To Spend Or Not To Spend: That Is Not The Question For The Market

by: Sustainable Free Cash Flow

September 13, 2013

A little over six months ago, the apparent "doomsday scenario" - the sequester - became a reality. With Congress now back in session, we can expect yet another round of debates revolving around one question - to spend, or not to spend? But, all of this talk for the chattering class is beside the real point. If we take a step back and listen to the arguments, we will realize that the debate is being framed incorrectly.

To most, the arguments surrounding government spending come down to one objective, that of increasing the holy grail of economic statistics - gross domestic product (GDP). But, if we get down to the nitty-gritty of what GDP is, we will find a very circular argument in this whole debate.

By definition, GDP is the sum of consumption, investment, government spending, and net exports. Thus, when a country increases its government spending, GDP, by definition goes up. This however, tells us very little about how good of a job the government does at increasing the other portion of GDP, or what is known as "private GDP" (GDP absent government spending).

By using this superior metric (private GDP), we can assess the performance of the government just as we can with any business. Using our own model to project the efficiency of government, it is possible to draw parallels to common private sector terminologies- the government's "revenue" can be equated to private GDP, and its "capital expenditures" are represented by its outlays. The goal of a company is to invest or grow its balance sheet in order to produce more sales and income. Similarly, the goal of government spending is to enhance incomes of its citizens and grow private sector GDP.

If a company's balance sheet growth does not result in new sales or revenues, the company will be a step closer to bankruptcy. If government spending does not produce private sector growth, the country's debt load will have increased, while the ability to pay it off will have gotten worse. Meaning, like any private company, if the money is not spent wisely, the government will be in a worse position for every year it runs a deficit.

If you believe that more government spending will boost the private economy, you are arguing that as government expenditures grow, so will private GDP at least in the same proportion (anything less means the growth was unfunded).

The Long Term View

As we said above, any time a company makes an investment, its income should go up. The key question is, over time, will that investment deliver sufficient income to justify its cost. Companies who do not pass this test, grow their balance sheets faster than they grow income. This disparity may not be noticed right away (for instance WorldCom's stock was a great performer for much of the 90's), but it cannot be sustained. In WorldCom's case this happened in 2002 when the company filed for bankruptcy. In similar fashion (albeit more slowly), the U.S. has steadily increased its debt load without a commensurate gain in the private sector. Since 1950, U.S. government spending has grown about .62% faster than private GDP. While this may not sound like much, over a long time period of time it has taken government spending as a % of private GDP from 16.70% in 1950 to 23.94% today (a 43% increase). Clearly, our investments have not been paying for themselves.

Growth in U.S. Government Spending vs. Private GDP

Government Spending

Private GDP





In Billions of USD





Annualized Growth Rate



Source: Bureau of Economic Analysis, Office of Management and Budget, and author's calculations.

Government Spending as a % of Private GDP





Source: Bureau of Economic Analysis, Office of Management and Budget, and author's calculations.

The Short Term View

In fact, it is not even clear that government spending promotes private sector growth in the short term. In the majority of cases over the last sixty years, as the government spent a larger share of private GDP, the growth rate in private GDP fell. This negative correlation means that historically, changes in government rates of spending have not provided a short term boost to private sector growth necessary to pay for themselves. In simpler terms, the growth rate of government spending moves in the opposite direction of the growth rate of private GDP (see accompanying chart).


In total, these data provide strong support for what many people take to be common sense. Governments do not grow the private sector by simply spending more. That said, none of this is meant to imply the government does not play a huge role in private sector growth or that spending is not justified. Just as a company cannot exist without a balance sheet, a country cannot exist without a government. However, it is clear that the U.S. has not been a good steward of capital. Given the country's current debt loads this leaves only two alternatives. Either the government starts spending money on investments with worthwhile returns, or they should cut spending. Adding debt for projects that don't at least pay for themselves is the worst of all outcomes. While the exact level of debt any country can support is debatable, it is common sense that at some level, the debt loads do become unsupportable because the private sector is just too small to ever pay it off.

Investment Implications

So what does this mean for investors? Well, what the stock market primarily cares about is the growth rate of businesses that comprise its averages - in short, stock markets care about private GDP. For the U.S., given the low probability of a thoughtful solution emerging from the fractured D.C. culture, it seems the best hope for the stock market is for a shrinking government, and a continuation of the sequester.

While this is the most likely outcome and generally expected, it still should be a positive for the market in the short term. As a result, an investor can take any market slide attributed to the "sequester" debate as a short term buying opportunity. Secondly, the debate should not be ignored altogether. The long-term prospect for private GDP growth is increased by a government that spends responsibly. A budget solution where spending is directed to high return projects could ignite a secular bull market,simply by driving private sector growth well beyond current expectations. Just because this outcome is unlikely, does not mean investors can afford to overlook its possibility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Blue Jay Research is a team of financial industry professionals and students. This article was written by Ryan Guttridge, CFA and Nicholas Krus. Ryan is a Fellow at the Johns Hopkins Institute of Applied Economics, Global Health and Study of Business Enterprise and Nicholas is a recent graduate of Johns Hopkins. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.