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With financial markets disintegrating, housing devastated, unemployment nearing double digits, and our incoming president warning that things will get worse before they get better, it is tough to see better times on the horizon. One simple observation should inspire some bit of hope, however: stocks go up the more government borrows and spends.

Basic analysis on data from 1962 to 2006 shows positive correlation between federal deficits and CPI-adjusted S&P 500 returns.

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You can see the wide spread in returns versus budget deficits. This shows ambiguity in drawing a causal relationship, particularly because the numerical correlation is only -0.2895. Nonetheless, the trend shows that during times of budget deficits stocks fared better.

Remember that correlation does not necessarily mean causation. We could note that the sky happened to be blue more often while stocks were up over a given period, but to suggest one caused the other would be insane.

We could rationalize the phenomenon by thinking of leverage and its relationship to equity returns. For companies and countries, assets are procured through either debt or equity capital. For a given rate of return on assets, equity returns can be enhanced through leverage. Persistent government budget deficits are akin to leveraging the entire countries balance sheet, which should flow down in some manner to equity returns.

There are no free rides in reality. We live in a world of constrained resources in which we must make trade offs. As such, equity returns cannot be forever enhanced by unlimited borrowing and asset acquisition. A big element to the equation is the use of borrowed proceeds. If borrowing to acquire productive assets, the level of productivity must exceed the cost of debt. It would be difficult to argue that politically driven borrowing and spending makes the best use of capital resources. Unfortunately, in most cases government debt is used to fuel consumption, not investment in assets that could potentially yield greater productivity than costs.

To illustrate a potential upper bound in the borrow-spend equation, note that there is a negative correlation between changes in public debt and stock returns:

In general, when public debt as a percentage of GDP increases, stock markets behave unfavorably. This could be an unrelated phenomenon, or it could mean that investors perceive that risks inherent to the financial system increase with leverage. Leverage risk is favorable when debt is being used productively, but when 70% of GDP is comprised of consumer spending it casts at least some doubt that the economy is efficiently using its capital resources.

With incoming President Barack Obama and the new Congress promising to “fix” the economy by more borrowing, spending, and printing, these considerations become more prescient than ever. Will enhanced leverage of the country's balance sheet prove productive or destructive?