Much noise has recently been made by fiscal hawks about the danger of high
fiscal deficits and national debts. Yet the purported danger comes not from the
size of the deficits or debt, but on how the proceeds from them are used. In
recent decades, the US economy has suffered from such proceeds being spent on
programs that were not conducive to sustainable economic growth or constructive
to economic health.
During the course of World War I, US national debt multiplied 27
times to finance the nation’s participation in war, from $1 billion to $27
billion. The US military drafted 4 million men and sent more than a million
soldiers to France, solving the domestic unemployment problem overnight plus
putting women into factories and creating a sharp rise in aggregate demand as
troops had to be supported at a level of consumption exponentially higher than
civilians could through market forces in peacetime. War was a blessing to the
US economy as military demand put US industries humming at full capacity while
the homeland was exempted from war damage.
Far from ruining the US economy, war production financed by public debt
catapulted the country into the front ranks of the world’s leading economic and
financial powers, because the US homeland was not affected by war damage and
civilian consumption was curbed in the name of patriotism. The national debt
turned out to be a blessing, because a good supply of government securities
provided for a vibrant credit market and public sector spending created the
rise in demand that private companies could satisfy profitably with a
guaranteed market.
The truth is that the positive economic functionality of the national debt
rests not so much on its level, high or low, but on how the debt is expended.
When the national debt is use to expand economic production with full
employment and rising wages, it will produce positive economic effects. But if
the national debt is used to finance speculative profits achieved through
pushing down wages via cross-border wage arbitrage, or to structure ballooning
interest payments to service old debts by assuming more new debts, it will
eventually drag the economy to a grinding halt by a crisis of debt implosion.
World War I raised the federal debt to about 34.5% of GDP. Nine decades later.
In March 2009, the Congressional Budget Office (CBO) estimated that US gross
debt will rise to 101% in 2012 from 70.2% of GDP in 2008, while the economy is
expected to stay in open-ended recession with unacceptably high unemployment at
over 10%. The difference is that in 1919 the federal debt was used to finance
war production while in 2012 the public debt is expended to refinance the
speculative debt bubble.
Less that a decade after World War I, by 1928, US gross debt fell to $18.5
billion, but the money so released was absorbed mostly by speculative profit to
cause the market crash in 1929. In 1930, a year after the crash, US gross debt
fell further to $16.2 billion under president Herbert Hoover's balanced budget
and the Federal Reserve's tight money policy under chairman Roy Archibald
Young.
During Young's term as Fed chairman there was confrontation between the Federal
Reserve Board and the Federal Reserve Bank of New York under George L Harrison
of how to curb speculation that led, inter alia, to the stock market boom of
the late 1920s. The board was in favor of putting "direct pressure" on the
lending member banks while the Federal Reserve Bank of New York wanted to raise
the discount rate. The board under Young disapproved this step; however Young
himself was not fully convinced that the policy of using pressure would work
and refused to sign the 1929 annual report of the board because it contained
parts favorable to this policy.
Eugene Isaac Meyer was appointed by Herbert Hoover to be chairman of the Fed on
September 16, 1930. Meyer strongly supported government relief measures to
counter the effects of the Great Depression, taking on an additional post as
chief of the Reconstruction Finance Corporation (RFC), modeled after the War
Finance Corporation of World War I.
The RFC gave $2 billion in aid to state and local governments and made loans to
banks, railroads, farm mortgage associations, and other businesses. The loans
were nearly all repaid after the Depression. RFC was continued by the New Deal
and played a major role in containing the Great Depression and setting up the
relief programs that were taken over by the New Deal in 1933.
Upon Franklin D Roosevelt's inauguration in 1933, Meyer resigned his government
posts. Months later, he bought the Washington Post at a bankrupt auction and
turned it into a respected and profitable newspaper. His daughter, Katherine
Graham, was publisher of the Washington Post when it exposed the Watergate
scandal that led to the resignation of president Richard Nixon on August 9,
1974. Meyer was appointed by president Harry S Truman after World War II to be
the first president of the newly formed World Bank.
After the launch of the New Deal in 1933, US gross debt rose to $62.4 billion,
at 52.4% of GDP. By 1950, World War II had pushed US gross debt five folds to
$356.8 billion but only at 94% of GDP. After 1950, US gross debt fell steadily
as a percentage of GDP to a low of 33%, with a nominal value of $909 billion in
1980 under president Jimmy Carter. Since then, US gross debt has not fallen
below 56% of GDP. Projected US gross debt for 2012 is $15.7 trillion at 101% of
GDP. Much of the debt money in the two years since the credit crisis has ended
up in the wrong pockets of distressed financial firm but not those of thee
needy public, depriving the US economy of full employment with rising wages to
increase aggregate demand.
While US public debt in 1946 reached $300 billion, at 135% of GDP, the post-war
years were prosperous one for the US. These data show clearly that it is not
the level of the public debt, but how the debt money is spent that determines
its impact on the economy.
The issue of the fiscal deficit
The federal fiscal deficit in 1919 was 16.8% of a GDP of $78.3 billion. The
wartime federal deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a
high fiscal deficit, US GDP kept rising after World War II to $275.2 billion in
1948 with a fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is
project to be 10.6% of a GDP of $14.6 trillion.
Between 1920 and 1929, the Federal budget had a small surplus, while GDP grew
to $103.6 billion in 1929. After the 1929 crash, the 1930 GDP fell $12.4
billion, about 12%, to $91.2 billion, while the Federal budget under Hoover
still had a surplus of 1% of GDP.
Franklin D Roosevelt came into office in 1933, when the GDP had fallen by
almost half to $56.4 billion, and the Federal deficit jumped to 3.27% of GDP in
1934. All through the New Deal years, the Federal fiscal deficit stayed below
5% with the average annual deficit at around 3% of GDP. It did not rise until
after the US entered World War II and peaked at 28.1% in 1943, 22.4% in 1944
and 24.1% in 1945 before falling to 9.1% in 1946 when the GDP was $222.2
billion.
The total federal fiscal deficit for the four years of World War II was about
100% of the average annual GDP of the same period. At the same time, the US
grew to be the strongest economy of the world because the fiscal deficit was
used to finance war production, not to bail out distressed financial
institutions and inefficient industrial firms.
US fiscal deficit for the fiscal year ending September 30, 2009 (FY2009), was
more than $1.75 trillion - about 12.3% of GDP, the biggest since 1945.
According the White House Budget Office, the cumulative fiscal deficit between
FY2009 and FY2019 is projected to be almost $7 trillion. Total gross federal
debt in 2008 was $10 trillion, projected to rise to over $23 trillion in 2019.
Debt held by the public is projected to rise from $5.8 trillion in 2008 to
$15.4 trillion in 2019. Interest expense in 2008 was $383 billion. Projection
is expected to rise as both debt principal and interest rate are expected to
rise.
The issue of inflation
Inflation is a different story. Moderate inflation is necessary for optimum
economic growth, provided the burden of inflation is equally shared by all
segments of the population, particularly wage earners. By the end of World War
I, in 1919, US prices were rising at the rate of 15% annually, but the economy
roared ahead as wages were rising in tandem with or slightly ahead of prices
through wage-price control.
Income policies involving wage-price control were employed throughout history
from ancient Egypt, to Babylon under Hammurabi, ancient Greece, during the
American and French revolutions, the Civil War, World War I and II. A case can
be made that that wage-price control has a mixed record as a way to restrain
inflation, but it is irrefutable that income policies are effective in
balancing supply and demand.
Yet in response to inflation, the Federal Reserve Board raised the discount
rate in quick succession in 1919, from 4% to 7%, and kept it there for 18
months to try to rein in inflation by making money more expensive when banks
borrowed from the Fed. The result was that in 1921, 506 banks failed.
The current financial crisis started in late-2007 and stabilized around
mid-2009 after direct massive Fed intervention. It was by many measures an
unprecedented phase in the history of the US banking system. In addition to the
systemic stress and the stress faced by the largest investment and commercial
banks, 168 depository institutions failed from 2007 through 2009. This was not
the largest number of bank failures in one crisis. At the height of the savings
and loan (S&L) crisis from 1987 to 1993, 1,858 banks and thrifts failed.
However, the dollar value of failed banks assets in the financial crisis in
2007-2009 was $540 billion, roughly 1.5 times the bank assets that failed in
the S&L crisis in 1987-1993.
A research paper funded by the Federal Deposit Insurance Corporation (FDIC), on
"Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930", by Paul
Kupiec and Carlos Ramireza (July 2008) found that bank failures reduce
subsequent economic growth. Over this period, a 0.12% (1 standard deviation)
increase in the liabilities of the failed depository institutions results in a
reduction of 17 percentage points in the growth rate of industrial production
and a 4 percentage point decline in real gross national product (GNP) growth.
The reductions occur within three quarters of the initial bank failure shock
and can be interpreted as a measure of the costs of systemic risk in the
banking sector. The FDIC was created by the New Deal only after 1934 to protect
depositors.
In the crisis that began in mid-2007, with the discount rate falling steadily
to 0.5% on December 16, 2008, from a high of 6.25% set on June 2006, 25 banks
failed in 2008 and were taken over by the FDIC, while 140 banks failed in 2009
and 33 failed in just the first two months of 2010, putting the fee-financed
FDIC in financial stress. Yet the Fed raised the discount rate to 0.75% on
February 19, 2010. In contrast, in the five years prior to 2008, only 11 banks
had failed from the debt bubble even when the discount rate stayed within a
range from 2% to 6.25%.
Volcker, slayer of the inflation dragon
In the 1980s, to counter stagflation in the US economy, the Fed under Paul
Volcker (August 6, 1979 - August 11, 1987), slayer of the inflation dragon,
kept the discount rate in the double-digit range from July 20, 1979, to August
27, 1982, peaking at 14% on May 4, 1981. From August 1982 to its peak in August
1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2,722. The rise
in market indices for the 19 largest markets in the world averaged 296% during
this period.
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