Deficits Matter: Why Ignoring Them Could Cost You

It`s a knee-jerk reaction again.

Back in 2008, when the financial crisis unfolded, we saw similar initial reactions from the financial community bringing in a sell off in gold along with other asset markets.

This time around, the crisis surrounds rising sovereign deficits and debt. There is a heightened fear of a sovereign default since many of the industrialized countries have been seeing their debt levels increase to an unsustainable "Debt to GDP ratio".

The risks surrounding sovereign debt are continuously being highlighted, and years of profligate spending and weakening economic activity are taking their toll. Earlier, we saw Dubai virtually on the verge of default and now it’s the "Greek Moment". In fact, the Euro region has a group of such nearly unsustainable debt carrying economies, called the "PIIGS" representing Portugal, Ireland, Italy, Greece and Spain.

Chart: Cumulative Increase in Real Public Debt Since 2007

Source: Draft paper "Growth in a Time of Debt" by Carmen M. Reinhart & Kenneth S. Rogoff

The European currency is increasingly weakening due to the fear surrounding the default risk of the countries in the Euro region and the realization that this can act as a contagion to further defaults as many of them face huge debt pile-ups.

However, the Dollar seems to be surviving due to lack of alternatives, and is gaining strength on account of weakness in other currencies- mainly the Euro.

Given that the Dollar is no different from the Euro, it is highly surprising to see it appreciating. The question is - Why?

Well, the U.S is clearly in a debt league of its own. Though President Obama has proposed a $3.8 trillion budget for the fiscal year 2011 which forecasts a stunning $1.6 trillion deficit, it is expected that the combined state and federal debt in the U.S will reach 94 percent this year.

Even rating agencies have recently issued warnings that the U.S will lose its AAA credit rating unless it acts to bring the budget deficit under control, citing a spiral in debt service costs and dependence on foreign lenders. Fitch expects the combined state and federal debt in the U.S to reach 94 percent of GDP in 2011 which has increased significantly from 57 percent at the end of 2007 on account of spending on stimulus and bailouts. Federal interest costs will likely reach 13 percent of revenues; this means that a one-eighth of all taxes will go only to service debt. Most fiscal experts view this level as dangerously close to the point of no return for debt dynamics.

The deficit amounts have been less dizzying in Europe, given that while the U.S and Japan both have a little more than 10 percent respectively, the average deficit of the Euro region has been around 6 percent.

There is little reason for the dollar to gain vis-à-vis the Euro.

But the fundamental question: How do deficits matter?

From a lay man’s perspective: If you are an individual or a company and say your debt has increased to near 100% of your revenues, then in this case, the individual / company will find it difficult to even repay the interest costs and would be in no position to repay the borrowing and would probably default. Also, it would become extremely difficult to further borrow for any requirements.

The same applies for a nation.

A recent study by Reinhart and Rogoff said that the "90% ratio of government debt to GDP is a tipping point in economic growth." This means that "debt to GDP ratios" above 90% starts hampering the growth of an economy; something similar to what inflation does.

Yes. Deficits do tend to increase especially when an economy struggles out from a recession.

But, here, it has become more of a habit for the policymakers to resort to spend excess money and run deficits which get piled over existing debt loads.

These debt loads would continue to weaken the purchasing power of fiat paper currencies.

Money backed by debt is no money. In such a scenario, "Gold", the ultimate currency is the only real form of money which would keep appreciating until these policymakers continue running deficits.

Going forward, it looks increasingly likely that gold would de-link itself from these paper currencies as investors realize that what they hold as money is no longer worthwhile. You could say that gold is in a process of re-establishing itself as a monetary unit.

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