Why the Deficit Isn't a Problem

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Both House Speaker John Boehner and President Obama agree the deficit is a problem that should be immediately dealt with. Where they disagree is how to fix the deficit: One side wants massive spending cuts and the other wants to raise taxes on wealthier Americans.

I'm here to say that they're both wrong. What we need right now isn't fiscal responsibility, but fiscal debauchery on an unprecedented scale. This is because the real threat to the economy isn't the deficit but unemployment and dismal growth. Only when the economy picks up will the deficit be a problem. Saint Augustine's plea "Lord, make me chaste -- but not yet" should guide our thinking on the deficit.

We're not bankrupt and we're not Greece
It's common to hear politicians on both sides proclaim that the U.S. is bankrupt. If we are, that's news to millions of institutional investors who are eagerly lending hand-over-fist to the U.S. government.

Over the past few months, the Treasury has been moving 30-year bonds -- like those held in iShares Barclays 20+ Year Treasury Bond ETF (NYS: TLT) -- at record low yields. And today investors are willing to lend money to the federal government for 30 years for only 0.73% per year after inflation. We know this by looking at yields available on TIPS, such as those held by iShares Barclay TIPS Bond Fund (NYS: TIP) .

So the question is: Who do you trust to assess the solvency of the U.S. government: politicians or investors with skin in the game?

What eager Treasury investors know is that the U.S. can never become Greece. This is because, unlike Greece, the U.S. can print dollars at will to pay off any debt, since its obligations are dominated in dollars. So in the most literal sense, the U.S. can never go bankrupt. It can always print any amount of money to pay investors back.

The problem with printing money is, of course, inflation. (For a country with fiat currency it's inflation -- not revenue -- that is the primary constraint on government spending.) But investors aren't too worried about inflation, either. The market's inflation expectation for the next 30 years (roughly Treasury yield-TIPS yield) is a benign 2% per year.

Why investors should oppose budget surpluses
So why does the market expect inflation to be so low when it seems like all the federal government ever does is spend money it doesn't have?

The answer is that the market thinks economic growth and unemployment are the real problem, and not the deficit. And the market knows that unemployment means slower growth, which means relatively fewer dollars chasing the same goods.

The basic problem with the economy right now is that businesses not named Apple are facing a dearth of customers. And without customers, there are few reasons to hire people and plenty of reasons to fire them, creating unemployment. And with unemployment there is even less spending, and with less spending even less employment, and so on and so forth in a vicious cycle.

What the government should do in such a situation is one of two things (or both). Either cut taxes to give people more of their own money to spend, or spend money it doesn't have via government projects. As presidents Reagan and Franklin Delano Roosevelt would attest, both ways can work wonders, and both ways expand -- not contract -- the deficit.

What won't work is the way of President Hoover, and what is rapidly becoming the way of Speaker Boehner and President Obama: raising taxes and/or cutting spending. It hasn't worked in Europe, and it won't work here.

I think the market intuitively understands this: The reason why stocks fell and Treasuries paradoxically rallied on the day of the S&P downgrade was fear that it would cause Congress to do something about the deficit. And doing something about the deficit is almost certainly bad news for the economy and stock market (less spending, more unemployment, less economic growth).

But don't just take my word for it. Ken Fisher, in his 2007 book The Only Three Questions That Count: Investing By Knowing What Others Don't, points out that stocks have actually done better during times of deficit spending than during budget surpluses (i.e., 2000). Fisher also points out that the federal government may be underleveraged, a view he reconfirmed postcrisis, but I won't deny him well-deserved book sales by divulging the details.

Don't get me wrong: Despite the government's ineptitude, I'm I'll still very bullish on the Dow (INDEX: ^DJI) . That's only because stocks are so cheap that growth is relatively unimportant. But things could be even better for stock investors (and certainly for the unemployed) if politicians would give up their austerity pretentions and focus on growth and unemployment.

There will come a time -- when the economy is booming -- that the deficit (via inflation) will become a real threat. But right now the deficit is a red herring that Congress, the president, and investors should ignore.

At the time this article was published Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by@askchrisbainesChris' stock picks and pans have outperformed 92% of players on CAPS. He owns no shares of the companies mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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