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Monday, June 8, 2009

Massive Borrowing is the Problem

The president continues to insist that he isn't responsible for the nearly two trillion dollar deficit we will have by the end of the year. He is trying to pull a misdirection hoping that no one blames him for the inevitable repercussions of unsustainable debt. Economics can be very complicated especially for those that don't make finance their profession. Yet, there are some fairly simple universal truths. First, debt, by nature, is not necessarily bad. If there was no debt, then we would only buy a home, a car, or go to college if we had enough money in the bank. It would limit business expansion to only monies that are available at any given time. Debt is not in and of itself a bad thing. It's why we have municipal bonds, corporate bonds, and even U.S. treasury bonds. These are all ways to finance debt. There is in fact no difference between a country's debt and a family's debt. As long as the debt you have is manageable then the debt is a positive in your life. Once you take on more debt than you can handle, that can wind up being disastrous. For individuals and businesses, it can mean bankruptcy. For countries it can mean high inflation, high interest rates, or high taxes. Neither of those are positives in the economy and President Obama has insured that our country is now facing one of these three results as a result of this debt.

Now, four about six years the Democrats continued to bemoan the growing budget deficit under President Bush. The results speak for themselves. Whatever happened to the economy, we never faced higher interest rates, higher inflation, or higher taxes. As a result, that is the best proof that the deficit was in fact manageable.

We know that this will not be a result of the budget deficit under President Obama because interest rates have already shot up since he took over as President. Back in January the rate on the 10 year U.S. treasury was just over 2%. It has since shot up to 3.8%. That's because the bond market is simply not going to loan the federal government an extra $2 trillion at the rates we were at when the president took over.

This phenomenon is that much troubling when you combine it with Fed action. For the last several months, the Federal reserve has been buying up hundreds of billions of dollars worth of U.S. treasury bonds in an effort to keep their interest rates artificially low. In other words, rates have nearly doubled despite artificial stimulus to keep them low. This is a process known as quantitative easing. It also leads to the second potential way to finance the debt, monetizing it.

By monetizing the debt, the federal government, in the form of the Federal Reserve, merely creates the money. In the old days, we would turn on the printing presses and print all sorts of money. Nowadays, the Federal Reserve merely creates the money using their computers and puts that money into their accounts. Then, they use this newly created money to buy up the debt of the government.

The third option is for the government to raise taxes in order to finance the debt. The government has done some of this as well though not much yet. The president is planning on raising the top marginal tax rate. He has increased tax rates on cigarettes and soda, and he's proposed raising taxes on foreign corporate earnings, capital gains, and reducing the credit on charitable giving and mortgage interest.

Now, all of these measures have serious ramifications on the economy. If interest rates go up, that will increase borrowing costs. It will mean that cars will be more expensive to finance. It will mean homes are more expensive to finance. It will mean that business expansion will be more expensive to finance. All of this is contractionary and depending on the rate of interest rate increase, very contractionary. That will stunt or even reverse any stimulative effect of the stimulus itself. So, if the federal government did nothing, the stimulus will have limited effect because it will eventually cause high interest rates which will cause a contraction before there is a full recovery.

If we were to monetize the debt, that would eventually cause inflation and a weak dollar. That would mean that the recession would be followed by inflation. The weak dollar would explode gasoline and commodity costs. This would mean a gallon of gasoline and everybody's groceries would become more expensive. Those on fixed income would be hurt the most.

Raising taxes would also be contractionary much like raising interest rates. All this would do is stunt or reverse any recovery. In 1937-1938, FDR did this very thing to try and control the ballooning deficit. All this caused was to increase unemployment back near 20% just as the economy looked like it was finally recovering. Had he not done this though, the economy likely would have faced high interest rates and the same phenomenon.

The important thing to understand is that the cures would NOT be the cause of the economic hardship. We will need to do something to finance the massive new debt. The problem is the massive new debt itself. It's also important to uderstand that raising our deficit to nearlyu $2 trillion was strictly optional. President Obama can do a misdirection and pretend as though he had no other choice, but he did. This deficit is entirely voluntary. It's the way President Obama wants to counter the weak economy. It's not the only way, but rather, the way he chose to do it. When one of the three things eventually occurs, we should all remember that it is a natural result of out of control deficits.


Anonymous said...

The Democrats would have you believe that the economy reversed in 1937 exclusively due to budget cuts FDR enacted to appease the conservatives.

mike volpe said...

Unfortunately, those sorts of things are impossible to prove. Harding cut government spending when the recession hit in 1920 and our economy grew. So, there is historical context for cutting spending and growing the economy. There is no historical proof for raising taxes and growing the economy.