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February 23, 2003

Deficits Do Matter
by Hans F. Sennholz

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

Copyright © 2002-2007 Hans F. Sennholz

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