Is $9 Trillion a Problem?

The S&P500 eked out a 0.27% gain last week, hinting that it’s running out of steam.  And after buying into every story based on “green shoots”, “less bad is good” and “V-shaped recovery” arguments under the sun, the equity markets are approaching judgment day.  Over the next two months, the economy must actually deliver on these expectations.  If it does, then the run up in prices will be justified; if it doesn’t deliver, then the prices ought to correct.

Economic data last week is suggesting that the consumer is still struggling.  Consumer sentiment fell slightly from July’s reading.  Personal income was flat, rather than growing 0.1% as expected.  Consumer spending rose only 0.2%, not the 0.3% expected.  Initial claims were higher than expected–570,000.  New home sales rose, but were driven by the temporary government tax credit and a continuing slide in new home prices.

Technically, the daily and weekly charts are still at nose-bleed levels (extremely overbought).  The monthly, long-term, charts are still in bear market territory.

The Obama administration last week made a startling announcement:  it now projects that the cumulative 10 year deficit will jump from $7 trillion to $9 trillion, and that federal debt (excluding agency debt and indirect obligations from Medicare, Medicaid and Social Security) will hit 77% of GDP in 2019, up from 41% of GDP in 2008.

Is this a big deal?

Paul Krugman, the Nobel winning economist blogging for the NY Times doesn’t think so.  He compares the U.S. debt (relative to GDP) after WWII, which hit 109%, and argues that since we hit high levels before (and were fine), we shouldn’t worry now.  We’ll be fine.  And besides, we don’t need to pay it down at all; we simply need to grow GDP (faster than our growth in debt) to bring the ratio back down to sustainable levels.

But several well respected economists beg to differ.  They point out the obvious differences in context between 1945 and today.   James Hamilton notes that over 75% of the federal spending in 1945 was defense related; and clearly, when the war ended, defense spending could be (and was) slashed to collapse the deficit. 

Today, and over the next seven years, mandatory (entitlement and interest) spending makes up almost 75% of the federal budget.  This spending CAN”T be slashed to collapse the deficit.  Hamilton concludes that the government is digging a hole for itself–a serious political and financial hole.

Ironically, even Krugman once thought that big deficits were dangerous, potentially leading to a Latin American style financial crisis.  He made this warning when the annual deficit was only in the $400 billion range.

How can this be?  Well, he made this warning in 2004, when the Republican party was in power.  Suddenly, after the Democratic party won the White House, Krugman tells the country not to worry about $2 trillion deficits at $9 trillion of additional debt.

Krugman is beginning to speak not like an economist but more like a typical politician.

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