Our Collective Journey from Thrift to Profligacy
Charles B. Atwill, CFP®
In a Reuters article published last October, former U.S. Treasury Secretary Larry Summers provided a rare - and candid - glimpse into what he really thinks about the global debt crisis (emphasis mine):
"The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending."
This mainstream view of fostering economic growth through perpetual increases in money supply and credit is sometimes likened to the plight of "The Junkie." The first "fix" creates good feelings and euphoria. Over time, more frequent and larger doses are required to create the same effect until, eventually, no amount of the drug (in this case new money and credit) provides an adequate high. Two paths lie ahead for The Junkie:
· Quit (and suffer terrible withdrawals - but ultimately survive)
· Continue (and, in time, die from the effects of chronic abuse)
Our current path, the continuation of an exponential growth of debt, will eventually lead us to a day of financial reckoning. Though it might still be possible to avoid such an event, in order to know where we are going - we must first know where we have been.
In the earliest days of our experiment as a constitutional republic, the debate over "a national debt" created a schism within the cabinet of George Washington. On one side, Alexander Hamilton argued that the establishment of a national debt (as well as a federally chartered national bank) would bind the States together under a common financial yoke, and therefore act as a uniting force.
Thomas Jefferson took the other side of the argument, expressing grave concerns about the dangers of placing too much fiscal authority in one central government. His concerns were perhaps expressed best by Benjamin Franklin, warning that "When the people find that they can vote themselves money, that will herald the end of the republic."
This debate raged in the U.S. for the better part of the 19th century. For most of that period, federal government debt never exceeded 40% of GDP (compared to 100%+ today). In fact, there was no national debt in 1835, as President Andrew Jackson's administration paid it off in full.
While debt was not a significant issue for the U.S. in the 19th century, the form of our money was. From the Revolutionary-era "Continental" to the Union's "Greenback" of Civil War vintage, we experimented with a variety of "paper substitutes" for money. Regardless of the particular version in circulation, gold and silver remained the ultimate medium of exchange. Paper could represent wealth; gold and silver were wealth.
A Hotel in New Hampshire
In July of 1944, as the Second World War raged on, delegates from the Allied nations met at the Mount Washington Hotel in the quiet town of Bretton Woods, New Hampshire. While the intent of the gathering was to bring economic order and aid to a post-war world, the result was the establishment of a new global monetary regime.
As it appeared that an Allied victory was almost certain - and that the U.S. was the principal architect of that victory - its position at the bargaining table was quite strong. The popular economic theory at the time, developed in large part by British economist John Maynard Keynes, promoted the benefits of a global currency regime, ostensibly to reduce the potential for international conflict that often began over currency and trade disputes. The theory derided the use of gold as a monetary standard, as it limited the supply of money and expansion of credit.
The delegates agreed to a compromise solution, whereby the U.S. dollar would be internationally convertible to gold and - in practical terms - become the world's reserve currency. The benefits conferred by that are many. Chief among them is the now unfettered ability to borrow in our own currency and print money. The end of the Bretton Woods Agreement in 1971 marked the beginning of what economist Irving Fisher referred to as a "debt supercycle."
Having achieved military and monetary hegemony, the U.S. set out on an expansionary course not unlike that of its progenitor, Great Britain. Just as the British Navy guaranteed safe passage and trade throughout the four corners of the globe, and the Pound Sterling represented a universally accepted medium of exchange - the U.S. now found itself without commercial or military equal.
With the Great Depression a distant memory, and a strong monetary wind at its back, the U.S. share of global wealth grew at a tremendous clip. Underpinning this growth was a confidence in the strength of the U.S. financial system, the pre-eminence of the dollar, and a rising tide of credit that - in nominal terms at least - has no equal in history. The age of U.S. consumerism was heralded by the ability to purchase cars, homes, appliances - quite literally everything - on credit.
If the private sector became enamored with credit, the political class raised its use to an art form. The benefits of attracting voters with programs, paid for with borrowed money, were particularly irresistible to career politicians whose "livelihoods" depended on dispensing favors, expanding the social safety net, and defending national interests in every corner of the world. While politicians promised "progress" financed with debt, a credulous electorate simply failed to understand that the "free lunches" being promised were, in fact, anything but free.
During most of the 20th century, we borrowed from the future to finance a standard of living that was the envy of the world. In 1947, total U.S. debt - public and private - was estimated to be 150% of our Gross Domestic Product. That is to say, for every $1.00 of economic production, there was approximately $1.50 of domestic debt. Today, that number exceeds 350% debt-to-GDP. As the bills came due - public and private - we simply borrowed more and kicked the proverbial can down the road. After all, to borrow a line from the songwriter Robert Earl Keen, "…the road goes on forever, and the party never ends."
The Party Ends
The credit bubble finally burst in the Fall of 2008. Trillions of dollars of capital evaporated; credit all but stopped flowing. Since financial markets abhor a vacuum, the U.S Federal Reserve flooded the system with new money in an effort to replace lost capital and re-establish the flow of credit. Concurrently, the U.S. federal government borrowed and spent trillions in an effort to "stimulate" the economy. Real interest rates in the U.S. were taken below 0% (when adjusted for inflation) - and according to the Fed - will now remain there through 2014. No effort has been spared to re-inflate the bubble economy.
And when previous rounds of monetary stimulus wear off (as with junkies), a new and larger dose will follow - bringing fewer benefits and more side effects (inflation). The law of diminishing returns does not exempt economics.
If Benjamin Franklin's warning about citizens demanding treasure (i.e., "free lunches") from the government is correct, perhaps we are approaching the nadir of this grand experiment in self-governance. Human nature being what it is, the path of least resistance - once discovered - is immeasurably difficult to leave. The collective delusion that wealth and domestic tranquility can be borrowed into existence is so ingrained in our culture that, to suggest otherwise, is - at best - considered economic heterodoxy. Politicians who favor thrift over profligacy risk an even more ignominious fate: unemployment.
Whether or not we alter our course, like The Junkie, the path ahead will likely be difficult. The decisions we are now making about our fiscal course have existential consequences for our constitutional republic. The graveyard of failed nation-states is littered with the corpses of once-proud countries that were unwilling to resist the temptation of living richly in the present at the expense of future solvency. If the current fiscal crises going on around the world are merely met with "more confidence, more borrowing and lending, and more spending," then our real challenges have only just begun.