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.
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.