Note from June 2010: You’ll forgive me if I have conflated private and public sector debt below as if they are the same. They are not. When I speak of deficit spending in the same voice as private sector debts, I really point to deficits to maintain the status quo ante as promoting the accumulation of private sector debt. The real debt problem in the U.S. is in the household sector – and to the degree deficit spending promotes excess household consumption, public sector debt contributes to this.
The U.S. economy is in recession and the misery is deepening by the day. We need to ask ourselves what the heck we should do to get ourselves out of this economic mess. The answer will need to be rooted in a careful analysis of cause and effect. We need to know why we got here, before we can build a solution for the future. How we got here is a Shakespearian tragedy in five acts.
My interpretation? — Reckless Spending
Let me take you on a forty-year journey with a play entitled "It’s the Debt Stupid (ITDS)," a tragedy, in five acts. ITDS leads right up to 2008 all the way back from the Vietnam era. What you will see is that our hero in ITDS runs up massive bills but saves very little. In this 40-year period, the elected officials cowardly allow not only the Federal Government, but also the citizens of the country to spend recklessly and become overly indebted, and hence poorer. This is the true cause of the recession we are now in. Printing more money won’t solve the problem. Spending less and saving more will.
Act I: Guns and Butter
The play begins in the present day. Our hero, the United States, is likely in the deepest recession since the Great Depression — all because our hero can’t seem to stop spending more than he earns.
Now, flash back to the last full scale American war and the Vietnam era. Our hero first decides to go with a Guns and Butter strategy in the 1960s. We spend beyond our means from that era forward. Deficit spending to keep this gravy train going first rears its head in the 1960s. Then comes inflation (slowly at first — but it is rampant late in the 2nd act). The dollar is worth less and less, even though exchange rates are fixed and do not reflect this fact.
Understanding this truth, the posturing French President Charles De Gaulle in 1967 decides that gold is worth far more to him than the $35 per ounce for which it could be redeemed. They begin a run on the dollar — everyone and his brother tries to get gold at the $35 per ounce rate in exchange for their dollars. The result is a suspension of the gold window by the Nixon administration and the out-of-control inflation of the 1970s.
So, in Act I, our Hero says he will redeem dollars for gold but goes out and spends money like it’s 1999. Others call his bluff, Bretton Woods falls apart, and the dollar de-links from Gold.
Act II: Inflation
Open Act II. Our hero has now de-linked from Gold. Before the 1960s, the Heroic Government had not engaged in significant deficit spending in peacetime except during the Great Depression. But, now it’s party time — time to start the printing presses in full gear. The Heroic Government no longer needs to pretend to adhere to fiscal prudence as it did with the dollar-gold peg. It can run up serious deficits to pay for domestic programs and fight the war in Vietnam without consequence. The result? Our hero suffers an inflationary depression as inflation and unemployment skyrocket, the dollar sinks, and gold hits an all-time high over $800 per ounce.
See, all that spending requires the Fed to increase the money supply at unprecedented rates. Nixon tries to halt the surge in inflation with wage and price controls. But, this is a futile effort as Oil Shocks in 1973 and 1979 only contribute to the inflation. By the end of the 1970s, not only is the Heroic government deep in debt, but our hero’s economy has grown to a halt with stagflation.
So, in Act II, our Hero parties like crazy, spending recklessly. The Government tries to print all the money it wants, to fund its programs, only to realize this leads to stagflation.
Act III: Enter Paul Volcker
Open Act III. In Shakespeare, the third act is always the crucial one, the high water mark in the play where the pivotal decisions are made. In ITDS, the pivotal character in Act III is clearly Paul Volcker who, as Fed Chairman from 1979-1987, stabilizes the economy and lowers inflation. What this means for our Hero, is a reprieve. It appears that he is not destined to fall. Will he use this chance wisely?
So, Act III is our perfect climax. Volcker saves the day with sound monetary stewardship and rights the ship. This gives our Hero the opportunity to see the folly of his ways. But, is he fated by hubris to fall?
Act IV: The Financial Economy
Open Act IV. The disinflationary period following Volcker’s appearance on the scene is used, not to right the ship and to start to live within his means, it is used to pile on debt. As inflation starts to recede, our budget deficit does not. In fact, on the Federal level and the personal level, our hero begins to lever up, increasing his debt load, as lower inflation allows him to do. In 1965, total debt is 150% of GDP. In 2008, it more than doubles in relative size to well over 300% of GDP.
The country is ruled like never before by financial interests. Whilst oil companies have a disproportionate share of the S&P 500 earnings in the 1980s, now it is Financial Services. As financial services go, so goes our economy.
Therefore, when recession hits, it is VERY important that one prevent deflation. Deflation makes, debt more expensive. Inflation makes savings less valuable but it makes debt less costly. A nation hooked on debt needs inflation in order to reduce the real value of its debt loads. This is why Alan Greenspan’s Fed pulls out all the stops in 2001 to stop the economy from imploding.
The recession of 2001 should be a nasty little downturn, purging us of the excess debt. But, alas, we postpone the day of reckoning and pile on more debt.
So, in Act IV, we continue to whoop it up, piling on even more debt than ever before (After all, aren’t we the world’s only superpower. We can do this). An ugly end is near.
Act V: The Collapse
Open Act IV. At some point, the day of reckoning has to come. And so it comes in 2008. The truth is that the housing bubble is an outgrowth of the easy money policies of 2001-2003. The Fed gives a nation addicted to spending yet more easy money, hoping to use this period as a reprieve and a way to shore up its collective balance sheet.
But, this is not how people operate — if one needs a respite from profligate ways, someone needs to come and literally take away the credit cards, not increase the credit line. The country is now at the conclusion of an historic bubble in housing of mammoth proportions.
And so concludes our little 5-act play. But, nagging questions remain.
Conclusion
The main question again is: what got us here? The answer is reckless spending and the associated debt. It is the debt servicing that is killing us. It is the debt and lack of savings which makes us unable to continue spending. It is the debt that makes us fear deflation. It is the debt that causes the Fed to reflate and wreck the dollar.
So, when we ask our government which policies it should follow in order to help us, the answer should be: help us reduce our private sector debt now and in the future. But Ben Bernanke and the Bush administration are giving us more of the same evil potion of easy money and deficit spending to finance malinvestment. Let’s hope a new President and a new Fed chairman will know better how to fix this problem in 2009.