. Paved bike trails in communities you'll never visit. Reflective paint on signs in National Forests. The money gets spent, and respent, and respent—and our economy benefits. It's better money gets borrowed and spent six times than if it doesn't get borrowed at all—even when the government does the borrowing.

This is not to say we're happy about bigger government. We'd prefer a smaller government because you're an infinitely wiser spender of your money than any politician. If you could take your own money and make that first spend, our economy would be better off still. But it's wrong to assume a government's debt is bad for the economy. We'd just rather see them borrow money than take more of it by force (i.e., taxes).

And the stock market's our proof! If budget deficits were bad and surpluses good, we'd see it in history—but we don't. So when you read about our massive budget deficit, you can roll your eyes and know the three remaining deer in Union, New Jersey are getting a world-class bypass over Route 78, but it doesn't spell trouble for the market. Quite the reverse!