The InvestMentor

February 12, 2003

_______________

Benjamin Disreali was said to have quipped that there are three kinds of lies: lies, damned lies, and statistics. Sir Ben was a British pol from the 19th century, and I suspect that he hung out with economists. Why do I think that? How else could he have so brilliantly highlighted the nature of fallacious economic theories supported by statistics?

Today, perjurious information is flowing freely about the impending fiscal budget deficit. Said information is often supplemented by meaty helpings of statistical data. But as one versed in the use, and misuse, of data and statistics (read: a numbers guy), I'm going to ask you to challenge three arguments for why the deficit will be the death knell to our struggling economy. I hope it will allow you to see the economy as I do—that the likely deficit, while not ideal, is a path of least resistance, likely to be short in duration, and to have a limited negative economic impact.

#1 "The deficit will cause interest rates to rise."

This is based on an old economic concept called "crowding out." Namely, if a government's need to borrow goes up, it should flood the bond market with Treasuries, and thus force the private sector to raise the interest rates on their issued bonds, in order to compete for investors. Sounds good. Doesn't really work that way.

Before going into why, let me show you a perfect example of when that should have happened, but clearly didn't–one you probably can recall. Ronald Reagan's terms as President are remembered for, among other things, ballooning fiscal deficits. Yet over the same period, interest rates fell steeply. Below, you'll see the rising annual budget deficit from 1981-1991, followed by a chart of the yield on 3-year Treasury bonds over that same period.

If the relationship held true, rates would have risen along with the deficit.

The same missing relationship can be verified elsewhere. In Japan, they went from a budgetary surplus in 1990, to a deficit that accounted for 7.1% of GDP by 2001 (a huge number, as you'll see later). While this deficit was undergoing its Jiffy Pop expansion, rates went into freefall. The yield on 10-year Treasuries was 7% in 1990. Last year it was 1.3%.

The reason marginal increases in government borrowing don't translate into a like increase in rates is that there are other pressures that trump crowding out concerns. Inflation is the greatest driver of interest rates along with economic growth and monetary policy.

But the proof is in the bond market pudding, where theory gets reconciled with reality every minute, trade by trade. Budget deficits for the next few years have been forecast for six months now. Yet intermediate-term bond rates haven't budged. If traders thought rates were rising in the future, they'd be pricing it into bonds that mature over the next few years and beyond. (You can verify rate changes online using the super-cool Dynamic Yield Curve at stockcharts.com).

#2 "We are headed for record levels of budgetary deficits."

This isn't so much a lie as it is a deliberate use of language that leads to a skewed perception about the burden of a budgetary shortfall.

Current projections are for an annual deficit to occur from 2002 to 2006.

Deficit projections are just that—projections. Projections are hard to make and change dramatically in a short period of time. Recall that just a year before the recession started, we were projected to be in a surplus this year and next.

Below are the annually projected budget surpluses and deficits, in billions of dollars, out to 2010.

Source: Congressional Budget Office

Let's say the actual numbers are higher—as some fear—for reasons that range from the cost of a war in Iraq to overly optimistic projections for future tax revenue. If, in that case, we actually had an annual shortfall in excess of $250 billion it would be true that it was a "record" deficit dollar amount.

However, at $250 it would still be less than half of the burden that the deficit was in the 1980s. That's because in order to assess the "level" of a deficit, it needs to be compared to Gross Domestic Product (GDP). Expressed as a percentage of GDP, a $250 billion dollar annual deficit is only 2.5% of a $10 trillion economy. As the chart below shows, in the '80s, we exceeded 6% of GDP.

In the same way that a 100-point move in the Dow ain't what it used to be, $250 billion is half as much as it was back then.

Most comparisons between the government's "checkbook" and ours are flawed for the same reason. You and I are not the government. We can't borrow at the risk free rate, can't print money (legally, that is), and we can't demand and dictate our income amount.

A government can earn as much as it wants, up to the aggregate amount of its citizens income. If it wants more income (properly referred to as revenue), it increases the tax on its citizens. Thus, deficits are always a choice. If you or I have a cash flow short fall, chances are we can't demand more income from our employer, the marketplace, or our investments, at will.

A government intentionally runs a deficit when it believes that an offsetting tax hike would permanently retard revenue and perpetuate the deficit. Conversely, it may not want to reduce expenditures for the impact they would have on aggregate demand, not to mention the political damage associated with cutbacks in services to the populace.

Yesterday before Congress, Alan Greenspan advocated the use of offsetting spending cuts to minimize, if not eliminate, the foreseen deficits to minimize the long-term destabilizing effects of deficits on the economy. It's hard to argue against that point. But a deficit of a couple of years in length, that doesn't breech 3% of GDP, is not something to get worked up about. No lie.