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The Debt Crisis And The Consequences

For Our Modern Political-Economy


by Martin A. Armstrong

©1994 Princeton Economic Institute

The Debt Crisis—The Ultimate Defining Issue of American Politics

There has been a lot of talk about bringing the deficit down. Clinton argued that issue in
support of his massive $245 billion tax increase. While it is true that the deficit declined
over the last two years, it is NOT true that this was due to massive cuts in spending or
the rise in taxation. The evidence clearly shows that the primary reason why the deficit
declined was simply the non-political market forces that drive world interest rates
themselves. With nearly 70% of the national debt being funded in 10-year instruments
or less, the sharp nose-dive in interest rates over the past two years has brought
Figure #1

interest expenditures of the federal government significantly lower. This declining trend
in world interest rates produced a net savings, as reflected in the declining deficit. It
would be extremely dangerous for anyone to characterize the recent decline in the
deficit as a political victory for either party or as proof of the benefits of a higher-taxation
philosophy compared to another. Instead, the fact that short-term rates fell to half that of
long-term, accounts for the recent decline in the deficit - not brilliant economic
leadership 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 finally
reached at 3% on July 2nd, 1992. This drastic decline of more than 50% had a direct
impact 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 amount
saved on interest expenditures for the federal government amounts to $168.2
billion had interest rates remained unchanged at the 8.5% level of 1989.
The response by the Clinton administration to this declining trend in interest rates was
the opposite of the policy government should have pursued. Long-term interest rates
failed to decline in direct proportion to that of short-term rates and at the bottom in the
interest rate cycle, long-term rates remained at an historical high of nearly double that of
short-term. As a result of this disparity between long- and short-term rates, the Clinton
administration attempted to manipulate the curve by forcing long-term rates
lower through reducing the supply of 30-year bonds and increasing the funding
of the debt with instruments of 5 years or less in maturity. The number of treasury
auctions for 30-year bonds were cut in half in an attempt to create a false demand
among long-term investors. The net result of this manipulation has placed the national
debt of the United States in an extremely precarious position where the interest
expenditures of the government can now be hel d hostage to the short-term changes in
confidence 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 also
realize that the power to tax is a power that does not translate into government
dictatorship. History has demonstrated countless times that as taxation rises, capital
flight begins. Capital is also impacted within a domestic economy by the net level of
return and taxation is a major component of capital investment. This is best illustrated
by 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 place
once government began to fully tax the interest derived from government bonds. Prior
to World War II, government bonds were ALWAYS tax free (with the exception of
partial taxation during World War I). The tax free status of government debt was the
primary incentive to buy government bonds in the first place. The low in bonds in 1981
took 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 began
to reverse trend once again and began to move higher. We simply cannot raise taxes
and 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 its


unsound finance, the speculator may prosper from the wild fluctuations in price.
The capitalist will protect himself by hoarding and refusing to invest while
commerce, having no nationality, will leave in search of more fertile ground; but
the wage earner, first to suffer under the ravages of a depreciated currency,
remains incapable of prospering from the fluctuations in price and frustrated by
his inability to hoard his own labour from the ever encroaching demands of
taxation. His dilemma is without peaceful resolution for he can but only flee to
another land or sacrifice his life in defiance of the injustices of the greedy ruling
class.
This ill-fated attempted manipulation by the current administration to lower long-term
interest rates took place precisely when government should have been locking in its
debt for the greatest possible maturity available. As a consequence, this manipulation
will now result in a more rapid advance for interest rates on the short-end of the curve
as we move into 1996. While there are those who have claimed credit for the deficit
reduction without mentioning the interest expenditure savings, the rise in the deficit that
will now take place as a result of rising interest rates will be blamed once again on any
reduction in taxation. Such unethical characterization of the financial position of the
nation for purely partisan self-interest runs the risk of dangerously masking the crisis in
debt that the United States now faces as we move into the turn of the century. We
MUST face the TRUTH about our budget and end this partisan characterization of
every change in trend to the sole exclusive change in trend in taxation with total
disregard of interest expenditures that now account for over 25% over dollar the
government receives.

To make matters worse, an analysis of the budget reveals that the savings obtained by
government during the period of declining interest rates was simply passed on through
greater social spending. Not one cent of the savings was actually applied by Congress t
oward reducing the national debt. For example, the interest for 1991 stood at $285.3
billion on a $3,665.3 billion national debt. This suggests that the average rate of interest
paid by the federal government was 7.78% during 1991. By 1993, the national debt
grew to $4,351.2 billion with interest expenditures of $292.5 billion giving an effective
average rate of interest of 6.72%. If interest rates had NOT declined between 1991 and
1993, then the 1993 interest expenditures would have been $338.5 billion at 7.78%.

Figure #2
This resulted in a $46 billion savings that paid for the crime bill.

We must realize that interest rates are not completely driven by the designs of the
Federal Reserve. While it is widely recognized that long-term rates are established
through the demand of the free markets, short-term rates are also subjected to those
same market driven forces. With the shifting of the national debt into a far greater short-
term funding cycle, the demand for capital has been shifted on the curve to 5 year or
less maturity. Regardless of fed policy objectives, domestic policy objectives are still
held hostage to those of international capital flows. With government demand for capital
increasing on the short-end of the curve, rates at this end of the maturity curve will have
a far greater tendency to rise more rapidly than those at the lower demand for long-
term. This shifting of demand for capital on the part of government will result in a self-
fulfilling inverted yield curve and an escalating cycle of rising interest expenditures in the
immediate fiscal year. The 2.75% rise in short-term rates during 1994 will now add
$23.5 billion in interest expenditures over the next year on just that portion of the
national debt that is funded 1 year or less.

We MUST now assume that short-term rates will continue higher, particularly
throughout 1995, irrespective of Fed inflationary policy. Just as the Japanese real estate
investors, who got into trouble through buying long-term investments with short-term
funding, the yield curve will invert whenever too much demand rests on one side of the
curve. In Japan, short-term rates DOUBLED within a single year as a result of the
improper funding of long-term debt with short-term funding. We now run the risk of US
short-term rates doubling from their recent historical lows by 1996 due to the
same improper fiscal position of the United States. As a direct result, we could
easily move into a crisis mode during 1995 and 1996. A doubling in the discount rate
back to 6% (1% less than the 1989 high), will shift the average interest rate on the
national debt well above the 8% level. This implies that by 1996, interest expenditures
could rise substantially irrespective of Fed policy or Republican changes in spending. If
we look at that portion of the national debt that is funded 1 year or LESS (33.4% of
total debt), every 1% rise in short-term rates will result in a $14.3 billion i ncrease in
interest expenditures on only that portion of the debt itself! Rates have already risen
2.75% during 1994. This warns that we could see the next fiscal budget result in a $43
billion increase or more in interest expenditures even if rates do not rise further from
current levels. Clearly, we are in SERIOUS trouble!

Figure #3

Figure #3 illustrates the rate of change in the discount rate compared to that in the
federal interest payments. It is important to note that during the pre-1981 period,
changes in the discount rate tended to be reflected in the interest expenditures on a 1
year lagging basis. This relationship tended to expand between 1977 and 1981 due to
the sharp rise in the overall level of interest rates themselves. As time passed, the
lagging period between the interest expenditures and the interest rate itself tended to
shorten. As a result, changes within the discount rate have a much more immediate
impact upon the total interest expenditures in today's financial climate.
Figure #4

We can also see in Figure #4 that the average interest rate on the national debt did not
exceed 3% until 1960. By 1966, the interest rate had exceeded 4%. The 5% barrier was
exceeded in 1969, 6% in 1973, 7% was exceeded in 1978, 8% in 1979, 9% in 1980,
11% in 1981 and finally 12% in 1982 . Our computer models have determined that given
the present set of circumstances, a 25% increase in the average rate of interest on the
total national debt could easily be the MINIMUM consequence by 1998 with a distinct

Figure #5
possibility of reaching a new record high between 1998 and 2003. If we consider that
short-term rates are capable of doubling from the 1993 low by 1996 and the amount of
2-year or less paper accounts for more than 45% of the national debt (Figure #2), then
the shortfall in the deficit could be very shocking as it exceeds $60 billion at roll-over
time in the 1995-1996 fiscal year. The seriousness of our Debt Crisis is well illustrated
by the maturity viewpoint expressed in Figure #2.

If we now look at the interest expenditures as a percent of total federal receipts (Figure
#5), we can see that the 10% mark was finally exceeded in 1971 following the closing of
the gold window and the abandonment of convertibility of the US dollar (gold standard).
The Federal Reserve's battle against inflation, which ran out of control under Jimmy
Carter, caused more serious long-term damage than the short-term benefits of reducing
inflation. The drastic rise in interest rates may have killed demand for capital in the
private sector, but it did nothing to stop the spending demand within Congress. By 1981,
interest as a percent of receipts soared reaching the 15.9% level. During the
subsequent 8 years of Reagan, the budget was balanced between social and defense
spending, but the interest expenditures reached $1 trillion. The lag between the current
interest rate and its effect upon the interest expenditures was clearly present despite
attempts by the Democrats to rewrite history. As a percent of total receipts, interest
expenditures reached the 27.14% level in 1991. The sharp decline in rates combined
with the shifting of the national debt short-term under Clinton has resulted in interest
expenditures as a percent of receipts falling back to 25.36% for 1993.

Figure #6

Figure #6 provides a look at the US interest expenditures as a percent of total federal


outlays. Here again, we can see that the steep advance in this percentage view began
under Carter in 1978. The peak was reached at 21.6% during 1991 and only a modest
decline back to 20.8% has taken place going into 1993.

Anyway we slice it, we have a major crisis in debt on the horizon that could easily send
the US into an inverted yield curve and disrupt the political forces at will. Politically, the
sweeping changes that the people have made in 1994 may be too little - too late. The
damage that the Clinton administration has already caused by shifting the funding more
short-term has only yet begun to work its way into the marketplace. Clinton essentially
reversed the trend of extending the maturity of the national debt which had been the
basic policy since 1976 (Figure #4). Clinton's use of interest expenditure savings to fund
more social spending has failed to produce any significant economic advantages and
may now result in a market-driven, forced shortening of maturity going into the end of
this century.

Figure #7

When we look at the yield-curve (Figure #7), the Clinton intervention becomes quite
clear. Short-term rates basis 1yr bills actually reached their historic low at 2.746%
during September 1992 going into the presidential elections. Following the Clinton
victory, 1 year rates jumped to 3.343% by the end of November 1992. 1 year rates
tended to gradually increase throughout 1993 closing that year at 3.598%. During this
same period, 30 year bonds rates fell from the election high of 7.63% to 5.965% for the
close of October 1993 and settled for the year at 6.348%. The Clinton manipulation
resulted in bringing 1 year rates up by slightly more than a half-point while 30 year rates
fell only about 1.65%. The only clear benefit was a reduction in current interest
expenditures that was pumped into social spending.
If we now look at how fast short-term rates have risen, we CANNOT solely blame the
Fed. The shifting of the debt from long- to short-term funding has resulted in a
sharply rising demand for short-term cash on the part of the US government.
Clearly, the Fed may have some concerns about inflation, but at the same time they are
being pushed toward higher rates due to the Clinton manipulation. As rates rise, this will
cause federal interest expenditures to rise irrespective of which party holds the reins of
power.

Our computer projection for a MINIMUM rise in 1 year rates shows a distinct potential to
reach the 12% level as early as 1996, but no later than 1998. While some might think
that this projection is insane, the y should keep in mind that the Orange Country default
is merely the tip of the iceberg. Any additional problems that arise in US municipals
combined with problems in Mexico and Canada could easily lead to wholesale
skepticism in government debt worldwide. This type of atmosphere will only propel this
trend into an exaggerated move toward higher rates. The government will thereafter
lower rates into the 2007 peak to reduce their borrowing costs, but volatility will rise
again between 2007 and 2011. Subsequently, the continued rise in debt should become
painfully obvious to government and they should the reverse policy seeking long-term
funding once again going into 2015.
Again, there will be many who would argue that a panic in government debt markets
would never happen. In fact, this is the precise thing that has ALWAYS happened
whenever government debt has grown to an alarming level in history.

The Truth About The Great Depression:

While many economists would like you to believe that the Great Depression was all
about greed and speculation, the truth of the matter is that it was about a massive
worldwide default in government debt! All of Europe permanently defaulted on its debt
with the exception of a 6 month moratorium in Britain. All of South and Central America
permanently defaulted as well as most of Asia. The German bond default of 1931
involved $12 billion alone and it took the BIS (Bank of International Settlements) until
1937 to calculate the total debt that was permanently wiped out. This stands in stark
contrast to the peak in broker loans on the NYSE in 1929 which had stood at only $6.5
billion.
The truth about 1929 has been largely hidden by many economists who painted a
scenario of greed to further their socialistic goals. Nevertheless, the blunt fact remains
that the amount of money ever invested in the stock market in comparison to that of
bonds is far less than 10%. In fact, leading into 1929 the ratio of bond to equity
investment ran 16:1. Today, the total amount of capital invested in the world bond
market is nearly 20:1 when compared to equities. As a result, a stock market crash may
be capable of creating a recession, but only a collapse in the bond market is sufficient to
wipe-out enough capital formation in order to create a major depression.

(Source: BIS, NYSE, Wall Street Journal, Time Magazine, Memoirs of Herbert Hoover
1952)

The evidence is quite clear when it comes to HOW BOND MARKETS TRADE
RELATIVE TO CONFIDENCE. During the Financial Crisis of 1931 as nation after nation
abandoned the gold standard and defaulted on their debts, both the currency and bond
markets were going crazy. Figure #8 illustrates an important point about bonds and
interest rates. Here we can see that even though the Fed lowered the discount rate,
the US treasury bonds still collapsed! Contemporary newspaper accounts reflected
the view of that era as one of distrust. If nation after nation was defaulting and the US
was the last nation still honoring its debts, it was assumed that a US default would also
take place. Therefore, despite lower interest rates, government bonds still collapsed.

Figure #9

In addition, the evidence is also quite clear that the Great Depression was at least in
part caused by governments through their G4 attempted manipulation of the world
capital flows in 1927. At that time it was widely suspected that there was a problem with
government debt being issued in Europe. The yield spread between US and German
bonds was nearly 7% at times. In an effort to help lower interest rates in Europe, the
central banks banned together for the first time in history in an attempt to deflect capital
flows from the United States back toward Europe (Figure #8). The individual powers of
the Federal Reserve branches were usurped into a single national policy as reflected by
a single discount rate. Previously, each Federal Reserve branch set its own discount
rate as a means of solving regional capital flow problems within the nation which had
been identified as the cause of the Panic of 1907. Once the powers were concentrated
into a single Federal Reserve, the discount rate was lowered in 1927 in hopes that
capital would be deflected toward Europe for the higher yield. Instead, the suspected
debt problems within Europe, which had been previously only rumor, were taken to be
real. Capital began to leave Europe and moved, for the most part, directly into US
equities. As a consequence, the US stock market DOUBLED between 1927 and 1929 -
despite the fact that the Fed doubled the interest rates in an attempt to stop what they
had misread as a purely domestic speculative bubble (Figure #10).

Figure #10
Figure #11
As bond markets fell and stocks rose between 1927 and 19(*9, the yield curve in the
United States also inverted as a consequence of the Fed's actions combined with a
growing lack of confidence within public sector debt overseas. The decline in
confidence within government debt also sparked a massive shift in investment
capital from bonds into the stock market (Figure #11). This trend is unfolding again
today in a gradual manner as it once began in 1927. As concern over the quality of
government debt builds in today's environment, capital will shift toward private sector
investment. This trend will be especially self-evident between 1994 and 1996.

In our historical research of net capital movement on an international, regional and


public vs. private sector flow basis, it is abundantly clear that capital begins to gradually
move away from the investment area that comes into question. The initial stages of this
capital movement is ALWAYS gradual and at first confusing to the contemporary
analysis of the day. Nevertheless, as capital begins to shift, shortages build in the sector
of concern. As a result, the financial crisis that follows NEVER appears in the blink of an
eye as many would tend to think. When the concern becomes visable to the majority -
panic strikes.

The Crash of 1987 was caused by an attempted manipulation on the part of the central
banks through their G5 activities. The intended purpose of the manipulation was to
lower the value of the dollar by 40% which was believed would result in a reduction of
the US trade deficit by making US goods cheaper overseas. They FAILED to realize
that by lowering the value of the dollar, not only do exports decline in value in the eyes
of foreigners but also all assets within the nation experiencing a depreciating currency.
As a result, the net losses to Japanese investors in US bonds has drastically altered the
investment horizon in Japan and worldwide. The Japanese use to buy up to 40% of all
US Treasury bond auctions prior to 1987 and in the post-87 era they account for less
than 3%.

Figure #12
There MUST be a concerted effort made at this point in time to shift the national debt
back into a long-term funding mode. The marketplace is already sensing disaster on the
horizon as evidenced by the gap narrowing between AAA corporate paper and that of
treasuries. Any attempt to increase the size of 30 year bond auctions will be met by a
drastic collapse in bond prices with its corresponding rise in yield. Capital has been
sensing a problem with government debt for some time now. First it began to move from
long-term into short-term following the Crash of '87 (See Figure #12). This is why short-
term rates fell in an exaggerated manner while long-term bond rates declined only
marginally. The second shift is evident by the fact that the bond market fell by more than
30% while the Dow Jones Industrials continued to move sideways despite higher
interest rates.

The pattern of capital flight is again the same today as it has been in every historical
situation where government debt comes into question. If government FAILS to
recognize these warning signs and continues to ASSUME that ALL THINGS REMAIN
EQUAL, a serious financial crisis will appear on the horizon as early as 1996, but most
certainly between 1998 and 2003. The swing in the political will of the people last
November 8th is indicative of the concerns that are building. Not only can we not afford
politics as usual, we can also no longer afford the management of our national finances
as usual.

Since the capital concentration within the United States, which took place as a result of
World War I and II, both the marketplace and American politicians have been mistaken
to assume that government debt is automatically regarded as secure and at the top of
the shopping list of demand. The evidence is quite clear that the preference between
various government sectors and that of the private sector debt issues is not written in
stone. There have been varying cyclical trends that swing back and forth depending
upon the confidence within the demand side of the equation. The Orange County
default is but one example of how changes int the perspective of risk is now entering the
equation. Unless a serious reversal in government spending takes place, the
assumption that demand will never change is an unrealistic assumption. Government
cannot simply continue to borrow with impunity. At some point along the way, all things
will NOT remain equal and demand will drift away from government securities and move
toward AAA private sector issues and equities. Therefore, this trend, which is self-
evident at this time, is NOT a temporary fluke, but a reversal of the postwar trend that
has existed only since the capital concentration within the US since World War II.

Can Government Prevent The Financial Debt Crisis? SUGGESTION:

1. The government MUST issue TAX FREE bonds with maturities of 10, 20 and 30 years.
They should be issued on a ZERO-COUPON basis thereby deferring all interest to
maturity. As an incentive to hold these issues to maturity, the interest itself should be
TAX FREE. The denominations should be small, perhaps starting at the $1,000 level. All
immediate savings in interest expenditures should be applied to retiring debt in the
current fiscal year. This will help reduce interest rates and also help bring our debt that is
currently held offshore back onshore. Most foreign citizens do NOT pay taxes on US
interest earned on our government debt. While the Democrats will argue that this will
benefit the rich, the Republicans should respond by stating that they are providing
Americans with the same benefits as foreign citizens.
2. A Tax-Amnesty should be called with a 1 year window. Anyone who has cash income
that they have NOT declared should be allowed to do so without penality or interest.
Better yet, make the rate only 15% (current income not qualified). With the underground
economy believed to be in excess of 20%, this could produce a huge windfall in revenue.
All revenue collected by this program should be applied to retiring debt. When the
Democrats argue that this will benefit the criminal rich, a simple point should be made
that this is revenue that the IRS is unaware of and would have no ability to collect.
3. An immediate FREEZE on all government hiring should be put in place. By 1996, a
MINIMUM 10% reduction in government personnel should be implemented with a legal
limit being impose d at 25% of the civil work force by 2000. In addition, any cost of living
increases on government pensions should be eliminated on persons collecting more
than one pension from the government. Ideally, CPI increases on government pensions
should be completely eliminated. If interest rates continue to rise at the current growth
rate, the point at which revenue will be unable to meet entitlement payments will arrive
BEFORE the year 2000 - instead of 2030 as current government reports suggest. Such
government reports are also assuming that the CPI remains virtually unchanged at
current levels in addition to interest rates remaining unchanged at 1993 levels.
4. A massive government consolidation effort MUST be undertaken. We simply cannot
afford one-third of the civil work force employed among the ranks of the public sector.
Government employees produce nothing whatsoever and instead act as a drain upon
the nation income and the productive forces of a modern society. This suggests that we
simply must reduce not merely regulation, but also the size and cost of government as a
percent of the total gross domestic production. We must launch a major effort to reduce
government by enacting a ONE AGENCY - ONE REGULATING AUTHORITY policy. For
example, in the financial sector there are two agencies that regulate the investment
industry - the CFTC and SEC. These two agencies should be merged into one thereby
eliminating two administrative staffs, accounting and management not to mention field
agents. A consolidation of these two agencies, which constantly battle each other for
authority, would save at least 25% of the current combined cost. There are countless
overlapping examples between the Department of Agriculture and National Parks,
Wildlife and the EPA, etc. The list is simply endless. A massive consolidation that follows
the premise of ONE AGENCY FOR ONE PROGRAM will reduce the cost of government
by at least 10-15% with the possibility of reaching savings as great as 20%-25%.
5. In addition to legal reform, a major effort should be considered where a sharp reduction
in the number of court cases and over regulation can be handled. The one NEW
government body that does need to be created is a separate panel of judges that will
determine the constitutionality of any new regulation or interpretation on the part of an
agency before that regulation or interpretation is enacted. Currently, a private citizen
cannot challenge a new law until that law inflicts harm on an individual. Once a harm has
been inflicted, it becomes that individual's right to appeal to the Supreme Court -
provided he has the legal resources to do so. If the individual does NOT have the
financial resources to challenge a new law or interpretation, the government wins by
default. This is simply immoral within a free society. Therefore, a new body must be
established where all agencies are compelled to seek the approval of that panel
BEFORE inflicting harm on the population at large. This will reduce the number of cases
that are causing a backlog in the courts and thereby reduce the mounting pressure to
establish more courts at the expense of the taxpayer. This new agency would have final
authority over ALL agencies and perhaps should be part of the Supreme Court. Any new
REGULATION or INTERPRETATION that goes into effect would therefore already be
clarified as to its Constitutionality.
6. To eliminate the pork-barrel politics that has propelled the budget crisis, NO bill in the
House or Senate should be amended with any proposed spending or state mandate that
is not directly related to the nature of the bill in question. In other words, no grants to
favorite universities and no midnight basketball funding labeled as fighting crime! Any
crazy study to watch the flow rate of Ketchup would have to be proposed as a stand-
alone bill and the author would have to face the consequences for doing so.

If these measures can be truly implemented, then there will be a hope of preventing this
debt crisis from destroying society. If we FAIL in these measures, keep in mind that the
collapse of Russia did not come about because of ideology. Russia collapsed because
of poor economic management and fiscal irresponsibility. This will be the fate of the
United States. We can already see the regional tension building over social differences
and illegal immigration. When economics plays into the equation, those regional
differences become magnified until they emerge as the battle cry for change and, at
times, even separatism and ultimately revolution.