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Why You Shouldn't Be Worried About Debt and Deficits

The U.S. has been dealing with a debt and deficit crisis for more than five years now, and it's still a hotly contested debate in Washington, D.C. The federal government is limited in what it can borrow with what's called the debt ceiling and every time we approach it  there's debate over how the deficit can be cut, whether to raise taxes, and exactly where cuts can come from.

Interestingly, over the past four years the Dow Jones Industrial Average (DJINDICES: ^DJI  ) has gone progressively higher as debt has piled up. How could that possibly be?

There are some crucial factors often missed in the debates over debt and deficits, and they're a few of the reasons markets keep rising. Below are the biggest reasons why I'm not losing sleep over debt and deficits these days.

How big is the budget problem?
To frame the discussion, we need to lay out the debt and deficit figures I'm talking about. The budget deficit for the last 12 months was $652 billion and the national debt stands at around $17.1 trillion with $11.9 trillion held by the public . These figures seem huge, but they have to be seen in context of the $15.8 trillion U.S. economy .

From that perspective, the deficit is only 4.1% of GDP while the debt is about 108% of GDP and debt held by the public is 75% of GDP. These figures are unsustainably high, but you can see below that they're also falling rapidly.

Source: Treasury Departmentand Bureau of Labor Statistics.

The reason I'm not overly worried is that there are tailwinds and structural advantages that will keep the debt from crushing the economy. The economy is improving, sequestration continues to cut spending, and the Fed has the ability to keep us from too much financial trouble. Let's dig into those a little bit.

The economy is just starting to kick into gear
We can't forget that the recession that began in 2008 was deeper and longer-lasting than any recession we've had since the Great Depression. The financial system nearly collapsed and as a result lenders began to increase borrowing standards when they loaned money at all.

The impact on the economy as a whole is tremendous when a recession hits at the same time the banking industry freezes. Most importantly, unemployment shot up, which meant that fewer people were paying taxes and more were collecting unemployment. The chart above shows a correlation between the rate of unemployment and the deficit, although the size of the deficit isn't entirely because of the unemployed.

What's also clear is that as more people begin working, the deficit will fall as the tax base increases. That's played out over the past three years, and it will continue in the future. If the economy improves, the deficit will fall, especially with cuts already put in place.

U.S. economy is the world's most robust
No matter what your thoughts on what caused the great recession or what side of the political aisle you stand on, it's hard to argue that the U.S. economy isn't more equipped to handle disruption than anywhere in the world.

We have a currency that can be expanded and contracted as needed to keep the economy afloat, unlike Europe. Economic recovery isn't as dependent on increased government stimulus, unlike China. And most importantly, we have a history of capitalism and innovation that breeds the best ideas and best businesses in the world.

These forces act to pull the U.S. from down times and they have for more than 100 years. With innovations in oil drilling, solar energy, electric vehicles, 3-D printing, and much more, I think the economy is proving very resilient once again.

The federal government always has a way out
We also need to consider that the U.S. always has a way out of debt, even if the results of reducing debt aren't pretty.

The Federal Reserve can print money to pay off debt, which is sort of what it's done with quantitative easing. In reality, QE takes U.S. debt out of public circulation and puts it on the Fed's balance sheet, but it has a similar impact to paying debt off from a budget standpoint. Of course, printing money to pay off debt would likely lead to massive inflation and has ended disastrously throughout history (see German hyperinflation in the 1920s), but it's an option. 

The government can also raise taxes, essentially giving itself a raise. This is a lever that's been used to reduce high debt loads in the past (after World War II) and has even been used in the past year.

The bottom line is that the federal government has tools to reduce debt and deficits that aren't available to your average family. Another reason not to lose sleep over debt and deficits.

Don't lose sleep over debt and deficits
I'm not suggesting that the debt isn't too high or that deficits shouldn't be smaller. What I am suggesting is that consumers and investors shouldn't lose sleep over them because there are tailwinds that are helping.

The Dow Jones Industrial Average has had a great year in 2013 and as deficits fall and the economy improves, I think there's a lot of upside for stocks. Remember that corporate America has some $1.5 trillion in cash waiting to be spent. If the jobs market improves, so does consumer spending, which leads to business investment, and a reinforcing loop of economic growth ensues. Falling deficits take a hindrance to growth away, and if federal spending cuts stop, they may actually add to the growth. 

Keep an eye on the long-term prize
Investors who outperform the market often look past short-term challenges like this year's budget to the bigger picture and long-term industry winners. That's why our CEO, legendary investor Tom Gardner, has permitted us to reveal The Motley Fool's 3 Stocks to Own Forever. These picks are free today! Just click here now to uncover the three companies we love. 

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Comments from our Foolish Readers

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  • Report this Comment On November 23, 2013, at 6:20 AM, Fight4Justice wrote:

    This was a nice article and very informative but there seems to be so many unbelievable actions taken by the US government over the past 14 years that I tend to think the debt and free spending will play a role in a world wide economic melt down. I hope I am very wrong.

  • Report this Comment On November 23, 2013, at 6:32 AM, EGTalbot wrote:

    Your conclusion that we shouldn't worry about it nearly as much is correct, but I'm not sure you mentioned the most significant reason for it. You sort of implied it in "the federal government has a way out."

    Here's where I think you went wrong:

    "These figures are unsustainably high, but you can see below that they're also falling rapidly."

    Yeah? No offense, but can you back up that they are unsustainably high for a nation that not only prints its own money but is the world's reserve currency? Without citing studies that come from Chicago or Austria ;)

    If you want to say, "we won't always be the world's reserve currency," you may be right, but that's what people have been claiming since Reagan first ballooned the debt (actually more like since Nixon broke the final tie with gold). At some point that becomes like saying the sky would be green if only it weren't blue.

    A lot of people like to claim the debt is unsustainable, but there is relatively little evidence to support that. The two studies most often cited in recent years were both discredited in 2013. I am sure there is a level of debt that is unsustainable. I find it likely that we're not close yet, but I could be wrong as well - thing is, my evidence for that is no weaker than the evidence that it *is* unsustainable.

    Side note on deficit - given how the government plays with the annual numbers, deficit is a massively misleading figure unless you dive hard into the more detailed numbers. Even the official debt numbers can be as well, since it includes money promised to the future, something that doesn't really get discussed when social security or medicare get brought up.

  • Report this Comment On November 23, 2013, at 2:47 PM, GaMbaJd wrote:

    The article does not address how much of the rise in stock prices are due to inflation. The question is, will you gain or loose purchasing power by investing in the stock market, after paying the "inflation tax", the tax on capital gains caused by inflation, not any growth in purchasing power.

    It ignores the explosion in the deficit which will be caused by the HUGE subsidies given to individuals to buy Obamacare (actually PelosiCare) health insurance.

    On the other hand, what are the alternatives (to investing in stock)?

    Bottom line is, the ruling 1% will do well.

    "Even the official debt numbers can be as well, since it includes money promised to the future, something that doesn't really get discussed when social security or medicare get brought up."

    The brunt of the economic hardship will be placed on the working class by cuts in EARNED and Paid for Benefits / now known as "Entitlements".

  • Report this Comment On November 23, 2013, at 10:01 PM, Unclegeek wrote:

    What? No mention of interest rates in an article about the debt?! The interest owed on the national debt stands at over $350 Billion YTD at these historically and ridiculously low interest rates. Rates have no where to go but up. Should they rise to even half the historical norm, the amount of interest alone on the National debt would exceed ONE TRILLION Dollars per year. Add to that whatever deficit you wish and it does not take too much imagination to conclude that the only way out is to inflate it away, while increasing taxes, since politicians find it so difficult to reform entitlements.

  • Report this Comment On November 24, 2013, at 1:57 AM, MareC0gnitum wrote:

    As long as the Federal Reserve continues to dump $85 billion a month into worthless seurities and bonds, your world will be rosey. Since you don't realize that there is no Federal Budget, you can't tell the difference between the national debt and the spending deficit. It doesn't matter that none of your bullett points are true beause no one should worry about things that can't be changed. Government spending is an addiction that will cause global economic winter. Foolish spending will spend people into the poorhouse. Over spending will break businesses. Uncontrolled spending will bankrupt corporations and cities. The Federal Government will bust the country and you will live to see it.

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