Deep in Debt, in Deep Danger
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, 6½ years later, the debt of $5.95 trillion again has reached the Congressional ceiling and, in the footsteps of his predecessor, 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 which 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 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 three percent while the debt would rise merely two 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 Treasurydebt 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 world-wide acceptance and demand. It played the pivotal role which 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, 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 eleven times in just twelve 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% 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 twelve countries and soon also by another twelve 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% - 7% 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% 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 realize 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 geo-political 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 for American troops to enter Baghdad and the American dollar to fall from loss of international support. Many a victory has been suicidal.
Hans F. Sennholz