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Deficit Spending : Cause and Effect - Part One

I had lunch yesterday with one of the owners of a very successful hedge fund (I will leave names out since I do not have his permission to disclose it).  I made an argument more on the doom and gloom side regarding the U.S. economy and he responded with what I believe to be a very standard Keynesian response.  Basically that deficit spending would solve our problems and keep our economy from further going downhill - and that our government appeared ready and willing to increase deficit spending as much as necessary to make sure that we didn't fall into a further recession or depression.  It was very academic and he went into quite a bit of detail discussing account transfers, the ability of our government to print as much money as they wanted, and the solid reserve status of the US Dollar.

I may be mistaken (I am trying to make sure I don't put words in his mouth), but one of the key elements that I thought I heard was that deficit spending was fiscally stimulating.

I understand "fiscally stimulating" to mean that putting more dollars into the marketplace will result in additional consumption, which in turn stimulates production and, again, in turn raises our GDP. (I hope I have not oversimplified this)  Of course this assumes that the increase in money injected into the marketplace is in excess of any increases in savings.

I didn't bring up my following argument as, frankly, I was a little in awe of his incredibly educated background in economics and was busy trying to keep my own mouth shut (difficult for me to do) so that I could soak up the knowledge he was providing me.

After our meeting I returned to my office and one key aspect to the discussion struck me.  It may seem to be a rather small thing, but I think it may be the single most important key to these economic theories.  My "revelation" (contrary to his assertion) was thus:  deficit spending does not create productivity, it requires it. 

I am going to use simple examples, which will most likely be critiqued by Keynesian followers as being "simple" and false due to the fact that I obviously don't understand the "real" world, but I like simple examples.  Any time something gets so complex that the average person can't understand it, I have found that it usually falls apart (e.g. go back and view the youtube videos where Cramer explains in depth how the subprime market can't cause a systemic problem, but it's far too complex to explain as assets are distributed all over the place and securitized, etc. etc.)

My "simple" example is this:  If a company can make 10% a year off their capital and can borrow money at 7% then it makes sense for them to borrow as much as they can as they make a 3% spread.  This works for as long as there is enough demand for their product so that they can continue to expand production.  This is great for the economy as the company (with the increased capital) is able to open new plants and hire more people.  This is the argument that works in favor of deficit spending.  With more people working and more capital expenditures putting more money into the economy, there are more people willing and able to purchase this company's products.

The problem with this is that now this company is REQUIRED to not only produce, but make sure there is a market for their product.  If demand fades, or a market becomes saturated then the company either has to cut back production or drop prices, either of which hurt their profitability.  Yet the company still has their debt obligation.  Even if they paid all of their 3% spread (profit) toward the principal of their debt, it would take 33 years to pay off the obligation.  So the company is FORCED to come up with upgrades, more expensive products, new product lines, etc. in order to continue growth.  Unfortunately this usually requires a company to raise additional capital for research, new plants, new marketing, etc. all on the promise that it can earn 10% (based on prior success) on the money it is asking to borrow at 7%.

This works just fine until the company is only able to earn 5% off the investment of capital.  This can happen for several reasons - saturation of their product in their marketplace, competitive pressures, economic downturn, or simply a downturn in the demand for their product (think hula-hoops and pet rocks).  At this point they are unable to service their debt and at some point bad things happen to the company.

Now, my friend the owner of the hedge fund would say, "yes, but there is a critical difference between a company and the US government:  A company does not have the ability to print its own money".  I completely disagree with this.

What is a dollar bill, but a bond certificate issued by the country that printed it?  Companies can print their own stocks and bond certificates as often as they want.  Of course the value of each bond certificate for a company is usually based upon some formula based on their earnings, earnings growth, free cash flow, revenues, ability to pay it back, or some such.  And the more a company "prints" the less each one is worth.

When I asked why it doesn't work the same way with the US government, the simple answer by Keynesians is that "it simply doesn't work that way" and follows is a dissertation on how it is really nothing more than account transfers between treasuries and currency and the sale of treasury bonds, and a bunch of other complex mechanics that I am sure are way above my pay grade.

So, I wonder why Venezuela can't simply print a few trillion dollars of B's, exchange them for US currency and buy up a few companies like Exxon and Microsoft.  Oh, they'd have to sell enough debt to offset the printing of currency?  Well why not have their own equivalent of a federal reserve pick up those bonds?  Oh, you say that printing that much currency would devalue it?  Why doesn't it work that way in the USA?  Oh...  The US is special...  I see.  We have the strongest military and the world's largest economy.  So what happens when we no longer have the strongest military (or people aren't afraid of it any more - like piss-ant countries like North Korea and Iran - do we really think that China is still afraid of our military?  We can't even win a war in Afghanistan!).  Or what happens when we no longer have the world's largest economy?  Or what if the world figures out that we have had the world's largest economy by falsely inflating it through deficit spending and have no way to pay it back (on a personal, corporate, or governmental level).

I fear the true believer in Keynesian economics is simply going to dismiss me with "oh, you simply have no clue" or by saying "we will continue to have the world's largest economy because we will make sure of it by printing money and continuing to deficit spend more and more so that our population can continue to buy more and more."

At some point, this HAS to fall apart.  There is no question that US citizens enjoy a very high quality of life while producing very little.  Our most successful export currently is our ability to export worthless pieces of paper (currency) to buy things of value that people in other countries have labored on while living in much less lavish conditions.

-- Continue to Part Two --


Disclosure: Long SDS