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With So Much Debt In the US Economy, Is It Even Possible To Grow Faster?

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The US national debt just broke above $19.5 trillion. Both Democrats and Republicans are to blame, but it is important to note that President Obama and Democrats increased the national debt more than all President’s before combined.

total-debt

George Bush exploded the national debt by $3 trillion in response to an imploding economy and 911. Obama exploded the national debt by $10 trillion in response to an imploding economy.

Debt increases are a function of the government not being able to pay its bills because it has too little revenue (taxes) compared to costs (spending). When spending exceeds revenue you have a deficit. Since 2002, this is what quarterly deficits (or surpluses) have looked like.

federal-deficit-chart-2017

The last time we have a surplus was back in 2001, some 16 years ago. That’s sad.

The interest on the $19.5 trillion dollar debt is about $482 billion a year or more than $60,000 per US citizen.

How does the US government finance the deficit?

The Crowding Out Effect

The U.S. Treasury sells IOUs in the form of bonds or treasury bills directly to the private capital markets and uses the proceeds of the sales to finance the deficit.

crowing-out

The US Treasury is competing directly in the capital markets with private corporations, which may also be seeking to sell bonds and stocks to raise money to invest in new plant equipment. To compete for these scarce investment dollars, the Treasury typically must increase the interest rate it is offering to attract enough funds. Running a huge deficit is largely a zero sum game because funds to finance the deficit would otherwise be spent on private sector investment (the I variable in the GDP formula).

Money used to finance the deficit is money that would otherwise have been borrowed and spent by corporations and businesses on private investment. Deficit spending by the government is said to crowd out private investment. Crowding out is the offsetting effect on private expenditures caused by the government’s sale of bonds to finance the deficit. The larger the deficit and the more government needs to spend on financing that deficit, the more crowding out occurs.

The crowding out effect, which is one of the most important concepts in macroeconomics, is illustrated below.

crowing-out-2

The initial equilibrium is at Y, where the aggregate expenditure curve AE, crosses the aggregate production curve AP. However, expansionary fiscal policy shifts the aggregated expenditure curve up to AE1. This leads to a new equilibrium of Y1. However, because the government has had to borrow money from the private capital markets to finance these expenditures, interest rates rise. This reduces investment and a resulting contractionary effect shifts the aggregate expenditure curve back down from AE1 to AE2.

crowding-out-3

The final equilibrium is now at Y2 as the net economic expansion equals Y2 minus Y. At the same time, the partial crowding out of private investment may be measured by Y1 minus Y2. The level of partial crowding out rises the more government borrows from the private sector.

It is my opinion that government deficits are a weak fiscal policy tool at best, and I think the last eight years of President Obama increasing the national debt and running the largest deficits in US history has proven that point.

A few readers have asked me if crowding out can be reduced by printing money. The idea is to avoid crowding out by printing money and here is how that scheme works. The Federal Reserve accommodates the Treasury’s expansionary fiscal policy by buying Treasury’s securities itself rather than letting the securities be sold in the open capital markets. In essence, the Federal Reserve simply prints new money.

The problem with this option is that the increase in the money supply can cause inflation. Moreover, if such inflation drives interest rates up and private investment down, as it is likely to do, the result of the print money option will be a crowding out effect as well. In other words, there is no escaping the crowding out effect when it comes to financing the deficit. Again, look at the last eight years of President Obama and look out how much he has put this country in debt and ask yourself has it really benefited the U.S. economy that much? Perhaps some, but ultimately crowding out took away much of the initial gains from Democrat’s expansionary fiscal policy.

Deficits Impact On International Trade

Deficits and a rising government debt is a serious threat to the US. Chronic budget deficits have not only been responsible for crowding out private investment, but also for America’s huge trade deficits over the last several decades. The macroeconomic relationship between deficits and international trade is illustrated below.

us-deficit-trade

As government deficits drive interest rates up in boxes 1 and 2, we observe crowding out in box 3. Now look at box 4. Higher US interest rates attract foreign investors but, for these investors to invest, they must exchange their foreign currencies for dollars. This not only leads to an increase of US external debt in box 5, but it also drives up the value of the dollar in box 6. A stronger U.S. dollar makes U.S. exports less competitive, and exports decrease in box 7 even as imports increase in box 8. The result is a larger trade deficit in box 9, and that’s why economists refer to budget and trade deficits as the “twin deficits.”

A trade deficit means a country is not exporting enough to pay for its imports. The difference can be paid by either borrowing from abroad or by selling US assets.

Mortgaging America

To finance its trade deficit, the US has had to sell off assets such as factories, shopping centers, hotels, golf courses, and farms to foreign investors. This mortgaging of America has reduced both the rate of economic growth and the level of real income of Americans.

Deficit Doves Say Don’t Worry

Deficit dove economists that work for Democrats and the Obama Administration say don’t worry about the national debt because most of that debt is internal debt owned by the country to its citizens. Obviously, that argument by Democrat economists is not so good as evidenced by the broken US economy some eight years after Democrats and Obama took office. I list four reasons below why this “don’t worry be happy” argument is wrong and how it has hurt the US economy.

#1: Internal Debt Leads to Higher Taxes

Internal debt requires payments of interest to bondholders. This, in turn, means higher taxes which distort the allocation of national resources and lead to an efficiency loss.

#2: Internal Debt Redistributes Income From Poor To Rich

Paying interest on the internal debt unfairly redistributes income from the poor and middle class to the rich. This happens because government bondholders as a group tend to be wealthier than taxpayers as a group.

#3: Servicing The Debt Cuts Government Services

Paying interest on the debt uses $482 billion each year, and this money could otherwise be spent on providing taxpayers with more education, health care, and other government services. The size of the interest payments to service the debt, relative to total tax revenues, has been rising every year. If nothing is done, we will eventually wind up using all available tax revenues simply to service the debt.

#4: A Burden On Future Generations

The accumulation of such a large debt places an unreasonable burden on future generations, which must pay this debt off. I don’t know what to even tell my daughters about the $19.5 trillion national debt, so I choose to say nothing. I could say I voted for Obama because I wanted to vote for the first African-American President and I thought he would save our household money on medical care. Then say, oops, my bad, now here’s the $9 trillion he added to the national debt during his Presidency that you have to pay off when you’re old enough to work. Thank you and have a nice day.

Niall Ferguson thinks that the “age of debt” is coming to an end. Apologies for the sub-titles but this Hard Talk interview has an important message.

With a growing crowding out effect, it may be impossible to increase GDP in a meaningful way until the national debt and deficit spending is reduced.