How Much Should the United States Cut the Deficit?

How much should the United States government cut its budget deficit?

This seems to be the big debate in Congress surrounding discussions/negotiations related to the new fiscal budget.

The problem as I see it is that the United States government is focused on the wrong objective! It is focused on an objective, low levels of unemployment that it cannot achieve without creating all other kinds of distortions in the economy, distortions that produce, in many cases exactly the opposite result from what the government is attempting to achieve.

Let me tell you what objective I believe the United States government should focus upon in determining its economic policy stance, which includes its fiscal budget.

I believe that the primary economic focus of the United States government should be on the value of the United States dollar. I believe that the United States government should attempt to stabilize and maintain the value of the dollar in international currency markets.

The current focus of economic policy in the United States government is employment…or low levels of unemployment. This objective was memorialized in The Employment Act of 1946 which set placed the responsibility for achieving high levels of employment, or low levels of unemployment on the back of the United States government.

In 1978 this objective was re-enforced by a new act, The Full Employment and Balanced Growth Act (known informally as the Humphrey–Hawkins Full Employment Act). This act just made stronger the government’s commitment to the achievement of low levels of unemployment.

The ability of a government to achieve full employment was contested in 1968 by the economist Milton Friedman who contended that continued governmental stimulus to achieve a “hypothetical” level of employment, called “full employment” would only achieve more and more inflation as people came to expect the government’s efforts to stimulate the economy through the creation of credit expansion…credit inflation.

Friedman’s expectations proved to be true as the government continued to promote government deficits and the expansion of government debt in economy.

From 1960 through 2010, the gross federal debt of the country expanded at an annual compound rate of more that 7% per year.

From 1960 through 2010, the purchasing power of the United States dollar declined by about 85%.

From 1960 through 2010, the United States removed itself from the gold standard and allowed the value of the United States dollar to float in foreign exchange markets. The value of the United States dollar has declined by more than 30% since it was floated and expectations are for it to decline further.

From 1960 through 2010 under-employment in the United States has gone from a relatively modest number which was not measured at the earlier date to more than 20% in the current environment.

From 1960 through 2010 manufacturing capacity has declined from about 95% to about 75%. The peak capacity utilization has every cycle since the early 1970s has been at lower and lower levels.

From 1960 through 2010 the income distribution of the United States has become dramatically skewed toward the higher levels of income earned. This is the most skewed income distribution curve ever for the United States.

I cannot see how the United States government can continue to keep “full employment” as a goal of its economic policies. Not only has “full employment” not been maintained, it has generated side effects that, it seems to me, has substantially worsened the life of many Americans.

Why should the government substitute the maintenance of the value of the United States dollar as its primary objective for the conduct of its economic policy?

Here I quote Paul Volcker: “a nation’s exchange rate is the single most important price in (the) economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate.” This quote is from Paul Volcker (“Changing Fortunes: the World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten, Times Books, 1992, page 232.)

Yet “ignore large swings in its exchange rate” is exactly what the United States did and is doing. The consequences of ignoring this value? I have reported those above.

By focusing on the level of unemployment the way the United States government did and pursuing an economic policy of credit inflation, the United States government actually weakened the country and hurt its citizens. The “unintended results of good intentions!”

The United States government should not, and realistically cannot, reduce its budget deficit too rapidly. Markets realize that.

But, the United States government must signal that it is changing the objective of its economic policy and is sincerely pursing a path to reduce or even eliminate the credit inflation it has inflected on its country…and the world…for the last fifty years.

My guess is that until international financial markets see this shift in policy objectives and sense a realistic change in the attitudes of the politicians in Washington, D. C. the dollar will continue to decline in value because participants in international financial markets will just see the government continuing to act in the same way it has over the past fifty years, acting in a way that will continue the policy of credit inflation.

And, if the government continues to act in this way, the economic health of the economy will continue to deteriorate and the standing of the United States in the world will continue to become relatively weaker.

In my view the government does not have to reduce the deficit by massive amounts this year. It does, however, have to signal that it is changing its goals and objectives and then provide enough evidence of this change in focus to convince the international financial markets that it is sincere.

In the current political environment, however, this may be too much to ask.

The Federal Reserve's Report Card

The headline reads “Conservative Republicans Propose to Pare Back Federal Reserve’s Dual Role.” (See http://www.nytimes.com/2010/11/17/business/economy/17fed.html?_r=1&ref=todayspaper.)

The Federal Reserve has been given two policy goals in the last half of the 20th century. The first policy goal given the Fed, the goal of full employment, was enacted into law in 1946. This act was called “The Employment Act” and it mandated that the federal government do everything in its authority to achieve full employment, which was established as a right guaranteed to the American people. This was supplemented in 1978 by “The Full Employment and Balanced Growth Act” also called the Humphrey-Hawkins Full Employment Act which encouraged the federal government to pursue "maximum employment, production, and purchasing power".

The inclusion of “purchasing power” introduced into government legislation the goal of maintaining stable prices, the second policy goal for which the Federal Reserve is responsible for.

The concern of the Conservatives regarding the “Dual Role” can be expressed in thoughts coming from the economist Milton Friedman. First, monetary policy does not determine the level of employment in the economy in the longer run. Second, inflation is everywhere and at every time a monetary phenomenon. So, to these Conservatives, the Fed cannot achieve full employment and the attempt to achieve full employment by monetary means just results in inflation.

Is there any way we can measure the success of the Federal Reserve in achieving the goals connected with its “Dual Role”? Do the Conservatives have any case for the stance they are taking?

I believe there is a report card related to Federal Reserve actions and that report card is the foreign exchange market. This belief is expressed by Paul Volker, former Chairman of the Board of Governors of the Federal Reserve System. He has written, “a nation’s exchange rate is the single most important price in its economy…” This quote can be found on page 232 of the book co-authored by Volker and Toyoo Gyohten, formerly of the Japanese Ministry of Finance, titled “Changing Fortunes.”

Volker goes on to say that “what the Fed does in regulating U. S. money and credit inevitably affects exchange rates, and even the world money supply. Domestic and international (monetary policy), it’s a seamless web…”

And, what grade is given to the United States in the foreign exchange market?

The grade is derived from the chart below.

The value of the United States dollar against major currencies has declined by 33% from January 1973 to October 2010. It has declined by 35% at the low point in the chart attained in April 2008, just before the financial collapse which came in September 2008.


There are two breaks in the decline. The first begins in the late 1970s as President Carter was forced to bring Paul Volker in as the Chairman of the Fed which was followed by a very severe tightening of monetary policy. Market participants gave Volker high praise. Note, however, that the value of the dollar has declined by 51% from its peak, reached in March 1985, to its low point in September 2008.

The second break came in the 1990s as Secretary of the Treasury Robert Rubin, under President Clinton, moved the government’s fiscal budget into surplus range accompanied by a relatively benign monetary policy. The effect of the surplus caused the value of the dollar to peak in February 2002 as the Bush tax cuts and military expenditures became a reality. From this peak, the value of the dollar declined by 37% from the peak to the low point achieved in September 2008.

The two peaks after September 2008 came from the “flight to (credit) quality” accompaning the subsequent world wide financial crisis and in early 2010 by the European Union sovereign debt crisis. The downward trend in the value of the dollar always seems to continue after these “short-run” crises.

The best grade that I can give the Federal Reserve from this long-term behavior is a D!

World financial markets do not seem to support the execution of the Feds “Dual Role”!

One further note: the Federal Reserve is supposed to be independent of the administrative and legislative branches of government. However, the legislation of 1946 and 1978 took away that independence, if it ever existed. The first evidence of this is the fact that the United States floated the value of its currency in 1971 as a result of the inflation that was growing in its economy. This is why the chart only begins in 1973, because the value of the dollar was fixed internationally before this time.

Monetary Warfare: Is An Independent Economic Policy Possible for a Nation?

John Maynard Keynes, after 1917, wanted to achieve full employment for England, but also for other major countries in Europe and the western world. The reason for this goal was that he was afraid of the Bolshevik menace threatening his civilized world.

Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates

Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.

Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.

The third component of this, international capital mobility, was severely restricted at the time.

What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.

Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.

Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.

And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.

The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.

The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.

World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.

But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.

For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.

And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.

The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)

The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.

The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.

That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.

In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.