Public Debt and Other Issues

Henry Liu explains why public debt is not the bogeyman we are led to believe.

Recently, much noise has been made by fiscal hawks about the danger of high fiscal deficits and national debts. Yet the purported danger comes not from the size of the deficits or debt, but on how the proceeds from them are used. In recent decades, the US economy has suffered from such proceeds being spent on programs that were not conducive to sustainable economic growth or constructive to economic health.

During the course of World War I, US national debt multiplied 27 times to finance the nation’s participation in war, from $1 billion to $27 billion. The US military drafted 4 million men and sent over a million soldiers to France, solving the domestic unemployment problem overnight plus putting women into factories and creating a sharp rise in aggregate demand as troops had to be supported at a level of consumption exponentially higher than civilians could through market forces in peacetime. War was a blessing to the US economy as military demand put US industries humming at full capacity while the homeland was exempted from war damage.

Far from ruining the US economy, war production financed by public debt catapulted the country into the front ranks of the world’s leading economic and financial powers, because the US homeland was not affected by war damage and civilian consumption was curbed in the name of patriotism. The national debt turned out to be a blessing, because a good supply of government securities provided for a vibrant credit market and public sector spending created the rise in demand that private companies could satisfy profitably with a guaranteed market.

The truth is that the positive economic functionality of the national debt rests not so much on its level, high or low, but on how the debt is expended. When the national debt is used to expand economic production with full employment and rising wages, it will produce positive economic effects. But if the national debt is used to finance speculative profits achieved through pushing down wages via cross-border wage arbitrage, or to structure ballooning interest payments to service old debts by assuming more new debts, it will eventually drag the economy to a grinding halt by a debt implosion crisis.

World War I raised the federal debt to $27 billion, about 34.5% of GDP to produce a vibrant productive economy of full employment. In March 2009, the Congressional Budget Office (CBO) estimated that US gross debt will rise from 70.2% of GDP in 2008 to 101% in 2012, while the economy is expected to stay in open-ended recession with unacceptably high unemployment at over 10%. The difference is that in 1919 the federal debt was used to finance war production while in 2012 the public debt is expended to refinance the speculative debt bubble.

Less that a decade after the war, by 1928, US gross debt fell to $18.5 billion, but the money so released was absorbed mostly by speculative profit to cause the market crash in 1929. In 1930, a year after the crash, US gross debt fell further to $16.2 billion under President Hoover’s balance budget and the Fed’s tight money policy under Chairman Roy Archibald Young.

During Young’s term in office as chairman of the Fed there was confrontation between the Federal Reserve Board and the Federal Reserve Bank of New York under George L. Harrison of how to curb speculation that lead, inter alia, to the stock market boom of the late 1920s. The Board was in favor of putting “direct pressure” on the lending member banks while the Federal Reserve Bank of New York wanted to raise the discount rate. The Board under Young disapproved this step, however Young himself was not fully convinced that the policy of using pressure would work and refused to sign the 1929 Annual Report of the Board because it contained parts favorable to this policy.

Eugene Isaac Meyer was appointed by Herbert Hoover to be Chairman of the Fed on September 16, 1930. Meyer strongly supported government relief measures to counter the effects of the Great Depression, taking on an additional post as chief of the Reconstruction Finance Corporation (RFC), modeled after the War Finance Corporation of World War I.
<>The RFC gave $2 billion in aid to state and local governments and made loans to banks, railroads, farm mortgage associations, and other businesses. The loans were nearly all repaid after the Depression. RFC was continued by the New Deal and played a major role in containing the Great Depression and setting up the relief programs that were taken over by the New Deal in 1933.

Upon Franklin D. Roosevelt’s inauguration in 1933, Meyer resigned his government posts. Month later, he bought the Washington Post at a bankrupt auction and turned it into a respected and profitable newspaper. His daughter, Katherine Graham, was publisher of the Washington Post when it exposed the Watergate scandal that led to the resignation of President Richard Nixon on August 9, 1974. Meyer was appointed by President Truman after WWII to be the first president of the newly formed World Bank.

After the launching of the New Deal in 1933, US gross debt rose to $62.4 billion, at 52.4% of GDP. By 1950, WWII had pushed US gross debt five folds to $356.8 billion but only at 94% of GDP. After 1950, US gross debt fell steadily as a percentage of GDP to a low of 33%, with a nominal value of $909 billion in 1980 under President Jimmy Carter. Since then, US gross debt had not fallen below 56% of GDP. Projected US gross debt for 2011 is $15.7 trillion at 101% of GDP. Much of the debt money in the two years since the credit crisis has ended up in the wrong pockets of distressed financial firm but not the needy public, depriving the US economy of full employment with rising wages to increase aggregate demand.

While US public debt in 1946 reached $300 billion, at 135% of GDP, the post-war years were prosperous years for the US. These data show clearly that it is not the level of the public debt, but how the debt money is spent that determines its impact on the economy.

The Issue of Fiscal Deficit

The Federal fiscal deficit in 1919 was 16.8% of a GDP of $78.3 billion. The war time Federal deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a high fiscal deficit, US GDP kept rising after the WWII to $275.2 billion in 1948 with a fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is project to be 10.6% of a GDP of $14.6 trillion.

Between 1920 and 1929, the Federal budget had a small surplus, while the GDP grew to $103.6 billion in 1929. After the 1929 crash, the 1930 GDP fell $12.4 billion, about 12%, to $91.2 billion, while the Federal budget under Hoover still had a surplus of 1% of GDP.

Not until Franklin D Roosevelt came into office in 1933 when the GDP had fallen by almost half to $56.4 billion that the Federal deficit jump to 3.27% of GDP in 1934. All through the New Deal years, the Federal deficit stayed below 5% with the average annual deficit at around 3% of GDP and did not rise until after the US entered WWII and peaked at 28.1% in 1943, 22.4% in 1944 and 24.1% in 1945 but falling to 9.1% in 1946 when the GDP was $222.2 billion.

The total Federal fiscal deficit for the four years of WWII was about 100% of the average annual GDP of the same period. At the same time, the US grew to be the strongest economy of the world because the deficit was used to finance war production, not to bailout distressed financial institutions and ineffcient industrial firms.

US fiscal deficit for FY2009 was more than $1.75 trillion — about 12.3% of GDP, the biggest since 1945. According the White House Budget Office, the cumulative fiscal deficit between FY2009 and FY2019 is projected to be almost $7 trillion. Total gross Federal debt in 2008 was $10 trillion, projected to rise to over $23 trillion in 2019. Debt held by the public is projected to rise from $5.8 trillion in 2008 to $15.4 trillion in 2019. Interest expense in 2008 was $383 billion. Projection is expected to rise as both debt principal and interest rate are expected to rise.

The Issue of Inflation

Inflation is a different story. Moderate inflation is necessary for optimum economic growth, provided the burden of inflation is equally shared by all segments of the population, particularly wage earners. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead as wages were rising in tandem with or slightly ahead of prices through wage-price control.

Income policies involving wage-price control were employed throughout history from ancient Egypt, Babylon under Hammurabi, ancient Greece, during the American and French revolutions, the Civil War, World War I and II. A case can be made that that wage-price control has a mixed record as a way to restrain inflation, but it is irrefutable that income policies are effective in balancing supply and demand.

Yet in response to inflation, the Federal Reserve Board raised the discount rate in quick succession in 1919, from 4% to 7%, and kept it there for 18 months to try to rein in inflation by making money more expensive when banks borrowed from the Fed. The result was that in 1921, 506 banks failed. <>

The current financial crisis started in late-2007 and stabilized around mid-2009 after direct massive Fed intervention. It was by many measures an unprecedented phase in the history of the US banking system. In addition to the systemic stress and the stress faced by the largest investment and commercial banks, 168 depository institutions failed from 2007 through 2009. This was not the largest number of bank failure in one crisis. At the height of the savings and loan (S&L) crisis from 1987 to 1993, 1,858 banks and thrifts failed. However, the dollar value of failed banks assets in the financial crisis in 2007-2009 was $540 billion, roughly 1.5 times of the bank assets that failed in the S&L crisis in 1987-1993. <>

A research paper funded by the Federal Deposit Insurance Corporation (FDIC) on Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930, by Paul Kupiec and Carlos Ramireza (July 2008) found that bank failures reduce subsequent economic growth. Over this period, a 0.12 percent (1 standard deviation) increase in the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real Gross National Product (GNP) growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as a measure of the costs of systemic risk in the banking sector. The FDIC had been created by the New Deal only after 1934 to protect depositors. <>

In the current crisis that began in mid-2007, with the discount rate falling steadily to 0.5% on December 16, 2008 from a high of 6.25% set on June 2006, still 25 banks failed in 2008 and were taken over by the FDIC while 140 banks failed in 2009 and 33 banks failed in just the first two months of 2010, putting the fee-financed FDIC in financial stress. Yet the Fed raised the discount rate to 0.75% on February 19, 2010. In contrast, in the five years prior to 2008, only 11 banks had failed from the debt bubble even when the discount rate stayed within a range from 2% to 6.25%.

Could it be the Fed is sending a signal that the pain of a falling dollar is greater than that of an economic recession?

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

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