Deficits Gone Wild?

This past weekend I spent an afternoon with my six-year-old nephew, who, between intermittent swigs of Jolt Cola and glassy-eyed Gameboy-induced trances, detailed his fondness for the San Francisco Giants and Barry Bonds, the team's much-maligned outfielder who's closing in on Hank Aaron's all-time home run record. My nephew told me how he hoped to be a famous baseball player someday and make lots of money hitting home runs. With only the slightest hint of irony, I asked him how much he thought he could make if he hit as many homeruns as Barry. Staring contemplatively at the floor and biting his lower lip with steely concentration, he finally looked up and hesitantly offered the most ambitious answer he could muster: "Ummmm…I guess maybe $100?"

To my nephew $100 is a big number and probably at the furthest end of what he can quantitatively fathom. We adults may smile at his naiveté, but truth be told, our ability to comprehend large numbers is not much further advanced. (That's not to say we can't imagine large numbers—especially attached with dollar signs—just ask my wife). We have progressed from thinking in hundreds to thinking in thousands or millions, but even the most cerebral among us has difficulty grasping the magnitude of billions or trillions. At that level, we tend to lose our sense of scale—objective analysis becomes increasingly difficult. Politicians exploit this cognitive handicap to great advantage, continuously calling attention to the audacity of numbers flaunting too many digits.

In few places is this trick played more often than in budgetary accounting, where eye-popping digits are plentiful, especially on a federal level. As presidential hopefuls ratchet up political rhetoric this year, there's one number sure to frequently surface: Federal budget deficits under President Bush—who during his two terms has been almost as maligned as Mr. Bonds. A budget deficit is the amount the government spends in any given year beyond what it collects in tax receipts. In framing these numbers, politicians tend to shy away from economic frameworks, instead focusing on the emotional resonance of scary-sounding numbers. For a multitude of reasons outlined often on the MarketMinder, debt doesn't pose a problem for America—in fact, I generally advocate higher levels of debt of all types! (Of course, some individuals get in trouble with debt, but for America in total it's a boon, not a bane.)

Let's look at the relative size of recent budget deficits to put them in better perspective. In 2006, federal government spending surpassed receipts by $151 billion (i.e. $151,000,000,000). This number looks huge! Any number with that many zeroes is worth a spit-take. Politicians seize on this and summon every ounce of disgust and condescension as they forcefully annunciate the filthy "b" in billion.

However, to understand the relative size of this deficit, we must also look at how much income we produce as a nation—the higher our economic output, the less the relative magnitude of a given year's budget shortfall. The best widely available measure for this is Gross Domestic Product (GDP). While not perfect, this measure offers a reasonably reliable indicator of a country's overall economic health, both over time and relative to other nations. Comparing deficit levels to GDP provides an apples-to-apples comparison of a deficit's relative size over time. In 2006, US GDP was roughly $13.2 trillion, which written out looks like this: $13,239,000,000,000 (another eye-popper). Comparing this number to 2006's budget deficit, we see the shortfall was only about 1.1% of our income (i.e. $151 divided by $13,239).

This same exercise shows budget deficits as a percent of GDP over the last few years have not been much different than they were throughout the 1990s—a time generally considered one of the most economically prosperous in our nation's history. Looking over longer periods of time, the last decade's budget deficits have actually been relatively lower than levels reached during the 1970s and 1980s, and nowhere near levels reached during World War II. (1943's deficit reached 30%!)

The point of this exercise is not to prop up President Bush's flagging legacy, but to provide a more appropriate framework for thinking about budgets and deficits on a national level. There's a lot of hysteria surrounding this topic—most of it simply preying on our inability to fathom seemingly large numbers' relative size. The practical application for investors is to recognize how our brains trick us by framing concepts without adequate context. Keep this in mind in forming your investment strategy—as you monitor risk factors facing your portfolio, you'll know not to include deficits as one of them. And, if you ever manage to score a big-time major league contract, you'll know to ask for more than $100.

Source: Thomson Financial Datastream