Deficits Do Matter
In their election oratory politicians usually stress their love of fiscal
discipline and balanced budgets. But as soon as they are elected they tend
to discover a great number of exceptions that require more funding.
President Bush clearly made the election pledge to avoid budget deficits,
but, ever since September 11, 2001, his budget proposals built on exceptions
project a deficit of more than $300 billion for each of the next few years.
Yet, he also argues for prompt tax reduction, which signals a brand-new
course of action in the annals of fiscal policy.
The prospect of soaring deficits and simultaneous tax reductions alarms a
few economists. On this new fiscal road they foresee deficits of $500
billion or even $600 billion annually, which in time may cast doubt on the
credibility of the federal government as debtor. Every few months the
Congressional debt ceiling needs to be lifted by a few hundred billion
dollars. Congress last raised it by $450 billion to $6.4 trillion on June
30, 2002; it needs to be lifted right now as the official Treasury debt
again has reached the ceiling. At the present rate of spending it will need
to be lifted in June or July of this year and, in case of war with Iraq,
even earlier.
The federal deficits are compounded by the budget shortfalls of most state
governments, estimated at some $105 billion in 1992-1993. State governments
are required legally to balance their budgets, which forces them either to
raise taxes or cut expenditures. Undoubtedly, most prefer to boost their
fees and exactions; the proposed federal tax reduction, if and when it
finally passes the U.S. Congress, may even compound their problems as many
state systems are based on the federal tax structure.
Both deficits, the federal and the state, constitute a heavy burden on the
capital market which keeps no idle savings amounting to hundreds of billions
of dollars. They force the Federal Reserve System to come to the rescue; it
can print any amount of money and create any volume of credit. The Fed is
the financier of last resort, the ultimate source of funds that enables the
federal government to finance any conceivable expenditure and cover any
possible deficit. Without the Fed, fiscal deficits of such magnitude would
soon depress the American economy and cause serious political repercussions.
Its ability to create dollars that enjoy world-wide acceptability enables it
to distribute the burden of U.S. Government deficits to countless millions
of dollar holders all over the globe. They pay for the deficits through
depreciation of the dollars in their pockets. Japanese and Chinese, Arabs
and Hindus, French and Germans, and all others with dollar savings join
Americans in bearing the
burden of federal deficits.
This ability to place the economic cost of government spending on millions
of trusting victims rests on the extraordinary position of the U.S. dollar
as the world's primary reserve currency. The dollar acquired this
distinction by international agreement reached at Bretton Woods in New
Hampshire in 1944 which committed the United States to provide an anchor for
world prices by pegging the dollar at $35 per ounce of gold and envisioned a
world economy linked by fixed dollar exchange rates. When the United States
suffered chronic gold losses and finally faced inability to make payments in
gold, President Nixon severed the dollar's gold link in August 1971,
devalued the dollar against major foreign currencies in December 1971, and
finally floated it in March 1973. The world has been on a floating dollar
standard ever since. It is a fiat standard, unbacked and irredeemable,
which can be inflated and depreciated at will. Managed by the Federal
Reserve System, it is a useful standard in the financial service of the U.S.
Government.
Other countries are narrowly limited in their ability to inflate and create
credit; if they indulge in expansion rates greater than those of their
neighbors and trade partners, they would soon face payment difficulties as
imports increase and exports decline. They would have to reduce the
expansion rates and fall in line with their neighbors and partners. The
Federal Reserve System as the manager of the world dollar standard has no
such narrow limits. It can inflate and create credit as long as its
expansion does not exceed the world-wide demand for its currency. It may
generate trade deficits year after year and aggravate its maladjustments as
long as foreign banks and investors hoard the dollars or invest them in
American obligations. It is bound to cause world-wide financial upheavals,
however, when it depreciates the dollar at excessive rates and thereby
inflicts painful losses on those foreign investors.
The floating system based on the U.S. dollar has been a precarious structure
ever since its inception. During the 1970s the country suffered the worst
inflation in decades. By the end of the decade the inflation rate stood at
13 percent, the Federal Reserve discount rate at 12 percent, and the prime
lending rate at 15.75 percent, the highest of the century. The dollar had
fallen notably in relation to the currencies of other trading countries and
especially to gold.
The 1980s saw some economic recovery but also brought new difficulties and
more maladjustments. They led to an explosion of personal, business, and
government debt which cast a shadow on the future of the financial
structure. Federal government debt soared from approximately $950 billion
to nearly $3 trillion. A growing share of this debt was acquired by foreign
banks and investors who used the widening imbalance of American imports over
exports to invest their earnings in the United States.
The 1990s, finally, seemed to defy all rules of economic behavior. Easy
money and credit spurred the most explosive stock market boom in U.S.
history, creating enormous speculative wealth and spawning new companies.
With financial markets booming, the federal government even reported a
budget surplus, borrowing from Social Security trust accounts. The
balance-of-payment deficit became a major concern as imports soared and
exports stagnated, which further raised the mountain of debt.
Toward the end of the decade, in 1998, the floating dollar standard suffered
a number of financial shocks that began in Asia and eventually struck
fragile economies around the world. American equity markets continued to
surge until 2000 when an economic slowdown became evident also in the United
States. In 2001, finally, the American economy slipped into recession for
the first time in ten years. The Federal Reserve immediately cut interest
rates, a record eleven times in one year; the U.S. Congress passed a large
multi-year tax cut, and the U.S. Treasury even sent out tax rebates to boost
consumer spending. Yet, the markets continued to plunge following the
terrorist attacks on September 11, 2001.
According to various market analyses, foreign investors now own some $7
trillion of U.S. assets, 13 percent of American corporate stock, 35 percent
of U.S. Treasury obligations, 23 percent of corporate bonds, and 14 percent
of ownership in American companies. They obviously do not take kindly to
Federal Reserve policies that depreciate the dollar and depress its exchange
rate. Last year alone, European investors in the S&P 500 lost 38 percent on
their property compared to just 24 percent suffered by U.S. investors
because of the fall of the dollar versus the euro. Suffering such losses,
their interest in American investments is bound to decline. They may even
liquidate and withdraw their holdings, which could lead to a crushing
stampede to the exits.
We now face a situation that resembles the late 1970s when the world began
to abandon the dollar and liquidate American investments. It took two years
of Federal Reserve inactivity and 20 percent interest rates to restore
foreign confidence and lure foreigner investors and creditors back. Today,
the Fed is doing the opposite; it is making every effort to stimulate the
economy by flooding the money market while the U.S. Treasury is accelerating
its deficit spending. Both point towards monetary upheavals and deep global
recession straight ahead, and both cast a shadow on the future of the
floating dollar standard.
Hans F. Sennholz
www.sennholz.com