Will the Democrats' Massive Borrowing and Spending Binge Kill the U.S. Economy?

Any reasonably intelligent person understands that if the demand for a product increases then (all things being equal, as the economist would say) its price will rise. The same holds in the case of borrowing, except for congressional Democrats. These people seem to think that economics laws are a vicious Republican plot.

Poll figures are now showing that the American public is growing alarmed by the Democrats' utterly reckless fiscal policy. Unfortunately, few people understand just how grave the danger really is. In less than five months Obama increased the national debt by more than $800 million and lumbered the economy with a $1.8 trillion deficit that looks like growing even bigger. (I still get silly emails from Obama cultists who were evidently screaming into their computer monitors: "Bush did!" Pathetic doesn't begin to describe these people). In 2003 Thomas Laubach, the US Federal Reserve’s senior economist, produced New Evidence on the Interest Rate Effects of Budget Deficits and Debt, a paper containing calculations for long-term interest rates based on historical evidence. He concluded that

a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points.

As the US deficit has rocketed from 3 percent to 13.5 percent one should therefore expect long-term rates to rise by at least 2.5 percentage points. In addition, he believes that a 1 percent rise in the ratio of debt to GDP will raise future rates by 4 to 5 basis points. It appears that recent movements in long-term rates support Mr Laubach's thesis. The 20-year treasury bill stood at 3.22 percent on 2 February: by the 8 July it had risen to 4.13 percent. It was the same story 10-year treasuries which rose from 2.46 percent on 2 January to 3.33 percent on 8 July while the 30-year mortgage rate had risen to 5.32 percent by 2 July as against 4.78 percent for 2 April. The government's insatiable demand for funds looks very much like it is driving up long-term rates very quickly.

Obama supporters with their fetish for big government can always claim that economic conditions in Japan refute Laubach. Japan has increased its national debt by a colossal amount and yet interest rates remain ridiculously low. These critics overlooked the economist's caveat: All things being equal. Just as the price of the a monetary unit (its purchasing power) is determined by the supply and demand for it, the same holds for all other economic goods. For example, though US car production has dropped car prices have not jumped. Why? Because demand fell.

The same holds for Japanese interest rates. They have not been driven up government borrowing because the private demand for loans has virtually collapsed. A similar situation prevailed during the Great Depression. Despite Roosevelt's spending and borrowing interest rates remained low — but so did business borrowing with the result that there was a great deal of capital consumption.

Professor Higgs calculated that from 1930 to 1940 net private investment was minus $3.1 billion. (Robert Higgs, Depression, War, and Cold War, The Independent Institute, 2006, p. 7). Arthur Lewis calculated that from 1929 to 1938 net capital formation plunged by minus 15.2 percent (W. Arthur Lewis, Economic Survey 1919-1939, Unwin University Books, 1970, p. 205). Benjamin M. Anderson estimated that in 1939 there was more than 50 percent slack in the economy. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, pp. 479-48). It ought to be obvious that where a process of capital consumption is underway — as it was in the 1930s — one should expect to see a rise in the average age of plant and equipment. This is precisely what happened as shown by the table below.

So where we have a situation in which extremely low interest rates reign while government borrowing has massively expanded we should expect to find — as in Japan — that the personal demand for loans. particularly by business, has plunged. In other words, critics have been looking at only part of the equation. It just so happens that most critics of Obama's spending mania have also overlooked a vital point — the crucial role that interest rates play in raising or lowering the standard of living.

If the government's fiscal policy imposes high long-term rates on the economy then prospective highly time-consuming projects, the ones that do so much to raise real wage rates, would have to be abandoned. Moreover, existing projects of the same nature would be eventually phased out. This is called capital consumption. What this means is that the quantity of savings necessary to prevent the capital structure from contracting are no longer available. As Hayek observed:

[I]t is quite possible that, after a period of great accumulation of capital and a high rate of saving, he rate of profit and the rate of interest may be higher than they were before — if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted tp form, or if the demand for consumers' goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving. (Friedrich von Hayek, The Pure Theory of Capital, The University of Chicago Press, 1975, p. 396).

Added to this is Obama's misguided energy policy that amounts to a massive tax on production. Once that is also taken into account one is left looking at economic carnage.

Comments

[Hask:]

The answer to your question - Democrats are already is killing the U.S. economy and they're just getting started. Wait until increased minimum wage kicks in, or how about Cap & Trade. Throw in a little universal health coverage and trillions more in spending and this goose will be cooked.

Jul 13 10:05 AM

[Prudent Man...:]

When U.S. Treasuries have a negative "real return", which it in all probability they already do, who will buy them? U.S. banks? With what? Foreign investors who are economic masochists? I doubt it.

It is factual, with the currency position of the Fed up 1,100% vs. last year, it is the Fed's policy to devalue the dollar. If the Fed's position is not devaluation they would have to deleverage and unemployment would go up in 2010, the year of the end of Bernanke's term and Congressional elections.

I hope that anyone reading this who doesn't understand the consequences of the foregoing is not taking risks and emphasizing providing their families with economic safety, which is not as easy as it has been in the past.

This is not a piece on opinion. This is the logical results of current U.S. economic policy. If and when that changes the facts will change and so will the conclusion. Unfortunately, I see more of this irrational disastrous policy rather than a change.

Jul 13 10:05 AM

[I need more...:]

None of what you say is not completely apparent to even the most casual observer, let alone rich peope, countries, etc.
And has been observable for some time.
And yet:
- gold has not only not gone up, it has come down markedly
- treasuries still being purchased
- dollar has fluctuated, but still about the same versus Euro, up versus Loony, down a bit versus yen
Conclusions?
- this is a global downturn, our issues are not necessarily the worst in the world, many would argue we are in better shape than Japan and the Euro Zone certainly
- China has many of thier own problems, with a new huge production infrastructure with no customers
- it may be hard to devalue one's currency when other countries want to do the same

It is a very complex mix out there.

Conclusion



On Jul 13 10:05 AM Prudent Man CFA wrote:

> When U.S. Treasuries have a negative "real return", which it in all
> probability they already do, who will buy them? U.S. banks? With
> what? Foreign investors who are economic masochists? I doubt it.
>
>
> It is factual, with the currency position of the Fed up 1,100% vs.
> last year, it is the Fed's policy to devalue the dollar. If the Fed's
> position is not devaluation they would have to deleverage and unemployment
> would go up in 2010, the year of the end of Bernanke's term and Congressional
> elections.
>
> I hope that anyone reading this who doesn't understand the consequences
> of the foregoing is not taking risks and emphasizing providing their
> families with economic safety, which is not as easy as it has been
> in the past.
>
> This is not a piece on opinion. This is the logical results of current
> U.S. economic policy. If and when that changes the facts will change
> and so will the conclusion. Unfortunately, I see more of this irrational
> disastrous policy rather than a change.

Jul 13 12:33 PM

[Living4Divi...:]

Gerard - thank you for writing this terrific article. I agree with your theory in the first half of the article: increased governmental borrowing leads to proportionally higher interest rates.

Reckless borrowing causes higher interest rates. Drastic expansion of the fed balance sheet, topped off with stimulus spending, cap and trade and hyped-up spending on health care - this will cripple the recovery.

I agree with you that it is foolish to compare the US now with the US during the Great Depression. Back then we had Price deflation. Massive government spending and public works didn't occur until FDR. They didn't help much. The real recovery was induced by WWII.

I agree with the first half but I have a hard time following the second half of your article. Where you begin with "Obama supporters with their fetish for big government can always claim that economic conditions in Japan refute Laubach."

Still it is amazing that Japan has ballooned their deficit to nearly 200% of GDP and still have low interest rates and a strong currency. While I agree with you that it is foolish, at least superficially, to predict that the US could have the same results as Japan experienced in the late 80's - 90's. I don't understand the point you are trying to make in your second half.

What makes the US so different than Japan, that we couldn't have the same outcome?

Jul 13 12:49 PM

[Rokjok777:]

Um, excuse me, it was YOUR TEAM, those prescient geniuses of finance 2000-2008 who started the ball rolling, leading to Hank Paulson's TARP, $780 billion if I recall correctly, not to mention that stroke of economic genius called Graham Leach Bliley legislation, named after the top economic advisor to YOUR CANDIDATE IN 2008. So since DEMS have been much better ECONOMIC MANAGERS than Repubs for the last three or four decades, let's throw the stones where they deserve to be thrown. Ahem.

Jul 13 05:13 PM

[Rokjok777:]

Of the top 20 largest deficits (as a percentage of GDP) in the last 50 years:
DEM presidents have been responsible for three out of 20; REPUB presidents have been responsible for the other 17 HIGHEST DEFICITS IN HISTORY:
traxel.com/deficit/sor...

the orange bar on the bottom indicates Repub party presidents, blue bar means Dem

Jul 13 05:23 PM

[Mill Rat:]

What would Austrian School economic theory say was the root cause of the dramatic increase in energy costs during the 2007 to 2008 time period?

Jul 13 06:37 PM

[Mill Rat:]

Can you also describe what you liked best about the Bush / Cheney energy policy?
Can you illustrate for us how the Bush / Cheney energy policy helped to maintain stable energy prices? (and, thus, helped our economy to prosper)

Jul 13 06:51 PM

[Al Fin:]

Neither Obama nor Pelosi ever needed to understand how a market economy works. Big government ideology is all they needed to get elected and work their way up the power structure.

Their incompetence just gets kicked up to a higher level over time, until they reach the point of maximum destructive potential.

Jul 13 10:56 PM

[Steve in Gr...:]

I believe Austrians would argue that the cause of the oil bubble in 2007-2008 was the massive money supply inflation engineered by Greenspan in response to the bursting of the dot.com bubble in 2000-2002. This was also the cause of the bubbles during the same period in real estate and U.S. equities.


On Jul 13 06:37 PM An MBA Still Learning wrote:

> What would Austrian School economic theory say was the root cause of the dramatic increase in energy costs during the 2007 to 2008 time period?

Jul 14 08:19 AM

[Mill Rat:]

Mr Jackson,
I believe you could sell your ideas better if you were to follow the example of today's (July 14th) article by Peter Morici ("Why Obama's Economic Policies are Failing"). Although the article is a critique of Obama's policies, it also acknowledges the profound shortcomings of the previous administration (which your recent articles have not done).
It is likely that you quickly lose your credibility among your non-liberal readers with your recent practice of making Obama the PRIMARY scapegoat for most of today's economic problems (and simultaneously giving a "pass" to the Bush / Cheney administration).

I'm not saying that Obama's ideas are perfect, but every American knows that this economy was performing poorly before Obama took office. When you ignore that fact, you look rather foolish.

A person can be critical of the Bush / Cheney policies without necessarily being an "Obama cultist".

At the risk of again being a smart*ss, let me point out some important facts:
- The Chairman of the "Federal Reserve" is appointed by the President of the United States (and then confirmed the Senate, if the Senate so agrees).
- In 2004, President Bush re-appointed Greenspan to continue his chairmanship. (It would, thus, seem that Bush was satisfied with his performance prior to that time. What does that say about Bush's judgement?)
- It was President Bush who later appointed Bernanke to the Chairmanship of the "Federal Reserve". (What does that say about Bush's judgement?)
- Obama's first official day in office [and Bush's last day in office] was January 20th, 2009 (and not any earlier than that).

I actually agree with several elements of Austrian economic theory (but not all of them).

Jul 14 11:27 AM

[Gregman2:]

Taking on debt for long-term investment often is a wise decision. Unfortunately, it's unclear that current borrowing is going for this purpose.

Jul 14 12:16 PM

[hpski:]

Quite simply, Bush and his enablers, who stole the 2000 election, saw it as a "mandate" to loot the federal gov't with closed bid crony capitalism contracts, mostly to prosecute a war of choice that he and alter ego Cheney lied the U.S. into. The Dems rolled over for him like lemmings going over a cliff, so they're not excused. At least Obama voted against it. Wolfie testified b-4 congress that Iraqi oil would pay for most of the war's expenses - yeah right. Then there were the ridiculous tax cuts adding fuel to the nat'l debt fire. Remember that Bush inherited a SURPLUS when he took possession of his stolen property. Bottom line, there needs to be and will be tax increases. The Europeans pay more taxes than us, and historically U.S. citizens have paid higher taxes. Don't let "conservatives" who love their corporate welfare checks and closed bids confuse the issue by saying it will "stall" the economy. They're self absorbed liars.

Jul 14 02:12 PM

[Northstar10000:]

hpski,
What are you drinking, I want some. Watch what he dems do and you best save some of that brewsky. It will be great fun to hear form you next year when everything is destroyed. Looking forward to another idiotic post from you.

Jul 14 09:20 PM