Please Listen: The Problem is Too Much Debt

For the past two years or so, my prediction for the cumulative debt of the United States government over the next ten years has been in the $15 to $20 trillion range.  This would more than double the current amount of government debt outstanding.

Since the events of the past few days in Washington, D. C., my prediction for the cumulative debt of the United States government over the next ten years is still in the $15 to $20 trillion range.

The most descriptive characterization of the “debt deal” that I have heard is that Congress (and the President) has just “kicked the can down the road.”

In this, the United States government seems to be in the same league as their “kin” in the eurozone.  One has to look hard to see any evidence of leadership. (See my post http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

As far as the Obama administration is concerned, in my mind, this “team” has observed the creation of three “camels” on its watch.  The first camel was the health care bill.  The second was the Dodd-Frank financial reform bill. (See my post http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The third camel is, of course, the just passed “debt deal”. 

The general comment about all three is that at the birth of all three, people were very unhappy with them. 

Never can I remember, except maybe under President Jimmy Carter, a President that exhibited less leadership in such important areas.  President Obama presented no “plan” to Congress in any of these efforts.  People say that the administration was responding to the “health care plan” rebuff experienced by the Clinton administration in the 1990s and wanted to involve Congress more from the start of any legislative attempt.  I believe that this was a gross mis-reading of the events surrounding the Clinton initiative. 

However, this strategy of holding back and letting Congress take the lead in proposing and disposing resulted in something more like chaos or anarchy than leadership.  And, this strategy has produced three camels that nobody really likes. 

And then people worry about jobs and the state of the economy.  How can you create smaller deficits through cuts in government spending without causing further danger to the health of the economy?

It seems like we are in some kind of situation in which everything that is proposed contradicts everything else.  President Obama, after the passage of the “debt deal” stated very clearly, that the issue now becomes one about jobs.  
In fact, the President plans a bus trip in the Midwest the week of August 15 as part of his new jobs push.  Whoopee!

To me, there is only one thing that ties all the different problems we are experiencing together.  It is the fact that there is just too much debt outstanding today…and, this debt load extends throughout the nation (and throughout Europe).  Consumers are still burdened with too much debt.  So are many businesses.  So are state and local governments.  And, so are sovereign nations. 

“Consumer Pullback Slows Recovery,” we read in the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111903520204576483882838360382.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj).  Why are consumers not spending?  They are saving…they are paying back debt…to get their balance sheets in line.  They are not buying homes because of the problems with bankruptcies and foreclosures (http://professional.wsj.com/article/SB10001424053111904292504576482560656266884.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj).

Many businesses are not borrowing because of a decline in their economic value and the increased pressure this puts on the amount of liabilities they are carrying on their balance sheets.  (See my post http://seekingalpha.com/article/279506-debt-deflation-and-the-selling-of-small-businesses.)

And, the state and local governments are also getting headlines about their budget problems.  What about the city in Alabama that is declaring bankruptcy?  And the municipality in Rhode Island?  And, what about the problems in Harrisburg, Pennsylvania?  And, California?  And so on and so on?

This is the scenario called “Debt Deflation”.  Debt deflation occurs after a period of time in which credit inflation has dominated the scene.  Credit inflation eventually reaches a tipping point in which the continued inflation of credit can no longer be sustained.  Once this tipping point is reached, people, businesses, and governments see that they can no longer continue to operate with so much debt and so they begin to reduce the financial leverage on their balance sheets. (See my post http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation.)

This process is called “Debt Deflation” because it is cumulative.  As these economic units begin to reduce their financial leverage, it becomes obvious to them that they must reduce this leverage even further than first imagined.  Whereas “Credit Inflation” is cumulative and leads to people adding more and more debt to their balance sheets, the reverse process is also cumulative.

The only short-term way to avoid this debt deflation from taking place is to create the condition called “hyper-inflation.”  This is exactly what Mr. Bernanke and the Federal Reserve System has tried to do.  I say short-term because all hyper-inflations come to an end sometime.

We have had fifty years of government economic policy based on the Keynesian assumption that fiscal deficits and the consequent credit inflation that results from the deficits are good for employment and the economy.  This assumption has, to me, been disproved given that the compound rate of growth of the economy has averaged only slightly more than 3 percent over the last fifty years, about what was expected in the 1960s, and the amount of under-employment in the economy has gone from less than 10 percent of the workforce in the 1960s to more than 20 percent of the workforce, currently. 

Furthermore, the income/wealth distribution in the country has become more skewed than ever toward the wealthy during this time period.  This is because the wealthy can protect themselves against inflation and even position themselves to take advantage of it.  The less wealthy do not have similar opportunities.  And, in the current situation, some, the more wealthy, are doing fine because they are not as indebted as others and so can continue to prosper during these difficult times of excessive debt burdens.

Getting back to my projections for the cumulative federal deficit over the next ten years and the “debt deal”: I really don’t see a fundamental change in the underlying economic philosophy of the Obama administration (which includes Mr. Bernanke) and/or Congress.  They seem to see the current problems as a “temporary” aberration from the existing “Keynesian” credit inflation philosophy that underlies all that they do.  They seem to believe that once this “period of discomfort” is passed that business will continue on as usual. 

Until this attitude is changed, I see little reason to change my prediction for the cumulative federal deficit over the next ten years.

Liqudity Traps are For Real

When I was studying economics, the idea that an economy might face a “liquidity trap” seemed absurd. Basically, the concept of the liquidity trap was that the monetary authorities could not “push on a string”. In other words, the liquidity trap represented a time when the central bank could inject a large amount of reserves into the banking system and people (and businesses) would prefer to hold more money than to hold debt. Thus, funds could not get into the bond market which would mean that businesses would not invest in inventories, plant, or, equipment, and the economy would stay mired at a low rate of activity.

This was why deficit spending on the part of the government was necessary, at least for those following the Keynesian dogma, because it was the only way to increase aggregate demand and re-charge economic activity.

Well, we are in a liquidity trap. The Federal Reserve has injected more than $1.0 trillion of excess reserves into the banking system and has kept short-term interest rates close to zero. And, commercial banks have not lent these excess reserves so they continue to rest on the balance sheets of the banking system. The question is, what needs to be done next?

Furthermore, the government has tried deficit spending to spur on the economy, but this effort seems to have had a less-than-dramatic impact on the economic recovery now seemingly underway. Keynesian dogmatists argue vociferously that the problem is that the government has not spent enough…that the Obama administration has been too timid.

But, this approach to the concept of liquidity traps hinges upon the assumption that the crucial economic relationship is found on the asset side of the balance sheet, on the division of assets between holding money or holding bonds. The analysis completely ignores the liability side of the balance sheet. Nothing is said about the amount of leverage the economic unit has built into its balance sheet. Hence, the issue of whether or not an economic unit has “too much” debt doesn’t even enter the picture. And, this is the problem.

There is an article in the Financial Times this morning that I believe does a good job in addressing this issue. The article is “Leverage Crises are Nature’s Way of Telling Us to Slow Down” by Jamil Baz, Chief Investment Strategist for GLG Partners (http://www.ft.com/cms/s/0/580fa460-8e8d-11df-964e-00144feab49a.html).

Baz argues that the near-collapse of the world financial system followed by a deep recession was “a crisis of leverage.” The ratio of total debt to gross domestic product in the United States reached 350 percent in 2007. Whereas nations could perhaps maintain a level of 200 percent and still achieve healthy economic growth, the 350 percent figure that remains in the United States (and that also exists at higher levels in many of the leading developed countries) cannot be sustained.

The consequence is that at some time in the future the United States and other developed countries are going to have to deleverage. But, deleveraging is going to be costly in terms of future economic growth. We, in essence, have to pay for the past sins we have committed in building up such an enormous debt structure.

Baz presents “three hard realities we need to bear in mind” that result from having too much leverage. These hard realities are:

• When you are bankrupt, you either have to default on your debts or you save so you can repay your debts;
• Policy choices under such circumstances are not appetizing with one school of thought advising taking morphine now followed by cold turkey later and the other school proposing cold turkey now;
• If you are a politician, you may be under the illusion that you are in charge whereas the real decision-maker is the bond market.

He concludes: “maybe leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

The liquidity trap now being faced by policy makers comes from the liability side of the balance sheet. People and businesses are faced with the choice of either going bankrupt or increasing their savings so as to repay their debts. As Baz says, “This is neither ideology nor economics, simply arithmetics.”

But, it does mean that commercial banks may not want to lend and people and businesses, in aggregate, may not want to borrow. Pushing on a string in this case has little or nothing to do with the asset side of balance sheets and everything to do with the liability side of balance sheets. The Federal Reserve cannot force the commercial banks to lend or people to borrow.

The liquidity trap looked at in this way is real and has been operating for more than a year.

The problem is that if you consider the liquidity trap in this way you can clearly see the dilemma presented by Baz in terms of the policy choices that are currently available. This is why one could argue that it took so long for the Great Depression to end. People and businesses had to work off their debts…they had to go “cold turkey” for a while. In this sense, the economists Irving Fisher and Joseph Schumpeter were closer to understanding the economic situation that existed in the 1930s than was Keynes!

If Baz is correct then the choices are pain now versus more pain in the future. The problems associated with the increased leveraging of the economy cannot be put off forever. Debt must eventually be paid down!

China is Changing the World

Earlier, on March 25, I raised the question “Why Should China Change?” in my post, “Why Should China Change?” (http://seekingalpha.com/article/193689-why-should-china-change)
The thrust of the post was captured in the following:

“The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s.”

The United States is still the number one power in the world, both economically and politically, but its relative position has changed. And we continue to see that in our relationship with China (and India and Brazil and Russia).

The current ‘high-level’ meeting in Beijing of representatives from China and the United States highlights the changing relations between the governments of China and the United States. As reported in the New York Times, “the opening session laid bare a recurring theme…the United States came with a long wish list for China…while China mostly wants to be left along…” (http://www.nytimes.com/2010/05/25/world/asia/25diplo.html?ref=business)

China is “turning into an economic superpower” according to the Times article and wants to continue along on its merry way. The United States, other than initiating an all out trade war, seems incapable of slowing down the Chinese economic machine or even getting the attention of the Chinese leaders.

Chinese President Hu Jintao did pledge to continue reform of China’s currency, but then repeated the standard operating response: “China will continue to steadily push forward reform of the renminbi exchange-rate formation mechanism in a self-initiated, controllable and gradual manner.” That is, we will change things when we want to change things and no sooner.

Secretary of the Treasury Geithner graciously replied: “We welcome the fact that China’s leaders have recognized that reform of the exchange rate is an important part of their broader reform agenda.” What else could he say?

The United States, and most of the rest of the west, is in a weakened state. But, this weakened state goes beyond the short-run. The United States is facing longer run, structural problems it must deal with. Economic growth and financial strength are important factors in world economic power. However, when a nation extends itself and stretches itself too far due to over-commitment and over-leverage, thinking it can do too much, it exposes itself to other nations that are not in a similar position.

It is the United States, the number one world power that is asking China to change. China is in a position where it does not feel the need to cave into the American requests. China is strong and disciplined. The United States is strong, but undisciplined. Therein lies the difference.

And, the (supposed) allies of the United States are little or no help. Europe is attempting to resolve the problems it created for itself. As a consequence it is slowly fading into the background. The G-7 group of nations, the United States, Canada, France, Germany, Italy, Japan, and England, is losing relevance in the world. The G-20 includes the seven, but more importantly includes several emerging nations that are more strategic to the future than is the “old boyz club” from Europe.

De-emphasize the G-7 and raise up the G-20!

The ultimate problem of the United States is its lack of discipline. For the past fifty years or so, the United States has lived for “the short-run” because, we have been told, that “in the long-run we are all dead.” The economic policy of the United States has been designed to combat short-run increases in unemployment with a constant pressure to achieve high rates of economic growth. But, this creates an inflationary bias in economic policy. Because of this the United States has seen the purchasing power of its dollar drop 85% from January 1961 until the present time, underemployment has grown to about 20% of the working age population and the capacity utilization of its industrial base has declined to less than 75% at present (but rose to only slightly more than 80% in its most recent cyclical peak).

These are not signs of economic strength. Furthermore, the value of the dollar over the past forty years has dropped by approximately 35%. Huge amounts of United States debt, both public and private, have been financed “off shore”. These developments do not put America in a very strong bargaining position.

China thinks in decades. The United States thinks in terms of the next election. Discipline does matter.

There are still many economists in the United States who argue that the government must spend more and create more debt to get the country going once again. Their fundamentalist view of how the world works blinds them to the fact that it was the loss of fiscal discipline, the exorbitant creation of huge amounts of government debt and the subsequent credit inflation that this encouraged, that put the United States into the position it now finds itself.

More spending and more debt are not going to make the situation any better. I examined this issue in my May 13 post “Government Deficits and Economic Activity”: http://seekingalpha.com/article/204948-government-deficits-and-economic-activity. My basic conclusion was that in the present situation where the Federal Reserve has pumped so much liquidity into the banks that big banks and big companies can play games in world financial markets and cause major problems for areas like the euro-zone. The continued creation of deficits and more government debt is not going to solve this problem for Europe…or the United States.

Until it gets it act under control and in order, the United States will be the one asking China to change the way it does things. China, given the present circumstances, will continue to do things in their own interest and at their own speed. In addition, it is my guess that other, emerging nations will begin to exert themselves in similar ways. And, the United States will not be in a position to resist their efforts.

As I said earlier, “The world has changed and we in the United States have not accepted that fact.”

All we can really control is ourselves and if we fail to do that we give up the chance to influence others.

Government Deficits and Economic Activity

Something is different this time. There is high unemployment, about 10% in the United States, and the politicians are crying that the political issue is jobs, jobs, jobs.

The resultant policy should be to increase government spending and increase fiscal deficits. Right?

Doesn’t seem to be.

What’s going on?

The international financial community is in charge this time and they are exerting their will.

The international financial community is doing very well, thank you! Central banks have subsidized the big financial institutions and big financial players with their “Quantitative Easing.” These large institutions have plenty of money and so they are not running scared. And, this money can appear and disappear all over the world without being controlled. And, they are using the money. See “The Banks’ Perfect Quarter” at http://seekingalpha.com/article/204617-the-banks-perfect-quarter.

In the past, the big institutions like JPMorgan, Goldman Sachs, and Bank of America and so on would have to wait until the Federal Reserve eased monetary policy by providing the financial markets with sufficient liquidity. Then their performance would begin to increase as the economic recovery progressed. But, even then, they never reached the heights that they are attaining now.

In addition, as the Federal Reserve began to stimulate the economy, it kept interest rates in line. That is, the Fed kept interest rates low, but did not let interest rate spreads get excessively “out-of-line” because that might cause the Fed to lose the sense of the financial markets they were operating within. The idea was to loosen but keep the market “taut” so that it could continue to monitor where market pressures were coming from.

The concept of “taut” came from sailing: if I am sailing a boat and I have a small craft attached to the boat with a rope, the idea is to keep the rope “taut” but not too “tight” or not too “loose.” The reason being is that if the rope is “taut” you know where the small craft is. If the rope is too “loose” you do not know where the small craft is; if the rope is too “tight” the rope can snap if the small craft is subject to another force. You want the rope attachment to maintain just the right amount of pressure, so that you know where the small boat is but not too tight so that the small boat breaks away from your ship and you lose it.

But, keeping money markets taut did not provide many trading opportunities, at least, not trading opportunities like the ones that exist today.

Today large financial institutions, internationally, are facing a bonanza market for raking in huge profits. The central banks have provided them with this opportunity to trade and it is almost risk free. And, the central banks have let the markets know that this situation will exist for an extended period of time! Wow!

Putting this in prospective, however, we see that the European Union and the governments of the U. K. and the U. S. have, over the past 50 years, created an inflationary environment that has created massive financial institutions that thrive on trading, not on what was formerly known as banking. These governmental institutions have, themselves, led the move toward financial innovation through the creations of Fannie Mae, Freddie Mac, Ginnie Mae, and the Mortgage-backed securities. These were not private sector initiatives.

The incentives that existed in this world of credit inflation promoted trading and arbitrage and further innovation. Forget the fact that the profits that come from trading activities is a “zero-sum” game in which there is someone that loses exactly what someone else wins.

Trading worked for the “big guys” and they learned how to do it very well.

That is exactly what is going on right now. The large, international financial interests are scouring the world in search of “targets”. And, no one is a better target than a government that has lived way beyond its means for many years. But, governments like these are crying “foul” because they feel they are being taken advantage of even though they were the ones that got their country in the position it is in through long periods of undisciplined, profligate behavior.

What is different this time is that these huge, financial giants are being subsidized by the central banks and they are traveling the world to use what has been given them.

I believe that we will look back on this time and say that the Obama Administration was perhaps the largest contributor to an unequal distribution of income the world has seen.

How can I say this? Well, we are seeing a major bifurcation of the world today, more so than the one that existed relative to the Bush 43 tax cuts. Major amounts of wealth are being created in most major financial markets. And, the traders love volatility. These people are getting everything they want and need. So are other many firms in other areas or sectors of the market.

But, those unemployed are not building up their wealth, and those people who are underemployed are not building up their wealth, and those individuals that are foreclosed on are not building up their wealth, and the small businesses that are going into bankruptcy or cannot get a loan from their local bank are not building up their wealth.

Seems a little unfair, doesn’t it?

The Federal Reserve states that it is keeping interest rates low, waiting for the economic pickup to spread into the distressed sectors of the economy. The longer the Fed holds to this stance and explains it’s reasoning in terms recovering economic growth, the longer I look for other reasons for such a policy.

My conclusion: there are many banks that are smaller than the biggest 25 that are in deep trouble. In addition, there are many businesses that are in deep trouble that might even put these “less than giant” banks in more trouble. Also, the Fed quickly encouraged the European Central Bank to move to “Quantitative Easing” and then supported this move by re-opening the swap arrangements the Fed had with other central banks. The rumor is that this re-opening of the swap window will postpone even further the “extended period” of time that the Fed will keep its target for the Federal Funds rate at its current level. Seems like we have a massive “solvency problem” in the world and not just in the United States.

What is different now? Large financial institutions around the world have enormous amounts of funds they can deal in and excessively large interest rates spreads to work with and large amounts of market volatility to trade off of and a promise by the central banks that interest rate risk will not be a problem. Given this ammunition, governments that are or have been undisciplined in running their fiscal affairs, are “sitting ducks” for these traders.

So governments are being forced to reduce spending and not increase it, to reduce deficits and not increase them. To get re-elected politicians may want to focus on jobs, jobs, jobs and health care programs and other social welfare initiatives. However, they may not be able to do that this time!

Headlines of the Day: How Are Governments to Finance Themselves?

More and more attention is being directed toward the problems that governments are having with their financial situation. We have spent so much time this year discussing the problems in the financial industry, in housing, in credit cards, in consumer credit, in business bankruptcies, in debt-swaps, and in commercial real estate, that the plight of governments, other than the federal government, has taken a back seat.

Is 2010 to be dominated by the financial problems of government: federal, state, and local?

The cloud is certainly on the horizon.

Budget and debt problems on the national level have risen to prominence in the last few weeks. Just to list a few, you can start with Ireland, Greece, Spain, Mexico, and Dubai.

Yeah, and what about California and New York?

More and more we are hearing about the sagging prospects for the states and for cities and other local administrative units. See, for example, “States Scramble to Close New Budget Gaps” in the Wall Street Journal, http://online.wsj.com/article/SB126110075141996495.html#mod=todays_us_page_one.

In almost all states, there is some kind of balanced budget requirement. This is also true of many local government bodies. This means that attempts must be made to bring budgets under control.

The problem is on the revenue side; funds are just not coming in at the rate even severely revised budget projections anticipated. And, all of these shortfalls cannot be filled by federal stimulus monies. Certainly some jobs, especially in education, were maintained by federal funds, but this source cannot be continually relied upon.

And, the situation is a cumulative one. Unemployment and non-existent economic growth have caused the revenues of these entities to slow down. This is resulting in more budget cuts, primarily in programs and layoffs which just exacerbate the problem in unemployment and slow economic growth. This in turn slows down the revenue flow even further. And, so on, and so on.

Just as businesses and households are doing, state and local governments are re-thinking what it is they do, what they can do, and how they are going to go about doing it. The de-leveraging and down-sizing are coming after 50 years or so of relatively constant expansion of budgets and programs.

The inflationary-bias that has existed in the United States for the last 50 years resulted in a very prosperous public sector to go along with the very prosperous private sector. As I have stated repeatedly in my posts over the last two years, inflation is wonderful for the creation of debt and for financial innovation, in the public sector, as well as in the private sector.

Ah, thank goodness for gambling, for it seems to be one of the “gap-filling moves” that states are relying on to replace revenue shortfalls. The problem with this is that “planned gambling expansions” are zero-sum games if people, on the whole, don’t increase their gambling activities. And, do we really want people to increase their gambling activities, especially at this time?

But, this leads us back to the federal sector. It seems as if future inflation is the only answer to the consequences of past inflation.

The latest official estimate for the federal deficit for 2010 is $1.5 trillion, up from 1.4 trillion the year before. Even scarier is that the Gross Federal Debt is projected to increase by $2.2 trillion this year, an increase of 18.6% from last year. Even shakier is that the public is supposed to absorb more of the increase in the federal debt than ever before: a rise of $2.0 trillion or 26.9% ahead of last year.

And, these budget figures don’t include the Pentagon “bill” that was passed yesterday with much pork and “earmarks”, buying things that the Pentagon didn’t even want! And, it doesn’t include the new Pelosi “jobs bill” which just passed the house last week. And, it doesn’t include real numbers for the health care legislation. Oh, yes, and where is the $100 billion going to come to help finance the climate concerns of the emerging or developing nations? This was just proposed two days ago. Also, where is the cost of the increased troop commitment to Afghanistan? And, there are four or five other things that could be included in this list.

Where are the funds going to come from to finance all of these expenditures?

In addition, we have a Federal Reserve System that is on the verge of “exiting” from the excessive liquidity that it has injected into the financial system over the past 15 months. The Fed has a portfolio of securities that amounts to $1.835 trillion. The composition of this portfolio is U. S. Treasury securities, $777 billion, Federal Agency securities, $158 billion, and Mortgage-Backed securities, $901 billion.

How is the government going to finance all of the new debt it must place on the market at the same time the Federal Reserve is trying to reduce the size of its balance sheet by selling off these securities?

Furthermore, the Congress is not going to be happy with the Fed selling securities to “exit” its current bloated balance sheet which will cause interest rates to rise at the same time that massive amounts of new federal debt is going to be hitting the financial markets.

Well, the Bernanke Fed is not independent of the government anyway.

So, inflation is the answer! Bring it on!

The interesting thing about the international concern over the financial health of the nations is that the value of the United States dollar has risen. International finance seems to be saying that maybe things in the United States are not that bad when you consider the state of other nations in the world.

As I wrote above, maybe in 2010 a lot more of the concern in credit markets will be with the status of government budgets and government debts. The question then becomes, how long can governments continue to bail out other governments? Maybe as long as some governments can still print money.

It's the Dollar, Stupid!

“A nation’s exchange rate is the single most important price in its economy.” Paul Volcker

The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.

The reason given for the current decline? The U. S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking lose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.

Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.

Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.

This is a tremendous cloud hanging over the financial markets!

We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U. S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.

But, now with the strengthening of the U. S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.

And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.
This is not a financial mix that participants in international financial markets like.

Let’s take a look at the historical record. We start during the Nixon administration because until August 1971 the value of the dollar was fixed in value relative to other currencies. But, once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.

In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.

The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.

Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23.0%! (Through one stretch, the value of the dollar actually declined by more than 40%.)

With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%

I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.

In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.