Fear the Deficit?

You can scarcely listen to the news without being bombarded with dire predictions about the economic consequences of the current U.S. budget deficit. At a projected $1.6 trillion this year, it’s by far the largest, relative to the size of the economy, since World War II. And it has prompted some people to recommend that investors shun U.S. financial assets and plunge into gold, silver or assets from countries such as Germany, which has relatively small deficits and low inflation. Should investors follow this advice?

To answer that, we should consider the economic repercussions of an outsize deficit. Holding all other economic variables constant, a big budget deficit should result in higher interest rates because government debt competes with other debt, such as corporate bonds and mortgage securities. It could also mean higher inflation, if the Federal Reserve helps the government fund its debt by buying government bonds. That creates bank reserves that fuel spending.

But right now all other variables are not constant. Even as the public deficit is at a peak, private debt creation has been squelched by the recession and the collapse of the housing industry. Sitting on record cash balances, few corporations are issuing new bonds (see Cash-Rich Stocks to Buy Now). As a result, Americans who are trying to beef up their savings are finding that government securities are just about the only high-quality new issues they can buy. That’s one reason interest rates on government debt are so low, despite Uncle Sam’s insatiable appetite for borrowing and spending.

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This state of affairs can’t last long. As the economy improves, more companies will issue debt to fund new projects that will compete with government bonds, so interest rates will rise. Even though tax revenues will increase in an expanding economy, it’s almost inevitable that interest rates will go up over the next few years, and bond prices (which move in the opposite direction) will fall.

Inflation Outlook

What about the inflationary consequen­ces of a large deficit? In the long run, deficits are inflationary if the central bank buys government debt, generating reserves that the banking industry then lends to others. But the U.S. is fortunate to have such a broad market for its bonds that the Fed is not forced to be the “lender of last resort” for the Treasury.

Nevertheless, one unusual aspect of the current U.S. budget deficit is that the Fed has been buying large quantities of government bonds as part of its “quantitative easing” policy. So far, these purchases haven’t been inflationary because most of the newly created reserves haven’t been loaned out by banks. But the Fed must withdraw these excess reserves at some point to defuse their inflationary potential. I believe the Fed will err on the side of providing too much stimulus, rather than too little, in the coming months. As a result, inflation over the next several years is likely to run modestly above the Fed’s unofficial 2% ceiling.

Rising inflation might seem to argue for investors to buy commodities, but I believe real assets will be disappointing investments. Commodities will do well if inflation reaches double digits, as it did in the 1970s. But with moderate inflation, commodities do not generate notably good returns, especially when gold, silver and many other commodities have already experienced big run-ups. Bonds of sound-money countries, such as Germany, are a choice, but their low interest rates aren’t attractive for investors.

Which assets fare best in times of moderate inflation? The answer is stocks. As I have written before, stocks are claims on real assets that rise in value with the general level of prices (see GOING LONG: Stocks Are the Best Inflation Hedge). Given their reasonable valuation and good dividend yield, they are the ideal investment vehicle to ride out higher inflation and interest rates.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.