If government budget gaps were really a threat, interest rates would be rising, not falling. By Jeremy J. Siegel, Contributing Columnist October 31, 2006 I am often asked whether we should be concerned about the "twin deficits": the large government budget shortfall and the even larger trade gap. The federal budget deficit in fiscal year 2005 was $318 billion and is expected to drop to $260 billion this fiscal year. The 2005 trade deficit was an even more massive $717 billion and is expected to worsen to about $770 billion in 2006. Do these shortfalls threaten U.S. prosperity?Of the two, the budget deficit is the less ominous -- at least in the near term. The gap is now well below 3% of gross domestic product, a level that is sustainable in the long run and below that of many industrialized countries. Entitlement claims The problem is that budget deficits will be much higher in the long run. Because of all those baby-boomers retiring over the next two decades, Social Security and especially Medicare will move into extreme deficit. By 2031, when the last boomers are eligible to start collecting benefits, it is estimated that Medicare will absorb more than half of revenues collected by Uncle Sam and that Social Security will claim a smaller but still significant share. The consequences of uncontrolled budget deficits are not pretty. Interest rates will soar as investors become increasingly reluctant to buy the burgeoning supply of bonds. And the Federal Reserve, trying to prevent irreparable harm from these higher interest rates, will be forced to purchase much of the debt, flooding the economy with money. That, in turn, could lead to spiraling inflation. Advertisement The trade deficit, on the other hand, is increasing as a fraction of GDP. Last year's trade deficit was a little less than 6% of national output -- twice the size that many economists believe is acceptable in the long run. A trade deficit means that more dollars are flowing abroad from our purchases of foreign goods and services than are being absorbed by foreigners purchasing U.S. output. Currently, foreigners are accepting our dollars and using them to buy U.S.-based assets, including stocks, bonds and real estate. But if foreigners balk at holding this increasing volume of dollar-denominated assets, the greenback's value will decline. A large drop would cause the cost of imported goods to soar and would not only tip the economy into recession but also permanently harm our standard of living. It is conceivable that the twin deficits will lead to a dire outcome, but I do not believe they will. Why don't I worry more? Because the bond and currency markets are telling me not to. If investors were truly worried about the budget deficit, long-term bond yields would not now be below 5%. Moreover, the difference between the yield on regular and inflation-protected government bonds, a good measure of inflationary expectations, would not be below 3%. Bond investors are convinced that powerful forces lie behind the demand for dollars. Boomers, pension funds and foreign central banks are sopping up the supply of bonds, and there is no sign that they will cut back soon. In time, increasingly wealthy workers in developing economies will also invest in U.S.-based assets. Advertisement The smart money History shows that bond and foreign-exchange traders are first to sense new and unsettling trends in their markets. If government budget gaps were really a threat, interest rates would be rising, not falling. And if the foreign appetite for dollars were likely to wane soon, the dollar would be worth much less than it is today. Markets aren't always right -- remember the irrational tech bubble? Yet when there is every reason for interest rates to rise and the dollar to fall, and neither is happening, something important is occurring. Between trusting the markets and the fear mongers, the markets get my vote any day. Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.