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The Obama administration is driving us deeper into debt at a rate never before seen.

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Democracy in Deficit

The Obama administration is driving us deeper into debt at a rate never before seen.

While the Bush administration used the War on Terror to cast aside the need for a balanced budget — and then-Treasury Secretary Paulson introduced us to $700 billion legislation that is to be passed with little examination or thought — the Obama administration is totally ignoring the reality that the government can only provide goods and services if it gets the resources from somewhere and is driving us deeper into debt at a rate never before seen.  

The stimulus bill, the omnibus appropriations bill, and the President’s new budget will bring the total debt issued by Treasury and other agencies to $12.704 trillion by the end of the current fiscal year and more than $14 trillion by the end of the 2010 fiscal year.  This can be compared with February of 2000 when the gross federal debt was $5.735.  The deficit as a percentage of Gross Domestic Product in the 2009 fiscal year will be the largest it has been since the end of World War II.  

The question is, how is this debt to be financed?

In recent years foreign investors have been large purchasers of U.S. Treasury securities and this has allowed our government to borrow without substantially increasing long term interest rates.  At the end of December 2008, China held $696.2 billion in U.S. Treasury securities and Japan $578.3 billion.  The question is, will foreigners wish to or be able to absorb the expected 2009 deficit of $1.75 billion, which is 3.8 times as large as the record 2008 deficit, and an additional $1.2 trillion in fiscal year 2010?  China is facing a slowdown in its economy, and Japan’s exports have fallen off a cliff and its GDP fell at an annual rate of 12.7% in the fourth quarter of 2008.  The UK is the third largest holder of Treasuries with $355 billion and its economy fell from the third quarter by the largest amount since 1980 as it moves into recession.  It is not likely that these countries will earn enough exports to quickly absorb the vast amount of new Treasury debt that will be hitting the markets.

In the current global uncertainty, U.S. Treasuries are still the safe haven of choice, which explains why the large increase in debt obligations that has taken place so far has not driven up long term interest rates as much as might have been expected.

However, we are now seeing long term interest rates rise, with the ten year Treasury rate moving from 2.07% on December 18 to just under 3% on February 26. Rising interest rates will reduce investment demand, including the demand for housing.  This is at loggerheads with the fact that a key to reducing the oversupply of the housing capital brought about by loose credit policies of the Federal Reserve and government intervention in the housing market is to increase demand for housing. Thus, as interest rates rise there will be pressure on the Federal Reserve to purchase Treasury securities.   

When the Federal Reserve buys Treasuries, this is known in economic parlance as monetizing the debt.  This is because the Federal Reserve will be increasing the monetary base in the process and increasing the money supply.  As Milton Friedman pointed out, inflation is always and everywhere a monetary phenomenon.  The massive federal deficits will lead to inflation and a declining value of the dollar.  Again, flight to safety has kept the dollar from depreciating as might be expected.  However, as the dollar begins to decline in value when the Federal Reserve monetizes at least a large portion of the new debt, foreigners will have an added risk from buying U.S. Treasuries — that of exchange rate risk.  This may further dampen demand for U.S. Treasuries and put further upward pressure on interest rates.

In the short run, the uncertainties of the global economy and equity markets and the dollar’s stature in the world’s currency market will probably provide sufficient demand for U.S. debt that the monetization will be slow and inflation will not be clearly evident. However, once the world economy begins to turn around, the safe haven effects of the current crisis on the Treasury securities market will begin to abate and the monetization of the debt will begin to affect prices. This is likely to happen within the next six to eight months.  There are already indications that inflation is on the way.  A primary one is the price of gold, which has risen from $720 per ounce in October to $936 on February 26.  

Lurking in the midst of this are the unfunded liabilities of Social Security and Medicare, as well as the pressures of Medicaid.  The Presidents budget projects that by 2014 Social Security spending will exceed $800 billion, Medicare $600 billion and Medicaid $300 billion.  The unfunded liability of Social Security and Medicaid is in excess of $100 trillion.  The 2008 Trustees of Social Security and Medicare Report says that: “For the second consecutive year, a "Medicare funding warning" is being triggered, signaling that non-dedicated sources of revenues — primarily general revenues — will soon account for more than 45 percent of Medicare’s outlays.”  The looming and current deficits in the funding of these programs will likely be paid for by further borrowings, adding to the federal deficit and pushing up inflation.

The sequence of massive deficits, rising interest rates, Federal Reserve debt monetization, and resulting inflation was spelled out by Nobel Laureate James Buchanan and Richard Wagner in their 1977 book, Democracy in Deficit.  We are about to see it writ large in the largest invasion of the federal government into the economy in our history, which will debase our currency and create a substantial drag on our economic system. This long term threat to American society can only be turned aside by restoring our belief in liberty, responsibility, and limited government, for as Friedman famously said, there is no such thing as a free lunch.

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Written By

Dr. Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to the Business & Media Institute.

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