The government’s bailouts of failed banks and its economic stimulus splurge widened the federal budget deficit to $102.8 billion in July.

Bond king Bill Gross would like to see the budget deficit reach $1 trillion.

Last month, he wrote an open letter to Barack Obama asking him, if he is elected, to save the US economy by upping federal spending by a further $500 billion.

According to Dan Amoss, Gross’s prescription for the economy would do more harm than good. For a start it would cause the price of oil imports to spike…

More from Dan…

In his July 2008 investment outlook, available on PIMCO’s Web site, Gross writes an open letter to Democratic presidential nominee Barack Obama. Presuming Obama will be the next president, Gross urges him to dramatically expand the federal budget deficit until it reaches a trillion dollars. I quote:

“While the Republicans will blame you for years and label you “Trillion-Dollar Obama” in future campaigns, there is, in fact, not much that you or any other president can do. You’ve inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender-of-last-resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years.”

The U.S. economy “will need an additional jolt of $500 billion or so of government spending real quick,” pleads Gross. His comically simple formula for GDP, this $500 billion “jolt” to the slowing real economy, is as follows:

“Some quick math for you, sir: Gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old C [consumption] + I [gross investment] + G [government spending] formula (scratch the trade deficit for now), when C + I is reduced by $500 billion, then G should increase by that amount in order to fill the gap. The G, sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well, there you have it: $500 billion + $500 billion = $1 trillion big ones, probably by sometime in 2011 or so.”

Only a Keynesian could argue that such an extraordinary waste of capital is a good thing. And only a Keynesian would believe that the simple GDP equation could summarize a vastly complex, adaptive economy.

I’ve always been skeptical of GDP as a measure of economic progress. It treats dollars spent and dollars invested equally (a dollar invested adds to capital formation, while a dollar spent subtracts from it). The GDP equation also treats government spending as a good thing. It is not. Aside from spending on the occasional “public good,” it just sucks capital out of the efficient, adaptive private sector and doles it out to politically powerful voting blocks.

Gross’ prescription to “save” the economy through wasteful spending would do much more harm than good. He aptly notes that the U.S. depends on foreigners to continually reinvest U.S. dollars back into the U.S economy and government.

As OPEC knows, many of the dollars recycled back into the U.S. were originally exchanged for oil imports. Gross acknowledges that the U.S. economy has an “energy cost” problem. But what does he think oil exporters’ reaction to an extra $500 billion spending “jolt” will be?

It won’t be pretty. Major oil exporters will demand higher oil prices and higher interest rates to offset what they know will be an ever-growing supply of U.S. dollar assets. Would you invest in an asset if you knew the future supply of that asset were guaranteed to increase at a rapid rate?

I have a more constructive suggestion for the next president:

DON’T dream up creative new ways to suck $500 billion in capital out of the private economy and redirect it into vote-buying programs. DO take a crash course on how the energy supply chain works, and invite Congress. Energy ignorance is the biggest immediate obstacle to the government being part of any sort of solution.

Inflation is here to stay, albeit with occasional “deflation” scares. Adjust your portfolio accordingly.

P.S. The above essay was pulled from the most recent issue of Strategic Investment. For more see here. Dan Amoss, CFA, runs Strategic Short Report and is a contributing editor for Strategic Investment. Dan joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years.

Source: Welcome to a Trillion-Dollar Deficit, Mr. President