By Bill Davis

July 6, 2010

This is part 2 of a 3 part series on economic myths.

Economic Myth 2: The markets are panicking about the deficit

From Personal Finance News from Yahoo! Finance

To hear the G-20 tell it, the U.S. and other top countries had better slash those budget deficits before the world comes to an end.

And maybe the markets should be panicking about the deficits.

But they're not. It's that simple.

If they were, the interest rate on government bonds would be skyrocketing. That's what happens with risky debt: Lenders demand higher and higher interest payments to compensate them for the dangers.

But the rates on U.S. bonds have been plummeting recently. The yield on the 30-year Treasury bond is down to just 4%. By historic standards that's chickenfeed. Panicked? The bond markets are practically snoring.

They aren't seeing inflation either. On the contrary, they're saying it will average just 2.3% a year over the next three decades. That's the gap between the interest rates on inflation-protected Treasury bonds and the rates on the regular bonds. By any modern standard the forecast is low. Instead of worrying about inflation, some are starting to worry about something even more dangerous: deflation, or falling prices.

If that takes hold, cutting spending and raising taxes would be a bad move.

It's certainly possible the lenders buying these bonds are being foolish. And it's worth noting that the Treasury market is also subject to political distortions, because foreign are among the heavy buyers of bonds. So it's worth treating its apparent verdicts with some caution. Nonetheless, the burden of proof, as usual, is on those who argue the market is wrong.

It's the age-old “deficits are bad” baloney. Well, deficits can be bad. But in our case, they're not. We've been running deficits since the 40s, regularly. There was a time when we got close to eliminating the yearly difference between tax revenues and federal spending (late 90s very early 2000s), but Alan Greenspan warned that surpluses were bad.

Maybe he was right. The federal government certainly heeded his warning: We've spend trillions over the past 9 1/2 years, well above our “normal.”

But most of that spending has come in terms of non-discretionary spending (“entitlements” that no politician has the courage to challenge, social security being one of the biggies, Medicare being the other horn of a really nasty bull) and very discretionary war spending.

Neither of which, I'll add, stimulates growth in the economy or jobs. Surely, soldiers have jobs, but they had those jobs before the economy tanked. What's going to happen if we every withdraw and don't need them any more? Will the government have the courage and discipline to “lay them off?”

I doubt it.

The problem is that, while we did put together a $787 billion stimulus package, it clearly wasn't enough. Yeah, you read that right.

They should have spent $2 trillion on boosting the economy from the get-go. But that's just my opinion. Prove me wrong 🙂

Part 3 here.

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