A look at the last two times a major economy has seen its budget deficit rise this rapidly
Anyone who reads the news knows that the U.S. budget deficit is growing rapidly in the as politicians try to combat the current recession through spending money that the government doesn't have on stimulus packages (cough pet projects cough) and bank bailouts.
The important question that arises is what is the implication of running such a large deficit? Many people believe a large deficit will create massive inflation as the value of the U.S. dollar falls and that interest rates will ultimately have to head higher, possibly much higher in order for the U.S. government to attract enough money to fund its spending.
On the other hand, there is another camp that believes that massive deficits are actually deflationary. That is the theory that Dr. Lacy Hunt and Van Hoisington recently laid out for in a recent presentation on behalf of their company Hoisington Investment Management (courtesy of John Mauldin's Outside the Box).
As illustrated in the chart above, the Congressional Budget Office estimates that U.S. government debt will increase to nearly 72% of the country's GDP over the next four years. This would be the largest budget deficit that the U.S. has seen since 1950, and I suspect that even the CBO's estimates are a tad optimistic.
In trying to determine what impact such a massive deficit will have on the country, Hunt and Hoisington looked at two times in relatively recent history when major economic powers ran such large deficits, Japan from 1988 to 2008 and the U.S. from 1929 to 1941.
The following two charts show what happened to interest rates and stocks in Japan while its government debt increased.
The duo from Hoisington Investment Management theorize that large government debt actually acts as a major drag on the private economy by transferring money from the private to the public sector, hindering rather than speeding an economic recovery stating "So, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time."
I don't personally think that things in Japan are quite that simple. Nothing in this world happens in a vacuum. The country has major demographic headwinds that it is dealing with, but the U.S. has its own demographic issues as well. Our population isn't shrinking, but the largest generation of consumers of all time, the Baby Boomers, are passing their peak spending years. Their drop in spending will definitely serve to slow economic growth for years to come.
I had a good chuckle when I read what the Japanese government used all of this deficit spending on. According to the presentation "The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects." Hmmmmm, that certainly sounds familiar.
The other example that I mentioned was when the U.S. deficit ballooned from 16% of GDP to nearly 50% of GDP between 1929 and 1941 as the Great Depression hurt government tax receipts and Roosevelt implemented the New Deal. As in Japan in the '80s, as the as the U.S. deficit rose during this period interest rates fell and the stock market languished. Despite a number of bear market rallies during the 1930s the stock market was 62% lower in 1936 than it was in 1929.
Hunt and Hoisington conclude that massive government spending actually hurts economies in the long run and that it is actually deflationary rather than inflationary.
One key difference that I see between the periods that they reference and today is that interest rates were substantially higher in Japan and I suspect in the U.S. prior to the Great Depression than they were when the current economic mess started. The Japanese government obviously slashed interest rates during its "Lost Decade" (and counting) in an effort to stimulate economic activity. Interest rates were already at an extremely low level here in the U.S. when the stuff hit the fan and they are essentially at zero today. So we won't get the economic benefit of lowering rates this time around.
There are two things that I can see derailing this deflation theory.
The first is that the economy is on the mend and that we will experience a "V" shaped recovery in the very near future. If that does occur, inflation we would indeed likely experience massive inflation. I find a rapid, V-shaped recovery to be unlikely however.
I suspect that economic weakness will last well into 2010 and that any recovery will be much slower than the 3% "normal" GDP growth that so many have become accustomed to. If so, then the only thing that I can think of that would create massive inflation is the implosion of the U.S. dollar.
Will the market begin to choke on all of the Treasuries that the U.S. government has to issue to fund the deficit over the next several years causing the value of the dollar drop dramatically? That's not what happened when Japan cranked up its deficit spending. However, that was a different time and the global economy is in much worse shape today than it was during most of the time that Japan was spending like crazy. Perhaps even if the desire is there, foreign countries will not have the ability to continue to fund the U.S. deficit.
Hmmmmmm, the inflation versus deflation debate is a very interesting one. As an investment advisor that specializes in fixed income portfolios, one certainly can accuse Hoisington of speaking its book. Having said that they make some interesting points. I am still personally leaning towards the belief that the U.S. will experience flat to stable prices as measured by the CPI over the next several years potentially, but not necessarily followed by inflation.