Let's Work Out the Massive Deficit the Right Way: Jim Paulsen

Jim Paulsen, chief investment strategist at Wells Capital Management, says that the record-breaking federal deficit certainly isn't wonderful, but it's not catastrophic either.
Deficits are the result of the cyclical nature of the economy and should be expected, he tells guest host Scott Bleier of createcapital.com. Paulsen predicts that as the economy recovers, the deficit will naturally shrink.

"We are going to have to contract these deficits in the next decade," Paulsen says. "There is no doubt about that. Part of the solution will be higher taxes. A bigger part of the solution is just going to be economic growth."

Paulsen estimates that the current deficit is around 9% of the federal GDP. This corresponds with the current level of real economic activity, which is 9% below its long-term trend line average. He explains that, historically, where the GDP is relative to the trend line roughly traces out cyclical deficits.

"If we grow for a few years, the level of economic activity gets closer to its trend line average. I think the deficit will shrink as well," he says.

The U.S. Has Rebounded in the Past

Paulsen underscores that the nation has rebounded from deficits in the past, using the 1980s as an example. When President Reagan took office, the deficit was 5% of GDP, one of the largest in the post-war era. It remained at that level for the next four to five years and the country still experienced great prosperity.

"If you look back historically, at the biggest periods where we had the biggest surge in deficits in the United States, that was followed typically by the strongest growth rates over the next five years in the economy."
Bleier counters that there is a major difference between today and the 1980s -- interest rates. He argues that interest rates were considerably higher during Reagan's presidency, where as today they are effectively zero.

Government Shouldn't Go to Extremes

When asked whether he thinks the government should become exceptionally frugal to control the deficit or continue massive spending to prevent an economic collapse, Paulsen responds that he sees no need to go to either extreme.

"I would argue that the government should just stand down for a while," he says.

Paulsen says the government should let natural economic growth lead the way toward better budgetary management. The way he sees it, we are already in a self-sustaining cycle, so it's best not to alter government programs and create uncertainty.

As for politics, which are unavoidably tied to the economy, Paulsen predicts that both parties will be forced to become more moderate as the country moves toward the middle. He expects the Republicans to gain seats in the November elections, making for more legislative gridlock and less legislative productivity. Still, he is not worried about the future.

"I think a lot of these concerns will work themselves out by just allowing the laissez-faire to do its stuff."