Friday, August 23, 2013

How Important Is It that the U.S. Repay Its Debt? (Part II)

 How Important Is It that the U.S. Repay Its Debt? (Part II)

Bert Whitehead, M.B.A., J.D.

Keynesian theory espouses the belief that the government can and should shape the economy through both fiscal policy (increasing government spending to spark economic activity) and aggressive monetary policies (expanding the money supply to pay off existing debt and fund higher spending). Thus, governments should expect to have a deficit during a recession in order to prime the pump so that the economy can get traction and create jobs.

Keynesians point to FDR's policy during the Great Depression of abandoning gold as the basis for U.S. currency and his unprecedented federal spending as the key to recovery at that time. Classical economists, however, insist that FDR's spending and unfettered increase in the money supply made the Depression worse, and that it was World War II that finally ended the Depression. They also note that Carter's application of Keynesian prescriptions in the 1970s led to unparalleled inflation and unemployment.

Can Growth Counteract Easy Money Policies?

It would seem that some level of government debt has been helpful for economic growth, but there’s a point where inflation compounds and gets out of control. The result is the collapse of the nation's economy as we witnessed in 1989 when Russia was terminally crippled by over-printing rubles to pay for its military.

The issue isn't whether the U.S. should pay off its debt, but whether it can grow the economy (i.e. grow our Gross Domestic Product, or GDP) enough to keep up with the additional money we’re printing. If “easy money” policies outstrip national production of goods and services, the inflation of our dollar will accelerate at a compounded rate to a point where other countries, and even our own citizens, will view it as worthless. Incidentally, this happened in the U.S. with Continental dollars during the Revolutionary War.

Money without Backing Loses Its Value

“Fiat” money is currency which is not backed by any specific assets, other than trust in the entity creating the money. It generally refers to paper money not backed by gold. However one of the first instances of fiat money was coinage in ancient Rome. In about 300 BC, Rome changed from a monarchy to a republic and the leaders started issuing a silver coin, the denarius. These coins facilitated world trade and became the world's reserve currency which greatly enhanced Rome's prosperity.

After about 300 years, Julius Caesar turned Rome into an empire, and as emperor he started debasing the coins by replacing an increasing percentage of the silver in a denarius with iron. People caught on quickly and started hoarding and melting down the older coins which had more silver content. This is an early example of Gresham's Law: "Bad money drives out good money."

Over time, successive Roman emperors continued to debase the denarius, so when the Roman Empire collapsed, less than 1% of the denarius was silver. This was called “fiat money” (“fiat” is Latin for “it is declared” or "let it be done"). The government declaration that the denarius was truly money was spurious, because it ceased having any value in world trade and even Roman citizens refused it. This is a classic example of what happens when a government produces too much money with declining credible backing.

The Chinese first used paper money 1,000 years ago and it was soon debased into fiat money. Successive dynasties attempted to support the paper, and Marco Polo described the use of paper money during the Yuan Dynasty. The government made several attempts to support the paper, but since notes were never retired inflation became evident. Since then fiat paper money has been tried by dozens of different governments, but none of the currencies has survived more than 100 years.

Excess Debt Can Lead to Unchecked Inflation

While some level of government debt has been helpful for economic growth, there’s a point when the inflation created unravels an economy. The U.S government’s current proclivity to spend without adequate consideration of economic implications (both positive and negative) puts the U.S. dollar at risk of becoming a worthless currency.

Although the world has never known a world reserve currency as strong and dominant as today’s U.S. dollar, we don't really know how much debt is too much, i.e. when other countries will be unwilling to accept dollars because our national production dwindles relative to new money printed. The bottom line is that when there’s nothing others can buy with U.S. dollars, it’s worthless.

Inflation Can Unravel and Economy

FDR took the US dollar off the gold standard in 1933, and in 1972 Nixon officially made the US dollar fiat money. During the following decade, the US economy tanked, while more dollars were printed due to the OPEC crisis. The value of the dollar fell 50% between 1970 and 1980, until spending and taxes were cut and production and employment increased. Inflation exceeded 14% and unemployment was over 10% at the end of Carter's term. It’s folly to think that by using fiat money we can continually spend with impunity on wars, welfare, infrastructure, education, etc. unless our productivity increases commensurately.

The crisis limit is widely estimated to be when national debt exceeds GDP. Most countries in this position experience serious currency inflation. The U.S. debt now is approaching 100% of its GDP. Japan (whose debt is 200% of its GDP) is an anomaly due to the factors detailed in my earlier blog, The Race to Zero.

It’s often difficult to evaluate economists' projections-- economic theory is more conjecture than science. We’ve never been able to truly test global economic reactions in a controlled experiment where we can limit the impact of the innumerable potential variables.

I do think that people who have a basic understanding of the principles involved can be more aware of economic shifts which may affect them without going to extremes and putting everything in gold, or mindlessly accumulating debt with the hope of winning. In short, if a $3 loaf of bread in today's prices costs $30 in 2060, it's not likely to be a big problem. But if we print so much money that today's $3 loaf of bread costs $30 in 2020, we will face an economic catastrophe.

Worry is not prevention and hope is not a strategy.

I appreciate copyediting by Shari Cohen and Laura Webber.

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