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.

Fiscal Stimulus

In order to justify the fiscal stimulus packages of the federal government we must be able to find some relationship between the government expenditures and the performance in the economy. Currently, there seems to be very little statistical connection between the year-over-year rate of growth of the real economy and the rate of growth of government expenditures.

Here is a chart showing the relationship between the year-over-year rate of growth of the real nondefense expenditures of the federal government (the upper line) and the year-over-year rate of growth of real GDP (the lower line). The first quarter pictured in the chart is the fourth quarter of 2007, the quarter in which the Great Recession is said to have started. The pattern is not changed when total federal government expenditures are used.

The average rate of change for real nondefense government expenditures during this time period is 5.9%. As you can see from the chart, the actual figures seem to be above the average during the earlier part of the period and below the average toward the end.

Also, you can see that the year-over-year rate of growth in real GDP was at its highest level in the fourth quarter of 2007 (+2.5%) and declined progressively reaching its trough of a negative 3.8% in the second quarter of 2009. With the large jump in real GDP in the fourth quarter of 2009, the year-over-year rate of growth became positive again, showing a 0.1% gain.

Fiscal policy on the spending side did not seem to play much of a role in the trajectory of the economy during the recession up to the present time. If anything, the recovery seems to have begun without much contribution of federal spending.

The factors that contributed the most to the swing in real GDP growth are real Gross Private Domestic Investment and Real Exports.

The trough in the rate of decline of real investment expenditure occurred in the quarter that real GDP troughed and showed a remarkable improvement, especially in the fourth quarter of 2009. The particular sectors that were strongest in the third quarter and the fourth quarter were nonresidential purchases of equipment and software and residential construction. The construction of nonresidential structures continues to be in a hole.

The pickup in the purchases of equipment and software is a good indication that, at least, in some business areas, companies are acquiring products that will contribute to their more efficient performance as the economy picks up. In terms of the investment in residential construction the best explanation that can be given is that things have been down for so long that any construction seems to be an improvement.

Real exports also moved higher in the third and fourth quarters of the year and outpaced increases in real imports. This movement can be associated with the decline in the value of the United States dollar in the second half of 2009.

However, the major contributor to the increase in real GDP in the third and fourth quarters of 2009 was the rise in nonfarm private inventories. These inventories had declined constantly from the fourth quarter of 2007. There was a slight increase in nonfarm inventories in the third quarter, but the increase in the fourth quarter was substantial. Analysts are interpreting this rise in inventories as being a very positive sign for the economy because it indicates, to them, that some businesses are becoming optimistic enough about the possibility of rising future sales that they are building inventories to meet the potential increase in demand.

The good news is that there seems to be some life out there in the economy. The bad news is that the good news does not seem to result from the fiscal stimulus coming from the government even though the government is building up massive amounts of debt to support it spending programs.

Obviously, the large deficits are resulting more from a shortfall in revenues than from the increases that are taking place in spending. However, the government needs to be aware of what it can accomplish and what it is accomplishing. The perception of the people and the perception of the financial markets are crucial to the success or failure of a presidential administration. Right now, the spending programs appear to be contributing little toward improving economic activity.

Consequently, the perceptions about what the administration is achieving don’t seem to be that favorable for the Obama team. And, the new budget figures released this week didn’t seem to help that perception at all. (See http://seekingalpha.com/article/186031-stein-s-law-and-the-u-s-federal-deficit.) Somehow, the president is going to have to turn this around or it is going to be a long three more years.

Stein's Law

Perhaps the most profound bit of information appearing in the news this morning concerning the budget proposal of the Obama administration is the citation of Stein’s law by the economist James Galbraith in the New York Times article “Huge Deficits May Alter U. S. Politics and Global Power.” (See David Sanger, http://www.nytimes.com/2010/02/02/us/politics/02deficit.html?hp.)

Stein’s law (as familiarly presented) states that “If a trend cannot continue, it will stop.”

Galbraith also provides us with his own wisdom: “Forecasts 10 years out have no credibility.”

Now to the budget of the United States government!

What is the primary trend connected with the federal budget? Government expenditures will go up, and up, and up. Congress does not have the discipline to stop expenditures from increasing. Neither do presidential administrations.

But, what about the deficit?

There is only one way the deficit can or will be reduced: revenues coming into the government must increase. And, of course, they must increase at a faster pace than expenditures are growing.

This was the pattern in the Clinton administration years, 1993-2001. For this 8-year period, total receipts coming into the federal government rose 7.1% per year. (Note that for the 7-year period of 1993 -2000, the annual rate of increase was 8.4%.)

This contrasted with the compound growth rate of total federal government outlays which rose by 3.6% per year. Thus, the Clinton administration began in fiscal 1993 with a total deficit of $255 billion and recorded a surplus in fiscal year of 1998 of $69 billion, followed by surpluses of $126 billion, $236 billion, and $128 billion.

The major contributors to the growth rate in total receipts was Individual income taxes and Social insurance and retirement receipts. The compound growth rates of these items was 8.7% and 6.2%, respectively. Note that the compound growth rate for real GDP during this time period was 3.5%.

The figures for Bush 43 show a substantially different configuration. Total receipts of the federal government grew by only 3.6% per year during this administration. (Note that the compound growth rate for real GDP was 2.3% at this time.) The greatest growth in revenue came from corporate income taxes which grew every year by 10.5%

There was a surge during the Bush 43 years of total outlays which rose by 8.3% year-after-year. The biggest contributor to this was the outlay for national defense, and these expenditures rose, on average, by 10.2% every year. (Note that in the Clinton administration these outlays rose by less than 1% per year.)

It seems to me that the trend in outlays over the next few years will remain rather high. America is a nation at war! Defense outlays will continue to rise. The question is, how much? This is a unknown known. My guess here is that present estimates are low!

The big question relates to how much other expenditures will rise, expenditures related to health care, energy, global warming and others. The exact cost of this spending are anyone’s guess right now. These expenditures we can put in the category of known unknowns. Given the history of government it is impossible for me to believe that health care reform will not “cost us one dime” as stated by the President. We don’t really know when these other programs will be pushed and expanded, but they still remain on the “to-do” list of the President.

There are always “other” things, the unknown unknowns. You guess.

The trend in outlays is up, but the question is by how much? The mean of the Clinton and Bush 43 years is just about 6% per year!

Is there any way that revenues can come anywhere close to a 6% per year annual increase?

It was done in the Clinton years, but that was with an economy that was increasing, in real terms, at 3.5% compound rate. I just don’t see it over the next 5 to 10 years.

Raising taxes? Are you crazy!

Yes, the Bush 43 tax cuts will not be renewed, but, there will not be any other tax increases that will raise revenues substantially. Not with the unemployment figures captured in the current budget document.

So, what are we faced with?

Given the scenario I have just painted my guess for the sum of government deficits over the next 10 years is from $15-$18 trillion. This is substantially above the $8.5 trillion total presented in the current Obama budget documents.

If this scenario for the federal budget is anywhere close to reality then one could argue that it is the blue-print for an excessive credit inflation in the upcoming years that will be unlike anything we have seen in the past in the United States!

And, what is the good news?

To quote Galbraith, “Forecasts 10 years out have no credibility.”

Whew! You had me scared two paragraphs ago.

Any more good news?

Sure, to quote Herb Stein, “If a trend cannot continue, it will stop.”

The trend commented on above is the growth of total federal government outlays. It must stop! But, it will not stop if the United States is fighting at least two wars, fighting unemployment, fighting for health care reform, fighting for other “musts” on the Presidential “to-do” list, and taking care of those unknown, unknowns that always seem to pop-up.

“If a trend cannot continue, it will stop!”

What is going to make the trend in total federal government outlays stop?

I’ve got my ideas. You go ahead and write your own script!