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A look at the last two times a major economy has seen its budget deficit rise this rapidly



April 21, 2009 – Comments (11)

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.



11 Comments – Post Your Own

#1) On April 21, 2009 at 4:27 PM, TMFDeej (99.46) wrote:

I meant to say flat to lower prices over the next several years followed by the potential for inflation.


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#2) On April 21, 2009 at 4:38 PM, TMFDeej (99.46) wrote:

I must confess that early last year I blogged that I thought that all of the action that the government and the Federal Reserve are taking would prevent Japanese style deflation.  Unfortunately, now I am not so sure.

While we're on the subject, the New York Times published an outstanding article on the potential for deflation in Spain and the rest of Europe today.  It's definitely worth a read:

Spain’s Falling Prices Fuel Deflation Fears in Europe


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#3) On April 21, 2009 at 4:44 PM, MikeMark (29.89) wrote:


You have to define your terms specifically. When you define your money as cash + credit created (and marked to market), deflation is definitely occurring. That's because of massive credit destruction. People who are hard working savers benefit from deflation. So deflation actually helps the economy recover by making new investment less costly for the hard working saver. Remember that inflation and deflation occur in the money system. Change in prices are one effect of inflation and deflation. Deflation is also an expected benefit from increasingly economical production. Seems to me like everyone has forgotten this fact. A great economy with a sound money makes things less costly over time.

It's unlikely the Fed can create enough cash and new credit to counter the implosion without destroying the US$. That's due to the destruction of savings (held in US$) that occurs during that process. People who have been hard working savers aren't stupid. They will find a way out of using that money (US$). Getting out of that money will cause high (maybe hyper) inflation in that money. The government may create laws that try to prevent it, but in the end the same thing occurs due to economy destruction from lack of freedom.

It's an ugly picture. There's some things to realize though. We are talking about the world's largest economy and the world economy. That means it's unlikely to happen fast. It also means you must pick your solid investments carefully, because the central banks seem to be waging a war upon savings, driving everyone out of them. That means there will be bubbles forming (and popping) in essentially any asset class. Under that scenario, how do you define safety and where do you find it?

Here's hoping for some sanity soon.


PS: pssst, CPI doesn't really measure true inflation. (Remember: price changes are a possible effect of inflation and deflation of the total money supply.)

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#4) On April 21, 2009 at 4:45 PM, kaskoosek (92.46) wrote:

Huge difference between US and Japan.


Japanese citizens funded the government. That is not the case for the US.


If the US keeps running current acount deficits this will definitely lead to inflation on imports. Assuming China and other countries stop funding the reckless spending of the US.

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#5) On April 21, 2009 at 4:49 PM, DemonDoug (92.48) wrote:

seems you have reached the same conclusion as myself deej.  It's hard to see inflation when the recent example of japan is sitting there smacking you right in the face.

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#6) On April 21, 2009 at 7:40 PM, whereaminow (42.76) wrote:

Prices are falling in Spain for the same reason they are falling here.

Here's the recipe:

1. Expand the money supply beyond what the market needs, i.e. the classical definition of inflation.

2. The new money chases fewer and fewer goods, driving up prices.

3.  Higher prices for goods leads to greater borrowing and reduces savings. It replaces real savings with fake savings. For example, if you buy a house because you see housing prices rising that is fake savings. You're merely in the middle of an asset bubble. 

4. Resources get diverted from useful projects to speculative projects since these have the highest return in a boom.  This is called malinvestment by some economists.  It's called greed by hacks.

4. Economic law rares its ugly head. Resources are scarce and no amount of paper money can change that. Every project can't be competed, since their plans exceed the amount of available resources.

5. Businesses start to fail. Their creditors implode on their pyramids of debt.  They call this fractional reserve banking.

6. Prices come tumbling back to reality.  Economists call this falling prices.  Hacks call this deflation.

7. The NYT runs a fear piece warning of global economic collapse.  Greed caused everything.

8. The government steps in the solution: Increase the monetary base beyond what the market needs. The cycle starts all over again.

9. Companies, banks, and governments run by nitwits are rewarded with money from the people that saved money and avoided unsustainable investments (exactly the people that benefit from falling prices.)  Historians call this economic fascism. The NYT calls this Capitalism.

David in Qatar

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#7) On April 21, 2009 at 7:48 PM, whereaminow (42.76) wrote:

I didn't mean to infer that the people involved in the inflation / deflation argument are hacks.  I merely want to point out that prior to the Keynesian revolution, falling prices had no associated negative meaning.  Prices fell consistently for 150 years from the late 1700's until WWII without anyone screaming deflation.

The boom/bust cycle created by monetary intervention excarbates the effects of falling prices.  Yet, the same people screaming about the dangers of inflation are the ones promoting the monetary expansion that causes the boom.  That's why I call them hacks.

David in Qatar

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#8) On April 21, 2009 at 7:49 PM, whereaminow (42.76) wrote:

dangers of inflation

Damn!  That should read:

dangers of deflation

I'm going away now :)

David in Qatar


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#9) On April 21, 2009 at 9:27 PM, walt373 (99.75) wrote:

I think the inflation vs. deflation debate is very interesting, definitely one of the most important ongoing economic issues.

I've read convincing arguments from both sides, but I doubt an obvious answer will emerge. There are too many factors. It's like arguments about religion. Just face it: you won't know what's going to happen until it happens :) Yeah, the answers are "obvious" to the people passionately debating, but zooming out and viewing the argument from both sides and it's only fair to say that both sides have valid points.

This leaves the average investor like me in a predicament. Even if I did believe in either inflation or deflation, I honestly don't think I have enough knowledge about the economy and economic theory to have an edge. It's my guess vs. the market. So how should I allocate my savings? Would the prudent answer be to diversify? Buy some stocks, buy some bonds, and hold cash? It seems like TIPS would be a good middle ground. Like Warren Buffet said, I'm looking for one-foot bars to step over, not a seven-foot hurdle.

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#10) On April 22, 2009 at 9:45 AM, dwot (97.03) wrote:


I would say if you haven't read my past posts that I linked to today in my blog "Prime going Deliquent"  read them as I completely disagree with this proganda that lower interest rates are somehow good.  They are only good for people who already have debt and are able to refinance and free up cash.  They are debt slavery for new borrowers.


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#11) On April 23, 2009 at 2:55 PM, OleDrippy (35.19) wrote:

@ Walt # 9

 I am with you, sir. Best to stay diversified. I'd hate to put all my eggs in one ideological basket and have them all broken. There are two major concerns. Your guess could be WRONG, or your TIMING could be off. Either way some teeth are getting kicked in. I'd rather hedge and be "pretty" right instead of going all in and being "all" right.

Cheers and good luck to us all... We're going to need it.

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