Debt Follies

The New Monetary Regime: An Expert Panel Discusses Debt and Inflation

Written remarks from our three panelists follow below:

U.S. Fiscal Profligacy and the Impending Crisis

by David P. Goldman

The Rise and Rise of Deficit Government

by Christopher DeMuth

The Costs of Our Debt

by Veronique de Rugy

These remarks from the symposium offer a revealing analysis of US financial and fiscal policy. I include in this post the essay by David Goldman, as I believe it offers a foundation for understanding the predicament we have created with poorly conceived financial policies that are now being accelerated and amplified. I have highlighted sections in RED.

May 5, 2021

Massive demand-side stimulus combined with constraints on the supply-side in the form of higher taxes is a sure recipe for inflation and eventual recession. The Fiscal Year 2021 US budget deficit will amount to 15% of US GDP after the passage of an additional $1.9 trillion in demand stimulus, according to the Committee for a Responsible Federal Budget, a proportion that the United States has not seen since World War II.

It is hard to avoid the conclusion that the Biden Administration’s fiscal irresponsibility arises from a cynical political calculation. It evidently proposes to employ the federal budget as a slush fund to distribute benefits to various political constituencies, gambling that the avalanche of new debt will not cause a financial crisis before the 2022 Congressional elections. The additional $2.3 trillion in so-called infrastructure spending that the Administration has proposed consists mainly of handouts to Democratic constituencies.

Where is Foreign Money Going?

During the 12 months ending in March, the deficit stood at 19% of GDP. Even worse, the Federal Reserve absorbed virtually all the increase in outstanding debt on its balance sheet. In the aftermath of the 2009 recession, when the deficit briefly rose to 10% of GDP, foreigners bought about half the total new issuance of Treasury debt. During the past 12 months, foreigners have been net sellers of US government debt. (See Figure 1.) The US dollar’s role as the world’s principal reserve currency is eroding fast, and fiscal irresponsibility of this order threatens to accelerate the dollar’s decline.

The Federal Reserve has kept short-term interest rates low by monetizing debt, but long-term Treasury yields have risen by more than a percentage point since July. Markets know that what can’t go on forever, won’t. At some point, private holders of Treasury debt will liquidate their holdings—as foreigners have begun to do—and rates will rise sharply. (See Figure 2.) For every percentage point increase in the cost of financing federal debt, the US Treasury will have to pay an additional quarter-trillion dollars in interest. The United States well may find itself in the position of Italy in 2018, but without the rich members of the European Union to bail it out.

The flood of federal spending has had a number of dangerous effects already:

  1. The US trade deficit in goods as of February 2021 reached an annualized rate of more than $1 trillion a year, an all-time record. China’s exports to the US over the 12 months ending in February also reached an all-time record. Federal stimulus created demand that US productive facilities could not meet, and produced a massive import boom.
  2. Input prices to US manufacturers in February rose at the fastest rate since 1973, according to the Philadelphia Federal Reserve’s survey. And the gap between input prices and finished goods prices rose at the fastest rate since 2009. (See Figure 3.)
  3. The Producer Price Index for final demand rose at an annualized 11% rate during the first quarter. The Consumer Price Index shows year-on-year growth of only 1.7%, but that reflects dodgy measurements (for example, the price shelter, which comprises a third of the index, supposedly rose just 1.5% over the year, although home prices rose by 10%).

If foreigners are net sellers of US Treasury securities, how is the United States financing an external deficit in the range of $1 trillion a year? The US has two deficits to finance, the internal budget deficit, and the balance of payments deficit, and here we refer to the second. The answer is: By selling stocks to foreigners, according to Treasury data. (See Figure 4.) Foreign investors have been dumping low-yielding US Treasuries and corporate bonds during the past year, according to the Treasury International Capital (TIC) system. Foreign investors bought $400 billion of US equities and nearly $500 billion of US agency securities (backed by home mortgages) during the 12 months through January, but sold $600 billion of Treasuries and $100 billion of corporate bonds.

This is a bubble on top of a bubble. [Double Bubble = Trouble.] The Federal Reserve buys $4 trillion of Treasury securities and pushes the after-inflation yield below zero. That pushes investors into stocks. Foreigners don’t want US Treasuries at negative real yields, but they buy into the stock market which keeps rising, because the Fed is pushing down bond yields, and so forth.

At some point, foreigners will have a bellyful of overpriced US stocks and will stop buying them. When this happens, the Treasury will have to sell more bonds to foreigners, but that means allowing interest rates to rise, because foreigners won’t buy US bonds at extremely low yields. Rising bond yields will push stock prices down further, which means that foreigners will sell more stocks, and the Treasury will have to sell more bonds to foreigners, and so forth.

The 2009 crisis came from the demand side. When the housing bubble collapsed, trillions of dollars of derivative securities backed by home loans collapsed with it, wiping out the equity of homeowners and the capital base of the banking system. The 2021 stagflation—the unhappy combination of rising prices and falling output—is a supply-side phenomenon. [Back to the Future of That 70s Show] That’s what happens when governments throw trillions of dollars of money out of a helicopter, while infrastructure and plant capacity deteriorate.

The present situation is unprecedented in another way: Not in the past century has the United States faced a competitor with an economy as big as ours, growing much faster than ours, with ambitions to displace us as the world’s leading power.

The source of the 2008 crisis was overextension of leverage to homeowners and corporations. I was one of a small minority of economists who predicted that crisis.

Federal debt in 2008 was 60% of GDP, not counting the unfunded liabilities of Medicare and the Social Security System. As of the end of 2020, Federal debt had more than doubled as a percentage of GDP, to 130%. The Federal Reserve in 2008 owned only $1 trillion of securities. US government debt remained a safe harbor asset; after the Lehman Brothers bankruptcy in September 2008, the 30-year US Treasury yield fell from 4.7% to 2.64%, as private investors bought Treasuries as a refuge.

The Treasury: Not a Refuge from, but a Cause of Crisis

Today the US Treasury market is the weak link in the financial system, supported only by the central bank’s monetization of debt. If the extreme fiscal profligacy of the Biden Administration prompts private investors to exit the Treasury market, there will be no safe assets left in dollar financial markets. The knock-on effects would be extremely hard to control

The overwhelming majority of over-the-counter (privately traded) derivatives contracts serve as interest-rate hedges. Market participants typically pledge Treasury securities as collateral for these contracts. The notional value of such contracts now exceeds $600 trillion, according to the Bank for International Settlements. Derivatives contracts entail a certain amount of market risk, and banks will enter into them with customers who want to hedge interest-rate positions only if the customers put up collateral (like the cash margin on a stock bought on credit) (See Figure 5) The market value (after netting for matching contracts that cancel each other out) is about $15 trillion. If the prices of Treasury securities fall sharply, the result will be a global margin call in the derivatives market, forcing the liquidation of vast amounts of positions.

Something like this occurred between March 6 and March 18, 2020, when the yield on inflation-protected US Treasury securities (TIPS) jumped from about negative 0.6% to positive 0.6% in two weeks. The COVID-19 crash prompted a run on cash at American banks, as US corporate borrowers drew down their credit lines. US banks in turn cut credit lines to European and Japanese banks, who were forced to withdraw funding to their customers for currency hedges on holdings of US Treasury securities. The customers in turn liquidated US Treasury securities, and the Treasury market crashed. That was the first time that a Treasury market crash coincided with a stock market crash: Instead of acting as a crisis refuge, the US Treasury market became the epicenter of the crisis.

The Federal Reserve quickly stabilized the market through massive purchases of Treasury securities, and through the extension of dollar swap lines to European central banks, which in return restored dollar liquidity to their customers. These emergency actions were justified by the extraordinary circumstances of March 2020: An external shock, namely the COVID-19 pandemic, upended financial markets, and the central bank acted responsibility in extending liquidity to the market. But the Federal Reserve and the Biden Administration now propose to extend these emergency measures into a continuing flood of demand. The consequences will be dire.

The present situation is unprecedented in another way: Not in the past century has the United States faced a competitor with an economy as big as ours, growing much faster than ours, with ambitions to displace us as the world’s leading power. China believes that America’s fiscal irresponsibility will undermine the dollar’s status as world reserve currency.

Here is what Fudan University Professor Bai Gang told the Observer, a news site close to China’s State Council:

Simply put, this year the United States has issued a massive amount of currency, which has given the US economy, which has been severely or partially shut down due to the COVID-19 epidemic, a certain kind of survival power. On the one hand, it must be recognized that this method . . . is highly effective. . . . The US stock market once again hit a record high.

But what I want to emphasize is that this approach comes at the cost of the future effectiveness of the dollar lending system. You do not get the benefit without having to bear its necessary costs.

A hegemonic country can maintain its currency hegemony for a period of time even after the national hegemony has been lost. After Britain lost its global hegemony, at least in the 1920s and 1930s, the pound sterling still maintained the function of the world’s most important currency payment method. To a certain extent, the hegemony of the US dollar is stronger than any currency before it. . . .

We see that the US dollar, as the most important national currency in the international payment system, may still persist for a long time even after US hegemony ends. Since this year, the US has continued to issue more currency to ease the internal situation. The pressure will eventually seriously damage the status of the US dollar as the core currency in the international payment system.

America has enormous power, but the Biden Administration and the Federal Reserve are abusing it. And China is waiting for the next crisis to assert its primacy in the world economy.

How I will Vote This Time. And Why.

Back in September, 2016, I wrote an essay posted here explaining why I would not be voting for either Hillary Clinton or Donald Trump for POTUS. At the time I stated that “I do not believe Trump has the temperament, nor do I feel Clinton has the integrity, while neither display the requisite political skills to lead this nation.” At the time I argued for a protest vote and explained why, but nobody really needed to listen.

One could probably argue that I was only half right, because Trump did win the election and we’re still here. Political competence is probably in the eye of the beholder.

So, four years later we’re back with a similar choice between Trump for re-election or former VP Joe Biden to succeed him and I am again faced with the same quandary. You’re probably thinking, who cares? But I will state here in writing my decision for several reasons, in brief so as to not needlessly bore you if you’re still reading.

First, I’m a political scientist and policy analyst, so I’m not uninformed when it comes to American politics as I have been observing, studying, and analyzing our party politics for the better part of four decades. Second, due to my professional interests I find myself frequently in these contentious debates over partisan and ideological politics where the accusations and projections fly, the result being that I find myself constantly having to restate my initial positions, which are now published here forever on the Internet. With this record, I can merely refer my discussant to review what I wrote, rather than waste time restating it and not being believed.

This has been useful because for the past four years I have tried to explain to Trump-haters (and they really do hate him) that Trump is not the cause, but the symptom of our political dysfunction. Now, if you’re a Trump-hater, and I’m not, you’ll have none of it and so I have often been accused of being a Trump supporter, and I’m not. I just want to live in a rational world and there’s nothing rational about our current politics.

Let me give a quick overview of the situation as I see it. I don’t see a knight in shining armor here, either in the person of the President or his challenger. On one side I see a bull in a china shop, being deliberately poked and breaking things as his ego, self-aggrandizement, and political survival require. I do believe his one desire, for better or worse, is to be judged by history as a successful president. I imagine every president’s ultimate aspiration is to be judged in the same company as Washington, Jefferson, and Lincoln.

On the other side, I see a historically weak candidate with 47 unremarkable years in Washington politics, paired with an ambitious dark horse running mate that failed miserably among her own voters; both being propped up by a shadow party eager to return to power. Given Biden’s obvious cognitive decline and the excessive demands of the presidency, I really have no idea who would be commanding a Biden administration or what agenda they would put forth once they no longer have an opposition to demonize. The candidate seems unable to articulate this.

Not a great choice, but this is where we are.

For me this election is not just about judging personalities and character, both of which I find wanting (the first debate confirmed this). What I see beyond the media-driven smoke and mirrors is a deep power struggle between two contending visions of American society and between two elite political camps who both want to secure that power. But these visions seem to be a means to an end rather than the defense of constitutional first principles. It also appears that either side will do anything, say anything, in order to prevail in the coming election, even fanning the flames of social conflict.

I don’t see American politics as a battle between Athens and Sparta, or Rome and Carthage, where the loser will be erased from history. Rather I see a pendulum swing that has always marked our national politics. In my own experience I have seen Nixon as a reaction to Johnson, Carter as a reaction to Nixon, Reagan as a reaction to Carter, Clinton as a reaction to Reagan/Bush, Bush as a reaction to Clinton, Obama as a reaction to Bush, and finally Trump as a reaction to Obama. Will Biden be a reaction to Trump, or will we need to wait for 2024?

At the same time, I have lived through a cultural evolution that has seen the decline of national identity that has diminished our sense of shared community. As a matter of fact, supported by data, this is most defined by a rural – suburban – urban divide, which has been blurred by our obsessions with multiculturalism and identity politics. We are also divided by class, with growing inequality between the asset-rich and asset-poor. These changes have accelerated with technology and globalization. The resulting tension is over the pace of change, between gradual managed traditionalism vs. proactive progressivism. This is a significant point, because opposing positions on the pace of change can be reconciled.

Unfortunately, I see us turning national politics into the ultimate prize conferring power over the present and future, and now even the past. I think this is largely a political conceit. The pendulum still swings, but in the short-term power means wealth and control and that seems to be what motivates our politics today, from the top down. Prudently managing change and stable continuity seems to have gotten lost in the shuffle.

If you love or hate Trump, nothing I write here is going to change your mind – that’s pretty much a given. But consider the endless parade of scandals for and against the Trump administration and how that reflects on our democratic governance. Look at the failures of the media – both for and against Trump – to inform us objectively. Look at the attacks on our institutions – again from both sides. Look at the decline in trust across our society. One can merely reference a long laundry list of inter-party sabotage: from Russian collusion investigations and counter-investigations; to impeachment proceedings that were cynically pursued even though everyone knew it was a purely partisan gambit; to the politicization of a global virus pandemic; to racial unrest that has degenerated into violence and disorder; to a democratic national election that establishment elites threaten to dismiss as illegitimate. As I write this, we can now expect to enjoin another fierce battle that further politicizes our Supreme Court and judiciary. And I thought justice was supposed to be blind.

Trump is not “doing” this to us, and I’ve already used his name too many times in this essay considering he’s merely a symptom. My evaluation of his presidency is mixed, but one would think it to be an unmitigated disaster according to much of the news media. I can understand the dismay because the current administration has largely reversed the direction of the previous administration across most of the policy landscape. But that’s free democracy, which, despite protests to the contrary, we have not abandoned as we contest competing visions through the electoral process. But obsessing over the person of the presidency is driving us to the brink of insanity. Thank goodness for the Federal Reserve and Treasury, which keeps pumping money into our pockets (please note the sarcasm).

These last four years of political clashes underline the deeper societal dysfunction that has plagued us for almost two generations through divisive identity politics and a multiculturalism that deemphasizes our shared national culture. This is what I find far more disturbing than an elected official I didn’t vote for. What happened to winning elections through persuasion and common interests?

So, in brief, in November I will be casting a vote for the re-election of Donald Trump for three main reasons:

  1. A Russian collusion/impeachment effort that has consumed 4 years of national governance for naught, promoted by a disingenuous political opposition and a complacent or duplicitous Fourth Estate;
  2. A pandemic policy that has ignored rational risk trade-offs in a further attempt to politicize a health crisis that affects us all, especially those who can’t vote;
  3. The promotion of racial animus and division through identity politics and public shaming in order to advance narrow political ambitions.

To be sure, racial minorities do have legitimate and pressing grievances. But these societal failures are not being addressed by cancel culture and the Black Lives Matter movement. Minorities, especially urban minorities, have been victims of poor housing policy, failures of public education that impede life opportunities, welfare policies that weaken family structures, failed drug and criminal justice policies, and class-based tax and financial policies that disfavor the asset-poor, driving inequality. I don’t see so-called woke activists addressing any of these challenges, but rather scapegoating the police who have been tasked to manage these aforementioned failures. With the exception of financial policy, these are primarily municipal and state failures and the only national demand on the POTUS will be to restore law and order.

In my reading of American politics, all the misguided efforts have been primarily driven by the singular desire to destroy a presidency by extraordinary, undemocratic means. And yes, he punches back with little concern for decorum. But this has only served to delegitimize and damage our trust in American democratic politics and institutions. In historical context this is truly a self-inflicted tragedy and one that our foreign adversaries certainly appreciate.

Perhaps the cultural rot goes much deeper and for that we have only ourselves to blame. Several recent books have traced this decline from the mid-60s to the present. Today one observes a certain psychological hysteria consuming much of the population over politics. Just yesterday I read another typical quote in the media on the upcoming SCOTUS nomination: “The Republican Party is preparing…to send the U.S. spiraling into an abyss of illegitimacy.” Really? This has been going on for four years and we wonder why so many voters have tuned out. In reality, I suspect some of these alarmists are staring into the abyss of political irrelevance.

I cannot see where this election takes us but I can’t condone political sabotage, no matter who’s holding office. And I’m not interested in childishness claims of, “He started it!” Four years ago, I registered a protest vote, but events have degenerated to the point I will cast my lot. What I seek above all in American democracy is the support and defense of liberty and justice for all, in the historical tradition of classical liberalism and a free society. A further descent into chaos and anarchy certainly doesn’t promote that objective. As I have tried to explain: Trump did not convince me to vote for him, the Democratic Party did.

I imagine many who read this will vehemently disagree with my interpretations and conclusion, claiming Trump is the threat to democracy. I’m unconvinced. Trump is a one-man force of nature opposed by the entire Washington establishment and mainstream press. He’s not an ideologue and can hardly lead an authoritarian coup – he has no army of Brownshirts and the other two branches of government have not collapsed. We can survive one man for four more years, but the collapse of democratic government will be far more costly. Trump’s election was a warning shot across the bow of both parties, so I would prefer to see the political establishments and media promote successful governance rather than trying to tear down a sitting POTUS. Trump’s instincts have been good, though he tests the waters with tweets meant to provoke. That’s his strategy to read public support.

Dissent is to be expected and tolerated in the messy process of democracy. However, there is a growing tendency to dismiss those who disagree with us as not acting in good faith. I find that tendency to run counter to the ideals of a free society. I would merely encourage each and every single voter to examine their own conscience, vote, and then accept the results with sober resolve.

Then we can get back to more important task of living in peace.