Deficits, Credit Inflation, and the Dollar

Over the past decade, but especially over the last year or so, there has been a concern over when the “deficit sharks” are going to turn against the United States bonds and the United States dollar. This question has certainly arisen in the minds of many as the Eurozone has been attacked and the Chinese make moves to make their currency “more international.”

My answer to this is that the debt of the United States will not really come under attack until the United States dollar ceases to be the one reserve currency in the world. And, the United States dollar will continue to be the one reserve currency in the world for a relatively long time.

It has been the status of the United States dollar that has allowed the United States government to “get away” with its fiscal irresponsibility for the past fifty years and it is this status that will allow the United States government to “get away” with its fiscal irresponsibility for a while longer.

Since the United States debt can always be paid off with United States dollars people and nations will hold the American debt and will rush to it when there is a “flight–to-quality.” This is just what we have seen over the past fifty years, especially during the worldwide financial crisis 0f 2008 and 2009.

The United States government took on a new philosophy in the 1960s, a philosophy that allowed that it was alright to run fiscal deficits, not only in periods of recession but also in “good times” so as to achieve higher rates of economic growth and keep people employed. This philosophy was inaugurated by the Kennedy administration and was absorbed by the Nixon administration and became the backbone of the economic policies for both Republicans and Democrats continuing into the present.

This “philosophy” achieved the following results: a decline of 85% in the purchasing power of its currency; under-employment in the economy reaching at least twenty percent of the workforce; and an income distribution that is highly skewed to the wealthy.

The philosophy called for a “credit inflation” in the United States economy that would result in prices rising on a regular basis which would put people to work and with a special emphasis on home ownership for almost all Americans which provided these citizens with an asset that constantly rose in price and which became the “piggy bank” of middle classes.

The debt of the United States government has increased at a compound rate of about 7% since 1960 up through the beginning of the Great Recession.

Prices rose at rate just below 4%, as measured by the implicit price deflator of Gross Domestic Product, during the same time period.

The rate of growth of real Gross Domestic Product rose by slightly more than 3%.

During this time period the value of the United States dollar declined.

The period started off with the price of the United States dollar fixed according to the Bretton Woods rules for international finance. By the end of the 1960s, sufficient inflation had been created along with rapidly increasing capital flows throughout much of the world so that the fixed exchange rates could no longer hold. As a consequence, the United States dollar was floated on August 15, 1971 by Richard Nixon and the race was on.

Dollar indices have only been in place since about 1973 because the dollar only began floating in late 1971. But, since then the value of the United States dollar measured against major currencies has declined by about 25%. (Remember the other major countries inflated their economies as well. And, many had currency crisis as well during this time period.) Against a broader range of currencies the dollar has declined by closer to 70% over the same time period.

There is no question that the “rest of the world” believes that the economic policies of the United States government are flawed. Just look at what the market is telling us!

However, the United States dollar is the one reserve currency of the world. Thus, the United States can get away with a lot of “stuff” that other governments cannot get away with.

And, the United States government has constantly argued that it is for a “strong dollar.” And, by the United States government I mean both Republicans and Democrats.

The United States government has lived off of its privileged position of having the one reserve currency in the world. It continues to live off of this privilege because it is still going to be a while before the United States dollar loses its position as the one reserve currency in the world.

This privilege has meant that the United States government does not have to conduct a “disciplined” fiscal policy because any consequence of its lack of discipline is sufficiently far off in the future to not really matter.

I presented my response to the current budget proposal of the Obama administration and the Republican posturing in my blog post of February 15. See “The Obama Debt Machine,” (http://maseportfolio.blogspot.com/). My conclusion is that we will have more of the same…more credit inflation.

So, that is my forecast for the “alpha” investor: the economic philosophy of the United States government has not changed.

Oh, there will be interludes in which “prudence” is popular. These will be like the “Volcker interlude” in the late 1970s and early 1980s when monetary policy was used to try and stop inflation, and the “Clinton interlude” in the 1990s when the federal budget was brought into balance. But these were just temporary diversions from the trend.

Maybe Charles “Chuck” Prince, the former chairman and chief executive officer of Citigroup, will have the last laugh. Prince, who made the remark that captured the attitude of the early 2000s, stated that “as long as the music keeps playing, you’ve got to get up and dance.”

In periods of credit inflation, taking on more debt, taking on more risk, mismatching maturities, and aggressive financial innovation pays. As Prince admitted, Citigroup got up and danced.

Dancing pays during a credit inflation. However, you need to be agile enough to sit out the intermissions when the musicians take a break as they did during the Great Recession.

All indications point to the fact that the “music” will continue on. The name of the dance is “credit inflation” and this dance will continue, with some periods of intermission, until the United States dollar ceases to be the one reserve currency of the world. Until then there seems to be little or no way to discipline the United States government for its profligate budgetary ways.

The U. S. Budget Deficit: It's Time to Get Serious!

The United States budget deficit will reach $1.48 billion in the 2011 fiscal year, according to the Congressional Budget Office.

The response: everyone seems to be pointing fingers at everyone else.

The President, on Wednesday evening in his State of the Union address, indicated that something needed to be done about the budget deficit.

Yesterday the CBO released its figures.

The evening news reported that the White House had some general things to say about the projection but would not come out with more specifics because they were waiting for the Republican response that they knew was coming.

There’s leadership for you.

No one in the top leadership positions in the country seem to be staking out a firm position on this. Like Health Care 1, the President is asking Congress to do something, but is not willing to step down from his intellectual tower to set out a path. As a consequence, like HC1, no one in the country really knows where he stands on containing and controlling the deficit.

As a consequence, no one really seems to be serious about the deficit.

The current estimate was constructed assuming that all current law will be used as the basis for the projection. If, for example, all the Bush tax cuts are allowed to expire, as is now the law, this will result in the budget deficit climbing to about 76% of GDP in 2020.

However, if Congress does not allow these tax cuts to expire and if Medicare programs are held constant, along with other spending and taxing programs, the budget deficit will rise to about 97% of GDP in 2020. This would place the cumulative total of deficits at around $12 trillion over the next ten years.

For the last 12-18 months, I have been arguing that the cumulative budget deficit for the next ten years will come in at least around $15 trillion, given the current attitudes about the budget deficit in Washington, D. C.. In my mind, Congress, given current attitudes, will not rescind the programs that are now in place, and, like always, will add more that will only cause the cumulative deficit to rise from current projections.

It seems as if the Congressional Budget Office is coming toward my forecast as time goes forward.

And the Gross Federal Debt continues to climb: the year-over-year rate of increase is now close to 20%. The compound rate of increase in the Gross Federal Debt between 1960 and 2007 was in slightly above 7% which some of us felt was excessive.

Since it took until fiscal year 2009 for the debt of the United States to approach $12 trillion, the idea that this figure would be doubled in the next ten years seems “unreal”. Yet, that is the way things look.

And, there are three major “holders” of this debt…Japan, China, and the Federal Reserve. Going forward it seems almost surreal the proportion of the new debt the Federal Reserve may have to acquire. There is, of course, the $900 billion that the Fed is intending to acquire as a part of QE2. But, what will the Fed have to do after that? With so much government debt coming on board it is frightening to speculate.

Why am I so pessimistic? Well, we really don’t know how much the health care program is going to cost us. We don’t know what military challenges we are going to be facing. The world is very unsettled now and I don’t see how commitments are really going to be lessened over the next ten years given all the turmoil taking place around the globe. We don’t know how the budget crisis affecting state and local governments is going to work out. Many are saying that the federal government will not play any role in state or municipal bailouts, yet, can you imagine the federal government not playing a role? And, what about the housing market and the government agencies called Fannie Mae and Freddie Mac? How much is this area going to impact the federal budget? One last unknown here is the cost of getting the commercial banking system back to full solvency. No one knows what these costs might be.

The problem with debt is that the more you have the fewer choices you have. Debt reduces your room to maneuver. And, as with Europe, it seems to me that the options are running out.

The other thing about creating more and more debt is that the options become less and less desirable.

That is why you don’t want to get yourselves “head-over-heels” in debt…you want to be able to make your own choices and you want the alternatives available to you to be desirable ones.

Right now, the choices are not good! And, we don’t seem to have any real leaders around in positions of authority that will step up to the table to take charge.

Funny, but the two Presidents that did take a leadership role in budget containment were George H. W. Bush (Bush 41) and Bill Clinton. Bush 41 made some decisions with respect to taxes that arguably cost him a second presidential term. But, Bush’s efforts set the stage for the Clinton era of strong economic growth and shrinking federal deficits.

There just is no leadership on this issue coming from the places that should be exercising leadership. To be more specific, in my experience, the top person, the CEO, the person where “the buck stops”, must take a leading role in getting something done or it just does not “get done” right. Secretary of the Treasury Robert Rubin was a major force behind the Clinton move on the budget, but the effort would have gone nowhere without Clinton getting on board and taking the lead.

As with the health care bill, people are not seeing Obama carrying the flag. Oh, he talks and talks, but where does he really stand? Tim Geithner has all but disappeared. The only real spokesperson for the administration on economics and finance seems to be Ben Bernanke and his “talk” has been getting lost in all the attention being given to other members of the Board of Governors of the Federal Reserve System.

The deficit problem is not going to be brought under control immediately. But, the lesson we can learn from the situation going on over in Europe is that someone eventually must take the lead. If no leader steps out in front of the crowd, the misery just drags on and drags on. The debtors just keep banging on the door. And, what happens during periods like this? Well, you lose focus.
I have seen this doing business “turnarounds”. When things start going downhill in a business and the debtors, or regulators, keep banging on the door, you stop doing what you should be doing in order to run a good business. You just have to “put out fires.” Thus, your organization continues to go downhill.

Likewise with a government: if the focus of the government is diverted from doing what it should be doing in order to resolve budget and debt issues, the government continues to experience problems in areas it should be focusing on.

It is past time to “get serious” on the federal government’s deficit problem. Are there any leaders in the room?

"Sharing the Pain: Dealing with Fiscal Deficits"

Over the past week or so, I have spent a lot of time on sovereign debt and the problems being faced by various nations across this planet with respect to their budget deficits. I suggest the article “Sharing the Pain” in the March 4, 2010 edition of The Economist as a good compilation of issues relating to the situation many countries are now facing. This piece is contained in the briefing, “Dealing with Fiscal Deficits,” http://www.economist.com/business-finance/PrinterFriendly.cfm?story_id=15604130.

We can separate the discussion into three categories: the problem, the pain, and the pragmatic response.

First, the problem. History shows us that when economies slow down, budget deficits appear or widen. Revenue growth declines as the needs to increase outlays rises. Put this general movement on top of decades of undisciplined management of government budgets and you can get “one hell of a problem”

The Economist article states that “deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt.” It continues, “when markets do lose confidence in a government’s fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions.”

Second, the pain. History shows, according to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, that it is highly unlikely that the “rich countries” of the world will experience a burst of rapid and prolonged growth. “Sluggish growth is more likely” and “the evidence offers little support for the view that countries simply grow out of their debts.”

“So, short of debt default or implicit default via inflation, that leaves just two other ways of closing the deficit. Spending must be cut or taxpayers must pay more.” Hence the pain!

Here we can point to the situation in Greece where much of the effort to return some fiscal discipline to the country is falling on cuts in government wages and in social benefits. This has resulted in substantial personal retrenchment and civil unrest. Today we read of a second general strike in the nation that closed all public services. See, “New Strike Paralyzes Greece,” http://www.nytimes.com/2010/03/12/world/europe/12greece.html?ref=business.

The deficits are so large in most of the affected countries that minor adjustments to spending or taxes will have little or no impact. The budget adjustments that must be made are quite substantial: hence the depth and breadth of the pain.

In recessions that are relatively minor, government monetary and fiscal stimulus seems to restore economic growth, thereby rectifying the situation and minimizing the pain. But, in a recession of the magnitude of the Great Recession the government does not seem to be able to “buy” itself out of the trouble. Hence, the spread of the pain.

Furthermore, there is an added difficulty that enters the picture in the more extreme cases. Those that are more affected by the recession and by the adjustments that need to be made in government budgets may come to see the changes as a break in the “social contract” of the country. This government that saw to their welfare, put them to work, and sustained them through the minor crises of the past, now seems to be abandoning them. And, for whom? The international financial community!

Obviously, if we get into this state of affairs, the emotions can become quite high, as in Greece.

This leads us into the third category which has to do with what government can do in such situations. The problem with the situation brought on by large budget deficits and a growing national debt is that there are no good solutions. Anything the government does in an attempt to get the budget under control while encouraging the economy to recover hurts someone.

This is why governments must be very pragmatic in what they propose. Doctrinaire approaches just do not seem to work. There are only two suggestions from the historical perspective that seem to have borne some fruit in the past. The first is that there needs to be some “social cohesion” in the country to achieve some success in the effort to get the country’s budget under control. The second is that governments “should focus on spending cuts rather than tax increases.”

The article in The Economist points to two instances where successful government tightening has taken place in recent memory: Sweden and Canada. In both cases the crisis in the country became acute enough and the ruling governments acted in a sufficiently pragmatic way so that voters finally got behind the efforts. However, this social cohesion was not always achieved on the first attempt.

Some of the social cohesion can be gained by raising some taxes, especially on the “better off”. This may be the “quid pro quo” for the less well off to accept the other things that need to be done. The downside to this is always that the “better off” have more escape hatches that will allow them to avoid any imposition of taxes they feel are excessive. And, many countries in the past twenty years or so have built up reputations as “low tax havens” to attract business. Ireland, for example, lowered its corporate tax rate to just 12.5% and is very reluctant to increase this and harm the climate they benefitted so much from. If taxes go up on these people and businesses, they can be very mobile and move to less oppression environments. Also, tax evasion can be a huge problem especially against sales or value-added taxes.

So, the burden of fiscal tightening falls on the spending side but this is not an easy road either. And, when one looks at the “big” targets for cuts, good arguments for not making cuts abound. Military spending is not a major item in many countries needing budget cuts, but it is in the United States. Here, there are two wars being fought and the need to maintain the world’s “top” military machine and keep it current through research and development makes the budget almost non-touchable.

The next major item that comes up on the list to consider is government employment. Over the last 50-60 years, governments throughout the world have exploded in terms of providing employment. Over the last several years the rate of government hiring has gone up, especially in the United States, in an effort to deal with the financial crisis and the Great Recession. Is it realistic to think that governments will shrink in size or in terms of payroll expenses? This is where Greece and Ireland and Portugal and Spain have promised to do something. And, of course, this is where much of the civil unrest has come from.

Next, social programs, a huge item in many government budgets and the primary cause of the expansion of government budgets in the post World War II period. (For more on this see Niall Ferguson’s book “The Ascent of Money: A Financial History of the World.) The Economist suggests that one area that can be rationalized here is the pension system in these countries.
And, there are other ideas available.

The thing the article (implicitly) points out is that the way out of the fiscal dilemma is not easy. But, I suggest three further things that need to be considered. First, leadership. The countries facing the problems discussed here need to have someone out in front that is understood and trusted. The only way out of this situation is pragmatic: not progressive, not conservative, not liberal, not socialist, or any other dogmatic approach. But, to achieve the “social cohesion” necessary for success, there must be leaders that draw people together.

Second, the proposed solutions cannot just force people back into the way things were. One reason for the depth and breadth of the Great Recession is the changing structure of the society and culture. (For more on this see my post, http://seekingalpha.com/article/192713-the-trouble-with-recovery.) If this is true, then the leadership must be forward-looking rather than serving just entrenched interests.

Finally, this will not be easy. As The Economist article closes: “There are many battles over deficits to come. Well chosen policies that foster growth may make them less fierce. They may be bloody even so.” Amen.