Big deficit-backed federal spending has the Fed worried. But to stimulate economic growth, deficits are the only way to go.
Some of the Fed's worries (like inflation) may be valid—but not for a while. Even better, deficits have been great for investors historically.
Future circumstances will certainly call for policy reassessment. But let's get this recovery in the books before preemptively fighting a battle that may never come.
Investors notoriously "fight the last war." That is, fretting over ills long gone while the market has already moved on. So it comes as something of a surprise to hear calls to fight the next war—one that hasn't yet arrived. But that's precisely what Fed Chairman Ben Bernanke did this week, warning Congress and the White House to control deficits. What gives?
To stimulate economic growth—the war we're fighting now—deficit-financed spending and money supply growth is the only way to go. Increasing government spending, backed by taxes, only reallocates funds—no real stimulus there. Worse, boosting taxes hurts all those consumers and businesses who're supposed jumpstart and sustain economic recovery. FDR vainly tried to balance the budget way back in the 1930s and, if anything, exacerbated economic woes. So far, that's a mistake the feds have seemed determined to avoid—good!
We don't have much faith the feds spend money well—but amazingly, it doesn't matter much in terms of stimulus. Once the money gets into private hands (and there's virtually nowhere else it can ultimately go), it'll be spent over and over—mainly in more productive, market-determined ways. But what about deficit-financed spending? Mr. Bernanke seems especially irked by two things: potential inflation and rising interest rates.
Sure, massive new money supply (an effort in which Bernanke was a chief conspirator in the first place) could spike inflation down the road, but we're talking a couple years from now—it's not today's war. (See Thursday's better-than-expected productivity report for just one reason why inflation isn't an imminent risk—productivity rose 1.6% for the quarter.)
And although bond yields are going up, it's not at all clear they're rising (nearer to more normal levels historically, we might add) because of inflation fears or deficit-funding troubles. There are other, more plausible, explanations. For instance, the recent stock rally and continued narrowing of credit spreads. Both indicate a return of risk appetite—meaning investors are looking for higher yields beyond the perceived safety of US Treasuries. Those are good things.
So what does Chairman Bernanke think he'll gain by urging deficit reduction now? Maybe he knows how long it takes to get things done in Washington and is just getting the ball rolling—fair enough. Or maybe he's playing politics—after all, he is up for reappointment early next year, and popularity is everything in the Beltway.
Either way, today's deficit is a good thing. It's getting money into private hands and making up for previously lacking velocity. Even better, deficits have historically been great for investors. Seems backwards, right? In fact, stocks have overwhelmingly performed better after deficit peaks than surplus peaks.
Future circumstances will certainly call for a policy reassessment—but for now, the Fed may be jumping the gun. Let's get this recovery in the books before preemptively fighting a war that may never come.