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November 18, 2003 THE NATIONAL DEBT, THE FEDERAL DEFICIT, AND THE FISCAL DRAG THE U.S. NATIONAL DEBT AND DEFICIT The U.S. National Debt is the arithmetic sum of all budget deficits and surpluses over the history of our nation. When deficits occur, if a national debt exists, that debt increases. Federal budget surpluses decrease our National Debt. The U.S. National Debt was relatively insignificant until the Second World War, going from $43 Billion in 1940 to $269 Billion by 1946. It currently is about $6.9 Trillion (with $4.0 Trillion held in the form of marketable debt - see the following for detail: this is your debt!). Throughout much of the post World War II Era, federal deficits were usually the case. This, of course, resulted in a more or less continual rise in national indebtedness. A budget deficit occurs when government spending exceeds tax revenues. The deficit necessitates borrowing, which increases the government’s debt. Federal Government borrowing in this country is of two types, non-marketable debt and marketable debt. The latter consists of bills, notes and bonds. Treasury Bills have a maturity of one year or less, usually in multiples of 3 months. Treasury Notes range up to around 10 years, and Treasury Bonds as long as 30 years, with a few exceptions. Recently the Treasury announced it would no longer issue new 30-year U.S. Treasury Bond maturities. The shorter is the average maturity, the greater the amount of debt that has to be refinanced each year, along with the initial financing of new debt resulting from deficits. For years 1998 through 2000, the U.S. Federal Government experienced budget surpluses and the marketable portion (see U.S. National Debt by Category) of the National Debt fell by some $435 billion. But as mentioned above, it was short lived in that beginning with the 4th Quarter 1999 and continuing through the 2nd Quarter 2000, the GDP rate dropped 8%, from 8.9% to 0.9% in nominal terms (in real terms, the GDP drop was even more dramatic, going from 7.1% growth in the 4th Quarter 1999 to -1.6% in 2nd Quarter 2001…totaling an 8.7% decline). Non-marketable debt is issued to the Trust Funds the Federal Government administers, such as the Social Security Fund and the Railroad Employees Trust Fund. Other special issues occur often related to problems arising out of occurrences such as the oil shocks of the 1970s. Also included in the non-marketable category are savings bonds. The marketable issues can be purchased by anyone. They are usually sold at auctions by competitive bidding but smaller amounts can be acquired by non-competitive bids. One of the major buyers is the Federal Reserve System, since it conducts its Open Market Operations in U.S. Government marketable securities and Federal Agency securities. It is important to note (and will be discussed further in future newsletters) that the FED operates almost exclusively in the secondary markets - it buys and sells securities in much the same manner as the ordinary trader would. The FED currently owns around 10 percent of the marketable U.S. Federal Debt from this activity. Since U.S. Federal Government spending resulting from the Great Depression and the Second World War, etc., has exceeded taxes for the most part, these deficits have accumulated and contributed to an awesome national debt. In recent years, transfer payment spending has usually accounted for more than 60 percent of all Federal Government spending. Transfer payments by the government results in receipts issued to the public that were not currently earned; that is no productive resource, such as labor, was currently supplied (and in many cases was never supplied). In order to fund transfer payments, the government must tax others and or borrow as required. Transfer payments increase a household’s disposable income just as taxes decrease the same disposable income of households. Since government spending of either type increases aggregate demand, it then stimulates the economy to a higher level of activity. Government spending on goods and services add directly to aggregate demand while transfer payments add to disposable income and thus also add to aggregate demand. On the other hand, taxes raised to finance government spending depress the level of economic activity by reducing the Disposable Income of the households paying the taxes. The result of lower Disposable Income is a reduced aggregate demand for the nation’s goods and services. If taxes are insufficient to fund all the spending of the government, borrowing occurs to fund the deficit. This borrowing puts upward pressure on interest rates and reduces spending sensitive or responsive, in a negative way, to rising interest rates in the private sector such as in the demand for new housing. This is why many argued that federal budgetary deficits stimulate economic activity to higher levels or if that activity is already pressing capacity (near full employment), inflationary pressures begin to appear. Federal budgetary surpluses tend to depress the level of economic activity either in nominal or current dollar terms, resulting in disinflation or even deflation, or in real terms, a fall in real output to lower levels of growth of even negative rates, a recession. …WHAT A DRAG!!! FISCAL AND MONETARY POLICY - TWIN POLICY DISASTERS In the first issue of this newsletter we argued that there were two major occurrences leading to recession: (1) Significant rise in federal receipts as a percent of National Income… (2) …and the FED’s change to a monetary policy of restraint, leading to rising short-term interest rates. The "twin policies" brought the nation’s economy to its knees: witness a positive growth of 7.1 percent to a three-quarter long recession, where the GDP collapse bottomed out at a negative 1.6 percent (real GDP). In other issues of this newsletter, it is argued that the increase in competition in a growing number of markets is providing anti-inflationary pressures and the role of fiscal and monetary policies to limit inflationary outbreaks is increasingly less needed now as compared to 20 or 30 years ago. CURRENT ACCOUNT (CONTINUED) As we began discussing in the last newsletter, the U.S. Current Account Deficit is continuing to rise. Focusing on the Trade Balance portion of the Current Account, it is currently at $41 Billion for the month of September. While exports are picking up, imports are continuing to rise as well. This phenomenon, where imports rise during recovery and expansion is known as the Locomotive Effect. The Good… The Bad… The Ugly… Japan and China: A Tale of Two Interventionists An important point to revisit is illustrated in the following graphs, highlighting two very different approaches to intervening in the foreign exchange markets. First, Japan… At first glance it might not be obvious to the reader how Japan goes about controlling its foreign exchange rate. If you keep in mind that deterioration in the Current Account (or Trade Balance) is tantamount to sacrilege in Japan, you will begin to understand the nature of their Ministry of Finance’s actions… In a report by Reuters, November 6, 2003 "Japan's Ministry of Finance had publicly confirmed interventions after the fact, including the MOF's announcement that it sold 4.4573 trillion yen (around $38 Billion) between Aug. 28 and Sept. 26, representing a record monthly intervention, the report said." Notice how at various times when the Yen has appreciated, or depreciated at a decreasing rate, it was in direct response to deterioration in the Current Account (actual or perceived)… China, on the other hand, has evidently targeted ever-higher ratios of trade surpluses (Chinese Surplus equates to U.S. Deficit). Where the Japanese have apparently targeted a roughly 2 to 1 ratio (2.4 to 1 for 2002) in its trade with the U.S., China has widened that gap on successive occasions to around $5.7 in Chinese exports to the U.S. for every $1 in Chinese imports from the U.S. It causes one to wonder how undervalued the Yuan really is… October 10, 2003 U.S. Trade Deficit: Good, Bad, or Irrelevant? It is not all bad, not all good, and certainly not irrelevant… In recent months, the U.S. dollar has seen increasing signs of weakening or as it is technically called, depreciating against other currencies. It has caused nations like Japan to massively intervene to keep the Dollar expensive in terms of the Yen in order to continue their large trade surplus with the U.S. New estimates show that the U.S. trade deficit with the world will be close to one half of a trillion dollars for 2003, clearly this in not sustainable. This recent turn of events should be understood within the context of the last thirty years or so. To clear up the myriad of confusing arguments both as to the cause and size of the problems, this newsletter begins a three part series on our economic/financial interface with the rest or the world in general and our growing trade deficits with Asian nations in particular. The hope of this effort is not to excite the readers into a new era of isolationism, but rather see the costs and benefits of an increasingly integrated world After many years of a trade surplus, in the early 1980s, the United States began to experience deficits in its trade balance with the rest of the world. The formal names for the trade balance are Net Exports of Goods and Services Accounts or the Balance on Goods and Services Accounts. Often the word Merchandise is used instead of the word Goods. As many readers are unfamiliar with the concept of the balance of payments, a technical presentation of this topic can be read on a hyperlink by clicking here. By convention, a nation’s imports of goods and services are subtracted from its exports of goods and services. If exports exceed imports, it is called a surplus and if imports of goods and services exceed exports of goods and services, it is called a deficit. Since the early 1980s the U.S. has had very large deficits in this balance. Are deficits in the trade balance good or bad? The truth is that there are both benefits and costs to a deficit in this balance just as there is when a trade surplus occurs. Exports and Imports Exports add to a nation’s aggregate demand. If inflation is occurring, exports add to those inflationary pressures. The rest of the world, by buying our goods, increases the scarcity of those goods. Imports represent Americans buying foreign goods. This is disinflationary or if deflation is occurring, it adds to deflationary pressures. If prices are rigid downward (as they were more so in the past), imports tend to depress the level of real economic activity and have a negative impact on employment. Why do imports depress either real output or prices? When Americans earn income by supplying resources such as labor or capital to the production process, they receive a reward called income. The income received enables them to buy back goods and services they helped to produce. If they choose to buy foreign produced goods and services, or import them, they have less remaining income to buy domestically produced goods and services. Thus, those unconsumed goods and services will become unwanted unless other spending of the non-consumption type demands them. Non-consumption spending is termed injections and includes demand for capital goods, government purchases of goods and services and exports or the demand for our production by the rest of the world. Exports on the other hand, add a stimulus to our economy by adding to total demand for the goods and services produced in this country. If our nation’s resources are fully employed, exports will be inflationary. If we have unemployed resources (as is currently the case), exports could move the economy toward full employment. Imports enable a nation to consume beyond its production capabilities while exports reduce a nation’s ability to consume all they produce. Current Account Deficit A closely related measure of a nation’s economic relationships with other nations is the Current Account. In addition to the Trade Balance, it adds in what are technically called Unilateral Transfers. These are official and private remittances to the U.S. from abroad and U.S. official and private remittances to the rest of the world. If foreign official and private remittances to the U.S. exceed U.S. official and private remittances to the rest of the world, it is termed a surplus in the Unilateral Transfer Balance. When we give more than we get, it is called a deficit in our Unilateral Transfer Balance. Since the rebuilding of Europe after the Second World War, the Unilateral Balance has usually been in deficit, but of small magnitude with occasional exceptions. The Current account Balance, which includes both the Trade Balance and the Unilateral Transfer Balance, has since the early 1980s, reflected a large deficit just as the Trade Balance has shown. The Trade Balance is often over 95 percent of the Current Account Balance. For those unfamiliar with the Balance of Payments, If the Current Account Balance has a $300 billion deficit for the year, the Combined Capital Account Balance (includes both long and short-term capital movements between U.S. and the world) must have a surplus balance of $300 billion. This is so because once all accounts in the balance of payments are included, the sum must equal zero, or be in balance. Again, click here to see the more technical discussion of these relationships. The Capital Account balances indicate whether the U.S. invested net in the rest of the world or vice versa. A surplus in our Combined Capital Accounts indicates that for the period under consideration, the rest of the world invested net in the U.S. In other words, they invested more in the U.S. than the U.S. invested in them. The U.S. has had surpluses in its Combined Capital Accounts since the early 1980s, mirroring the deficits in the Current Account for the same time period. By about 1982, the U.S. was the world’s largest net creditor nation. Within several years, that position had switched to a net debtor status and has continued to grow, so that now the U.S. is the one of the world’s largest net debtor nations. This is evidenced by American businesses being owned and controlled by foreign interests such as Chrysler by Daimler, Columbia records by Sony as well as transplanted foreign corporations such as Honda and Toyota and many supplier firms as well. They currently possess an increasing portion of American financial securities including about 20 percent of the U.S. Government debt. While that has provided capital accumulation in this country, it nonetheless requires those investments to be serviced as interest and profits are repatriated back to foreign interests. Foreign Exchange Markets and the Price of the Dollar As the U.S. position of having been the World’s largest net creditor nation was changing to that of a large net debtor nation, foreign demand for the dollar persistently exceeded the supply of the dollar in foreign exchange markets, resulting in a strong dollar. Many would say that the dollar was appreciably overvalued given our large and persistent trade deficits. Why the strong dollar despite the large and persistent trade deficits? Recall that most of the current account deficit is due overwhelmingly to the trade deficit (more formally called the Deficit in the Merchandise and Services Account). By definition, when added together, the Current Account Balance and the Combined Capital Account Balance must sum to zero. Which caused which? This gives rise to two opposing arguments as to the cause of the growing indebtedness of the U.S. to the rest of the world. Is the villain, so to speak, the large and sustained deficit in the Current Account Balance that causes the Capital Account Surplus, or is it the Capital Account Surplus that causes the Current Account Deficit? Since this condition began to occur over twenty years ago, the popular argument was to blame the Current Account Deficit on our inability to compete in world markets due to lack of labor productivity, excessive consumption due to the easy availability of credit, the desire of Americans for instant gratification, and so on. It became a part of American bashing, even from within. This argument has become untenable in recent years for more than one reason. American productivity has been soaring for the past several years. Data on consumer debt does not support the fear of household debt reaching crisis proportions. Researchers such as Courtenay C. Stone, in a 1989 article published by the St. Louis Fed, have shown that the personal or household savings rate is much higher than shown in the National Income and Product Accounts. The measure of personal savings in the NIPA is inadequate for the generally understood meaning of savings. As Stone pointed our in the late 1980s, when broadly defined to make it comparable to other nations, the U. S. Personal Savings Rate is favorably comparable to most other nations including Japan. There is an alternative argument that the editors of this Newsletter support. The Dollar is overvalued for at least two reasons. As a result of the Fed’s decision in early 1980 to shift its policies from fighting unemployment (by more or less ignoring escalating inflation) to fighting inflation, while nominal or market interest fell dramatically during the early 1980s, real interest rates (inflation adjusted) rose significantly and stayed there until very recently. In the early 1980s, while the American economy had been moving gradually but inexorably toward the New Paradigm, the remnants of monopoly power and the Old Paradigm still lingered on in a number of markets. The Fed’s actions to eliminate accelerating inflation were delayed out of fear that unemployment would rise as the anti-inflationary policy was implemented. This fear rested on the significant downward price rigidity still pervasive in the economy. Recall that most of the high nominal or market rates of interest toward the end of this period were due to what is called inflation premium (Fisher Effect, see excerpt from Financial Economics, D. Byrne revised 2003.). Inflation had to be crushed to avoid its continued upward spiral. The resulting recession achieved this purpose; though the costs were high. Three quarters of the inflation was eliminated with the Fed stating the rest of the job would be achieved with a soft landing or no recession, and price stability would be achieved. That goal was pretty much achieved several years ago but the lesson learned was to dominate the Fed’s thinking in the late 1990s and early 2000s. As pointed out in the very first issue of this newsletter, they provoked a recession that should never have occurred. Speculative bubbles? They were present, but were mere bubbles in a very solid economy sorely in need of policies to support the transformation to an increasingly competitive economy: enter the New Economic Paradigm. Undoubtedly, the high real interest rates even though nominally low by 1980 standards, worked wonders on the elimination of the inflationary scourge. What many do not understand is that the relatively high real interest rates helped cause disinflation and now the growing probability of deflation. The U.S. financial markets are where the world finds a safe haven from a host of financial and political problems. Flights to safety or quality mean flights to the financial markets of the U.S. For this reason, relatively low risk adjusted and inflation adjusted yields assure a healthy inflow of capital into the U.S. As the graph shows, the real or inflation adjusted interest rate has been higher beginning about the time of the switch from Current Account Surpluses (mirror image of the emergence of capital account deficits, to a period of continuing and large Current Account Deficits (mirror image of the continuing and large Capital Account surpluses). The effects of the relatively high, real-risk adjusted interest rates, and the resulting appreciation of the dollar has been exacerbated by ongoing intervention in exchange markets by Japan, China and the like, in order to keep the dollar overvalued. United States: The 900 pound Gorilla? Or the 409 Kilogram Primate? THE DEVIL IS IN THE FOLLOWING DETAIL… SHANGHAIED BY CHINA and/or TSUNAMIED BY JAPAN??? Here are two examples of countries intervening in the foreign exchange markets to achieve and continue a significant trade surplus with the U.S. There is more to this story and we will discuss it in greater detail in upcoming newsletters. …TO BE CONTINUED IN THE NEXT ISSUE