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July 17, 2019 / 1:07 PM / a month ago

Why Budget Deficits Are Not a Sign of Financial Armageddon

Most folks believe budget deficits are bad and budget surpluses are good. This conventional wisdom is, in large part, the product of a steady stream of news stories lamenting the current US budget deficit. Although the particulars change, these largely fearful stories might focus on raising the debt ceiling (yet again!) or on an impending record budget deficit. Very often the alarm over budget issues extend to a concern that it might cause stock markets to tumble.Most folks believe budget deficits are bad and budget surpluses are good. This conventional wisdom is, in large part, the product of a steady stream of news stories lamenting the current US budget deficit. Although the particulars change, these largely fearful stories might focus on raising the debt ceiling (yet again!) or on an impending record budget deficit. Very often the alarm over budget issues extend to a concern that it might cause stock markets to tumble.

Although the underlying assumptions are not always articulated, in general they go something like this: Debt is bad. Therefore, if our government is running a substantial deficit, that’s bad and a sign of irresponsibility since it means the government must go into more debt to cover its expenses. Moreover, deficits will eventually drag markets down, and the bigger these deficits are the more they will weigh on markets. But just because people believe something doesn’t mean it’s true. A better gauge of truth is back-testing your idea against historical data. In this case, doing so is pretty easy.Testing Against History

There are troves of data readily available on budget surpluses, deficits and market returns. By putting these together we can easily test the popular idea that budget deficits lead to terrible market returns. What we discover may surprise you.

Exhibit 1 shows US budget deficit and surplus peaks going back to 1947. These are shown as a percentage of GDP, so they are measured against the size of the US economy and not as an arbitrary dollar amount as might typically be reported in the popular news media.

Exhibit 1: Federal Budget Deficit as a Percentage of GDP

 

Source: Federal Reserve Economic Data, as of 4/2/2019; Quarterly Net Federal Government Saving, SAAR, 1/1/1947 – 12/31/2018; Quarterly Gross Domestic Product, SAAR, 1/1/1947 – 10/1/2018. FactSet, as of 4/2/2019; S&P 500 Price Return Index Level, 1/1/1947 – 12/31/2018.

In Exhibit 1 we see a big surplus at the end of 1999. What followed wasn’t a market upsurge, but a bear market. And the deficit peaks of 1982 and 1992 were followed by strong bull markets. Perhaps most surprising—alongside the huge budget deficit of 2009 we experienced a massive market recovery as stocks surged upwards. In these cases, budget surpluses didn’t drive market returns and the deficits didn’t hold back bull markets.

Perhaps this is easier to see and understand if we look at Exhibit 2. The average returns after budget surplus peaks are -1.2 percent after 12 months and 8.8 percent cumulatively after three years. This shows us that surpluses don’t seem to help stock returns — in fact, they hurt them.

Perhaps this is easier to see and understand if we look at Exhibit 2. The average returns after budget surplus peaks are -1.2 percent after 12 months and 8.8 percent cumulatively after three years. This shows us that surpluses don’t seem to help stock returns—in fact, they hurt them.

Source: Federal Reserve Economic Data, as of 4/2/2019; Quarterly Net Federal Government Saving, SAAR, 1/1/1947 – 12/31/2018; Quarterly Gross Domestic Product, SAAR, 1/1/1947 – 10/1/2018. FactSet, as of 4/2/2019; S&P 500 Price Return Index Level, 1/1/1947 – 12/31/2018.

Exhibit 3 tells a very different story. The average returns after budget deficit peaks are 16.7 percent after 12 months and 29.2 percent cumulatively after 3 years. By looking back on the data we can see that stocks perform much, much better after budget deficit peaks than after budget surplus peaks.

Debt Reconsidered

While many regard government debt with suspicion or outrage, attitudes are generally different when it comes to personal debt. Most individuals would be unable to buy a house or car, send a kid to college or start a business without the ability to take on debt. And there is also an understanding that companies also often need to take on debt to expand, to fund research and development or to buy up a competitor. Of course, there will always be individuals and companies that use debt foolishly and suffer for it. But more often than not, access to capital is an important driver of economic activity and well-being.

You might point out that governments often or frequently spend foolishly. This may be true, but what matters most is what happens to the money once the government spends it. That spend can go to other governments; companies and institutions (for-profits or non-profits); and individuals. As that money makes its way into the pockets and bank accounts of companies and individuals it is usually spent again, whether on payroll or groceries. This cycle repeats itself again and again. As money is spent it is, in turn, spent again. All that economic activity creates value and drives economic growth—regardless of whether the initial government spend was the best use of that money.

The Velocity of Money

We can further understand how government spending—even if it is not well thought out—can benefit the broader economy by considering the velocity of money. This is the rate at which money moves through the economy. You can think of it simply as the rate at which money is spent. In general, a higher velocity of money is a good thing. It’s a sign of robust economic activity—with companies and individuals feeling confident and spending accordingly. Government spending can increase the velocity of money, regardless of whether the government spends well or poorly. The economy doesn’t really care.

When deficits grow there’s more money flying around the economy and more of that money is used by individuals paying their bills, companies expanding their operations and investors buying stocks. The opposite is true in cases of budget surpluses. In a surplus situation, the government takes in more than it spends and typically pays down some of its debt—which reduces the quantity of money circulating through the economy.

While you may not love government debt, big budget deficits are often bullish, so long as the government is able to afford the cost of servicing that debt. In fact, for investors, often budget surpluses are to be feared much more than deficits.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return.  This document constitutes the general views of Fisher Investments and should not beWhile you may not love government debt, big budget deficits are often bullish, so long as the government is able to afford the cost of servicing that debt. In fact, for investors, often budget surpluses are to be feared much more than deficits. regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

The Reuters editorial and news staff had no role in the production of this content. It was created by Reuters Plus, part of the commercial advertising group. To work with Reuters Plus, contact us here.

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