Princeton Economics Archive Debt-Crisis-1994 (1)

The Debt Crisis And The ConsequencesFor Our Modern Political

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Economy

by Martin A. Armstrong

The Debt Crisis

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The Ultimate Defining Issue of American Politics

There has been a lot of talk about bringing the deficit down. Clinton argued that issue insupport of his massive $245 billion tax increase. While it is true that the deficit declinedover the last two years, it is NOT true that this was due to massive cuts in spending orthe rise in taxation. The evidence clearly shows that the primary reason why the deficitdeclined was simply the non-political market forces that drive world interest ratesthemselves. With nearly 70% of the national debt being funded in 10-year instrumentsor less, the sharp nose-dive in interest rates over the past two years has brought

interest expenditures of the federal government significantly lower. This declining trendin world interest rates produced a net savings, as reflected in the declining deficit. Itwould be extremely dangerous for anyone to characterize the recent decline in thedeficit as a political victory for either party or as proof of the benefits of a higher-taxationphilosophy compared to another. Instead, the fact that short-term rates fell to half that oflong-term, accounts for the recent decline in the deficit - not brilliant economicleadership on the part of Congress or the current Administration.

The decline in interest rates basis the Federal Reserve Discount Rate is self-evident.From the recent high in the Discount Rate of 7%, established on February 24th, 1989,the decline in interest rates remained rather steady until the lowest level was finallyreached at 3% on July 2nd, 1992. This drastic decline of more than 50% had a directimpact upon government expenditure as the average rate of interest declined from 8.5%in 1989 to 6.6% by 1993.

For the fiscal years 1990-1993, the total minimum amountsaved on interest expenditures for the federal government amounts to $168.2billion had interest rates remained unchanged at the 8.5% level of 1989.

Figure #1

The response by the Clinton administration to this declining trend in interest rates wasthe opposite of the policy government should have pursued. Long-term interest ratesfailed to decline in direct proportion to that of short-term rates and at the bottom in theinterest rate cycle, long-term rates remained at an historical high of nearly double that ofshort-term. As a result of this disparity between long- and short-term rates,

the Clintonadministration attempted to manipulate the curve by forcing long-term rateslower through reducing the supply of 30-year bonds and increasing the fundingof the debt with instruments of 5 years or less in maturity

. The number of treasuryauctions for 30-year bonds were cut in half in an attempt to create a false demandamong long-term investors. The net result of this manipulation has placed the nationaldebt of the United States in an extremely precarious position where the interestexpenditures of the government can now be hel d hostage to the short-term changes inconfidence that acts as the driving mechanism behind interest rates as a whole.

We must realize that capital responds in the free global market on a level of confidence.If confidence is lost within the fiscal responsibility of any administration, capital will flee.This became self-evident in Sweden, Italy and most recently in Mexico. We must alsorealize that the power to tax is a power that does not translate into governmentdictatorship. History has demonstrated countless times that as taxation rises, capitalflight begins. Capital is also impacted within a domestic economy by the net level ofreturn and taxation is a major component of capital investment. This is best illustratedby the change in tax policy that has affected interest rates within the United States.

Figure #1 clearly demonstrates that a massive decline in long bond prices took placeonce government began to fully tax the interest derived from government bonds.

Priorto World War II, government bonds were ALWAYS tax free

(with the exception ofpartial taxation during World War I). The tax free status of government debt was theprimary incentive to buy government bonds in the first place. The low in bonds in 1981took place in combination with the peak in inflation and the tax-cuts under Reagan!When tax rates were again raised under the current administration, interest rates beganto reverse trend once again and began to move higher. We simply cannot raise taxesand then expect capital to remain unaffected in its investment decisions.

The Reality of History

Confronted by an evil and corrupt government and the consequences of itsunsound finance, the speculator may prosper from the wild fluctuations in price.The capitalist will protect himself by hoarding and refusing to invest whilecommerce, having no nationality, will leave in search of more fertile ground; butthe wage earner, first to suffer under the ravages of a depreciated currency,remains incapable of prospering from the fluctuations in price and frustrated byhis inability to hoard his own labour from the ever encroaching demands oftaxation. His dilemma is without peaceful resolution for he can but only flee toanother land or sacrifice his life in defiance of the injustices of the greedy rulingclass.