The Glorious Evils of the Twin Deficits

For reference, we have been going through the deepest trade deficits in our history; these deficits exploded after the Asian crisis of 1997-1998 as export demand slowed and huge capital inflows from Asia to the U.S. necessitated a counterbalancing current account deficit. A trade deficit can be restated as a capital surplus, and vice versa. The federal deficit, while quite large in absolute terms, is rather tame as a percentage of GDP. Its size is exaggerated by the recent period of federal surpluses during the late Clinton years.

Growth

Do the deficits affect GDP growth? Under the Keynesian model of the economy, a trade deficit lowers GDP, and government borrowing may raise GDP to the extent it does not exceed foregone investment.

Do Deficits Lower Growth?

Source: Bloomberg

The periods of recession coincide with near-balance or surplus in the current account deficit; this is to be expected, as import demands fall during recessions. The periods of deep federal deficits, concentrated in the Reagan and early Clinton years, correspond to periods of solid GDP growth. The federal surpluses and massive trade deficits seen in the late Clinton and early George W. Bush years correspond to the post-bubble recession; the present combination of twin deficits is associated with solid GDP growth. On balance, the twin deficits have not slowed the economy.

Interest Rates

If you borrow money, you have to pay it back, and that would suggest that deficits might push up interest rates. Nominal 10-year note yields peaked at a time of near-balance or surplus in the current account deficit, and well before the deepest federal deficits. Note yields have fallen continually since then, and reached their lows at a time of large twin deficits. Federal borrowing is only one component of total credit demand, and those big trade deficits really are capital surpluses. Statistically, the twin deficits do not appear to have any ability to push note yields higher.

Do Deficits Cause Higher Interest Rates?

Source: Bloomberg

What About Inflation?

The note yields depicted above are nominal, not adjusted for inflation. Surely our massive debts give us an incentive to inflate the money supply and pay our creditors back with worthless paper, right? Wrong: The start of the disinflation of the 1980s was preceded by an expansion of the federal deficit and accompanied by an expansion of the trade deficit. The GDP deflator actually rose after the budget surpluses of the Clinton years, and then fell again as the deficits rose.

Do Deficits Cause Inflation?

Source: Bloomberg

The Impact on the Dollar

The dollar had its period of greatest strength, as predicted by Nobel laureate Robert Mundell, during periods of fiscal stimulus and tight money. It did not rally as the current account deficit closed in the late 1980s and early 1990s, nor did it rally as the federal budget moved back into balance in the early Clinton years. It remained firm after the Asian crisis, as the Federal Reserve's rate hikes of 1999-2000 provided support. Its present weakness correlates far more closely with the federal funds rate of 1% than with any measure of the deficit.

Do Deficits Hurt the Dollar?

Source: Bloomberg

Stocks and the Deficits

Stocks strengthened in the face of the expanding twin deficits in the early 1980s as both inflation and interest rates fell. The great boom of the late 1990s coincided with the closure of the federal deficit but in the face of an expanding current account deficit -- remember those capital inflows. The stock recovery of 2003 has occurred despite an obvious lack of fiscal discipline in Washington and an out-of-control current account deficit.

Do Deficits Kill Stocks?

Source: Bloomberg

The Bottom Line

Given all of the caveats above about the limitation of analysis done without a controlled experiment and with quarterly economic data, it is striking that only one indicator and only at one time -- stocks during the move toward federal budget balance in the late 1990s -- had the "good" outcome in association with narrower deficits. In all other cases, GDP, inflation, interest rates, the dollar and stocks all either shrugged off wider deficits or rose in the teeth thereof.

This is not to defend a lack of discipline or economic imbalances, and it certainly is not to promote the Orwellian "less is more" conclusion. It is, however, to suggest or even insist that we all abandon our knee-jerk reactions to the latest economic datum and instead look at how it modifies the larger picture. That will produce fewer panics and fewer headlines, and in this case, fewer are better.