Re: [A-List] Gold strikes back

["Anne Williamson" <annewilliamson@xxxxxxx>]

http://www.mises.org/fullstory.asp?control=967

Deep in Debt, Deep in Danger

by Hans F. Sennholz

[Posted May 30, 2002]

Politicians rarely suit their actions to their words. They may wax eloquent
about budget surpluses while they incur huge deficits. The president may
"wage a war to keep the peace," and senators and representatives may orate
about frugality and "national defense" but spend freely on items designed to
increase their popularity and re-electability. They may even use the
opportunity to cater to powerful special interests in their own states and
districts. For many, national defense is an opportunity.

Outside the world of politics, the budget surpluses actually are budget
deficits that consume Social Security trust funds. While this kind of
deficit financing does not weigh heavily on present capital markets, it
shifts the burden of repayment to future taxpayers, or future loan markets,
or both, when the Social Security obligations fall due. Any manager of a
private trust fund who would dare to spend the funds entrusted to him and
replace them with his IOUs would face criminal charges. When the U.S.
Treasury does it, it is called "creative financing."

Federal expenditures were financed "creatively" in late 1995 when the
Treasury encountered a congressional debt ceiling of $4.9 trillion. Treasury
Secretary Robert Rubin's strategy nevertheless kept the government funded
until Congress raised the ceiling at the end of March 1996. Now, six and a
half years later, the debt of $5.95 trillion again has reached the
congressional ceiling and, in the footsteps of his predecessor Rubin,
Treasury Secretary Paul O'Neill is resorting to similar stratagems. It casts
serious doubt on the value of any congressional debt ceiling.

The ever rising federal debt raises the gnawing question of its ultimate
solution. Will it ever be repaid? Will future administrations curtail their
expenditures or boost their tax exactions in order to cover the deficits of
their predecessors? Will future generations of Americans be prepared to
cover our debts, or will they follow in our footsteps?

If they follow us, the federal debt is likely to rise ad infinitum and, in
time, reach $10 trillion and more. It is debt incurred to finance not only
national defense but also a myriad of programs such as foreign economic and
financial assistance; farm income stabilization and commodity price support;
commerce and housing credits; ground, air, and water transportation
subsidies; community and regional development aid; social services; and
numerous other support programs. No matter what the political, economic, and
social effects of these expenditures may have been, they consumed
potentially productive capital that would have served consumers, raised the
productivity of labor, and improved living conditions.

Treasury bills, notes, and bonds are certificates of capital consumed. As
claims against the U.S. government, they also function as evidence of
individual or corporate wealth, which enjoys the highest credit rating in
all capital markets. The relatively low interest rates of U.S. Treasury
obligations reflect this rating; they were relatively low even during the
late 1970s and early 1980s when double-digit inflation rates commanded
double-digit Treasury rates. Such rates invariably would return if and when
inflation should soar again.

We cannot plan the future by the past. But human nature is the same
throughout the ages, which allows us to speculate on the future of the
national debt. At the present, with the U.S. government debt at some 60
percent of gross national product (GNP) and the rates of interest at 40-year
lows, the U.S. Treasury undoubtedly can and will meet its obligations.

But how reliable and trustworthy would it be if, in a dollar crisis,
interest rates would return to double-digit levels and interest costs alone
commanded the lion's share of federal revenues? After all, interest rates
reflect not only the debtor's credit worthiness but also the quality of the
money owed.

At double-digit inflation rates the purchasing power of the national debt
would shrink rapidly to insignificant levels. But even if the inflation rate
were held at the moderate level of just 3 percent while the debt would rise
merely 2 percent, its purchasing power in time would fall to trifling
amounts. The ever shrinking purchasing power of the national debt encourages
the politicians' love and habit of deficit spending.

The present political wrangle over the debt ceiling casts a shadow on
international credit markets. Throughout the late 1990s, when President
Clinton was "mouthing" about budget surpluses and debt repayment, the U.S.
dollar was soaring above all other currencies, and American investment
markets soon became a "safe haven" for international funds. Equity prices
rose to unprecedented levels.

This "safe haven" actually is a very dangerous harbor carrying the biggest
debt on earth. At the end of 2001, the United States had a net external debt
consisting of direct foreign investment and investment in financial paper of
some $2 trillion 700 billion. Americans import much more than they export,
suffering current account deficits of some $400 billion a year or 4 percent
of GNP. At the present rate of deficits, the U.S. external debt may soon
surpass the federal government debt; it is the most dangerous of all because
it casts a dark shadow over the U.S. dollar.

The present hassle about the Treasury debt ceiling may remind foreign
investors that the safe harbor is heavily mortgaged and sinking ever deeper
into debt. If a few fearful foreign investors should suddenly liquidate
their dollar investments for any reason, American capital markets would come
under severe liquidation pressure. If a few Arab oil sheiks should add their
weight to the pressure, they could precipitate a panic run. The U.S. dollar
would plummet, interest rates would soar, and equity markets would crash. It
could shake the world financial and economic structure.

During the 1990s when several international currency crises shook world
capital markets, the American haven was remarkably safe and the U.S. dollar
extraordinarily strong, although it lost some 2 to 3 percent in purchasing
power every year. As the primary reserve currency of the world, it enjoyed
worldwide acceptance and demand. It played the pivotal role that gold played
throughout the ages, and placed the United States in the same position
formerly played by gold-producing countries.

When gold was discovered in California in 1849 and mined in substantial
quantities, commercial banks used it to expand their notes and credits.
Goods prices rose, exports declined, and imports expanded. Most of the gold
was shipped abroad in settlement of adverse balances of international
payments. Today, with the U.S. dollar in the role of gold, the Federal
Reserve System substitutes for the gold mines, and its dollars are shipped
abroad in settlement of adverse balances of trade. Although both monetary
systems function in a similar fashion, a crucial difference forebodes future
difficulties.

Gold is a precious metal used in jewelry and decorations, and as a plated
coating in a wide variety of electrical and mechanical components. Its
mining and refining impose considerable costs. People throughout the world
cling to it as a store of value. The U.S. dollar, the production of which
requires little effort or cost, is a medium of exchange the value of which
depends entirely on the belief in its trustworthiness. Just like gold, it is
subject to the economic principle of supply and demand, but in contrast to
gold, its stock is a many-layered quantity of claims of unknown reliability.
It resembles an inverted pyramid, with Federal Reserve notes and reserves at
its base and many-layered bank credits resting on the base.

Commercial banks and non-bank credit institutions lend, securitize their
loans, sell them, and lend again in a continuing process of credit
expansion. Offshore banks in the Bahamas, the Cayman Islands, Hong Kong,
Panama, and Singapore create more dollar credits, building their pyramids on
U.S. dollars flowing from the chronic current-account deficits of the United
States. They and 174 central banks like to hold their dollar reserves in the
form of U.S. Treasury obligations paying interest. Total dollar holdings by
foreign central banks alone now exceed $1 trillion.

How safe is the dollar pyramid? Last year the Federal Reserve System lowered
its rates 11 times in just 12 months, to the lowest level in more than 40
years, in order to stimulate the sagging economy. It allowed money in the
broadest sense (M3) to expand by some $1 trillion. The effects of this huge
burst of credit expansion are bound to be the same as a huge strike of gold
would have been during the 1850s. Current-account deficits are bound to
rise, possibly to 5 or 6 percent of GDP.

While the gold mined was real wealth, which is in someone's possession even
today, 150 years later, the U.S. dollars sent abroad in payment of a flood
of imports are mere claims against the United States. But since these claims
merely guarantee the right to more dollars, some owners, ever eager to earn
profits, may choose to trade them for other national currencies that are
believed to increase in exchange value.

Fearful of the ever rising U.S. government debt and external debt, they may
prefer to hold euros rather than dollars; that is, the new European currency
used in 12 countries and soon also by another 12 waiting to adopt it. As the
dollar declines in foreign exchange markets, other dollar holders may follow
suit, which in the end, may become a run by foreigners and Americans alike.
The dollar-euro exchange rate will tell the story.

Only a strong dollar can avert an international run from the growing
mountain of American international debt. Unfortunately, the Fed is playing a
dangerous game by keeping its rates far below market rates and expanding
credit at record rates. Sooner or later, signs of price inflation will
appear and force the Fed to raise its rates lest it stoke the fires of
inflation. It may retreat gradually from its current expansionary stance to
a more neutral policy when market rates will return not only to the basic
time rate but also add the anticipated inflation rate.

Instead of short-term rates just returning to 3 or 4 percent, they may rise
to 5 or 6 percent. If the Fed then should remain "neutral," the economy
would soon face new readjustment symptoms. But once again, as soon as a new
recession comes in sight, the Fed can be expected to abandon its neutral
stance and return to its "accommodating" ways. It is likely to continue thus
until an international run on the dollar may overwhelm it.

The Fed obviously is the world's primary monetary juggler seeking to keep
afloat both the American economy and the American dollar. The economy,
according to official dogma, presently calls for easy money and credit. The
dollar, on the other hand, requires due restraint in order to carry the
mountain of American international debt. At this time, the Fed apparently
chooses to ignore the debt problem and to concentrate on economic revival.
Many corporations burdened with much debt are suffering losses which do not
encourage new investments. Consumer debt as a percentage of income is the
highest it has ever been.

 As interest rates have come down, people have built and bought homes. The
effect has been felt throughout the economy, especially in construction,
materials, labor, furnishings, etc. Low interest rates have given rise to a
bubble in the housing market with home prices rising continually ever since
the early 1990s. But while they are appreciating at some 5 to  7 percent a
year, the percentage of home- owner equity has gone flat. For every $1,000
in home appreciation, the home owners are taking at least $500 out to
finance consumption. As many home buyers own just 20 percent or less of the
market value of their homes, they would face great difficulties if housing
prices should ever decline. There would be a financial calamity should
interest rates rise and recession descend on the industry.

Inexorable economic principle assures us that interest rates are bound to
rise as human nature always prevails over the machinations of political
authorities, including the Federal Reserve governors. They may falsify the
rates temporarily, but the undesirable consequences of their machinations
are bound to overwhelm them in the end. Interest rates then will soar,
seeking their natural levels in addition to an anticipated currency
depreciation rate. At that time, the housing bubble is bound to burst.

Fearful of the soaring external debt and a looming dollar crisis, some
investors may prefer to hold gold, the money of the ages. They may not rely
on the intention and ability of the European central bankers to maintain the
value of the euro nor trust any other fiat currency. They may even be
distrustful of the return to economic growth, which, in their view, merely
amounts to continuous growth of consumer, corporate, and, especially,
federal debt. And fearful of fiat inflation, which is the favorite way for
government to rescind old debt, they may choose to purchase and hold gold in
any form.

Gold is not only an asset that at any time may be converted into legal
tender currency but also an alternative investment. When stock, bond, and
commodity markets disappoint, gold may shine above all others. When the
economic recovery fails to materialize and the debt pyramids begin to
crumble, gold may emerge as the most reliable possession.

Despite its massive international indebtedness, the United States is playing
the global role as a warrior against terrorism and guardian of peace. U.S.
armed forces are stationed in more than 100 countries and, since September
11, are building new bases in Afghanistan, Pakistan, and several former
Soviet republics. In the coming months they may wage a new war against Iraq
without much international support.

While the United States undoubtedly has the military might to reach into
every country and assert its global empire, its precarious financial and
economic foundation may crumble under the burden of rising international
debt. Even if we ignore the geopolitical overreach and the growing Muslim
suspicion of everything American, the pyramid of American debt calls for
caution and repair. There would be no greater irony and tragedy than for
American troops to enter Baghdad and the American dollar to fall from loss
of international support. Many a victory has been suicidal.


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Hans F. Sennholz, emeritus professor of economics at Grove City College, is
an adjunct scholar of the Mises Institute. Send him MAIL. See also his
Mises.org Articles Archive and his Personal Website.