In the optimists versus pessimists debate over the state of the US economy neutrals ask just why are twin deficits supposed to be so threatening. With last week's (non-partisan) Congressional Budget Office projection that the federal budget deficit is set to hit $422 billion it's a topical question.

Deficits are not always Bad. Budget deficits, for example, are generally Good when used as a short-term macroeconomic tool to stimulate a weak economy that has idle capital and labour capacity. Similarly, the current account deficit (at least, the trade element) is not automatically Bad. It's like any lender situation: if the borrower believes his investment will return more than his cost of capital, he has a leveraged investment opportunity. If the lender agrees, the transaction occurs.

It tends to be sustained deficits that are Bad. In the case of the US, pessimists argue that demographics are likely to turn the current federal budget deficit trend - described by its friends as a Good short term stimuli - into something much Naughtier. That's due to more baby boomers hitting retirement and consequently jacking up the Medicare and Social Security budget requirements. Meaning, don't expect US debt sales to ease off any time soon.

The pressure of such a persistent debt is that much greater, with the existing low domestic savings rate causing domestic investment to decline further. Concurrently, there is upward pressure on interest rates in order to attract the missing savings. That bites on investment at home although it does attract international finance. And it is that foreign financing that creates the link between the federal budget and the current account (see our article on some of the dangers of large current account deficits here).

Uh, and that's about it for the good news. The bad news is that Europe and Japan have baby boomers too, and their governments run current account surpluses. They happen to hold a great deal of US debt and equity already (Federal Funds data show that net foreign claims on US assets are 21% of GDP), and are still buying. What happens if (really "when" as there is not much point saving madly beyond retirement) they, and/or their governments sell up to buy goods and services from China, India et al like the US is currently doing? What happens is that there will be an awful lot of US assets and debt for sale at the same time. And this brings us to an important non-economic side-effect of persistent deficits.

Pure economics does not entirely capture one aspect of persistent budget deficits on financial markets - uncertainty. It is uncertainty that plays on the minds of creditors and investors reflecting their certain knowledge that the degree of political difficulty of adopting policies (read higher taxes and reduced spending programs) to right the ship is high.

Faced with a glut of US asset and debt sales by fun-loving baby boomers the world over, buyers would be foolish not to recognise the dangers of the US federal government adopting a weak dollar inflationary policy in order to reduce the real value of its debt. Such an outcome might mean that buyers simply do not show up. The risk of panic selling increases. Dollar depreciation might loom together with markedly higher US interest rates. There could be knock-on effects on domestic confidence and investment.

So the central question in the debate becomes will buyers of US assets and debt come to the point where they begin to back off. Pessimist says it's coming. Optimists laugh and call Charles Schwab.

It may be true that the twin deficits are entirely sustainable in economic terms - the US is after all the largest and most dynamic economy in the world. The greatest danger for investors and creditors nonetheless remains the psychological pressure of the twin deficits on financial markets. And don't think your portfolio is panic-proof: when the police raid the brothel, all the girls get taken away.

Well, at least for awhile.

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