princeton economics archive debt-crisis-1994 (1)

8/7/2019 Princeton Economics Archive Debt-Crisis-1994 (1)

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The Debt Crisis And The ConsequencesFor Our Modern Political-Economyby Martin A. Armstrong

1994 Princeton Economic Institute

The Debt CrisisThe Ultimate Defining Issue of American PoliticsThere 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


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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


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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 Clinton

administration 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 #1clearly 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 the

primary 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 HistoryConfronted 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 while

commerce, 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.
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This ill-fated attempted manipulation by the current administration to lower long-terminterest rates took place precisely when government should have been locking in itsdebt for the greatest possible maturity available. As a consequence, this manipulationwill now result in a more rapid advance for interest rates on the short-end of the curveas 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 thatwill now take place as a result of rising interest rates will be blamed once again on anyreduction in taxation. Such unethical characterization of the financial position of thenation for purely partisan self-interest runs the risk of dangerously masking the crisis indebt that the United States now faces as we move into the turn of the century. WeMUST face the TRUTH about our budget and end this partisan characterization ofevery change in trend to the sole exclusive change in trend in taxation with totaldisregard of interest expenditures that now account for over 25% over dollar thegovernment 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 throughgreater social spending. Not one cent of the savings was actually applied by Congress toward reducing the national debt. For example, the interest for 1991 stood at $285.3billion on a $3,665.3 billion national debt. This suggests that the average rate of interestpaid by the federal government was 7.78% during 1991. By 1993, the national debtgrew to $4,351.2 billion with interest expenditures of $292.5 billion giving an effectiveaverage rate of interest of 6.72%. If interest rates had NOT declined between 1991 and1993, then the 1993 interest expenditures would have been $338.5 billion at 7.78%.

Figure #2


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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 theFederal Reserve. While it is widely recognized that long-term rates are establishedthrough 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 orless maturity. Regardless of fed policy objectives, domestic policy objectives are stillheld hostage to those of international capital flows. With government demand for capitalincreasing on the short-end of the curve, rates at this end of the maturity curve will havea 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 theimmediate 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 thenational debt that is funded 1 year or less.

We MUST now assume that short-term rates will continue higher, particularlythroughout 1995, irrespective of Fed inflationary policy. Just as the Japanese real estateinvestors, who got into trouble through buying long-term investments with short-termfunding, the yield curve will invert whenever too much demand rests on one side of thecurve. In Japan, short-term rates DOUBLED within a single year as a result of theimproper funding of long-term debt with short-term funding. We now run the risk of USshort-term rates doubling from their recent historical lows by 1996 due to thesame improper fiscal position of the United States. As a direct result, we couldeasily 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 thenational debt well above the 8% level. This implies that by 1996, interest expenditurescould rise substantially irrespective of Fed policy or Republican changes in spending. Ifwe look at that portion of the national debt that is funded 1 year or LESS (33.4% oftotal debt), every 1% rise in short-term rates will result in a $14.3 billion i ncrease ininterest expenditures on only that portion of the debt itself! Rates have already risen2.75% during 1994. This warns that we could see the next fiscal budget result in a $43


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billion increase or more in interest expenditures even if rates do not rise further fromcurrent levels. Clearly, we are in SERIOUS trouble!

Figure #3

Figure #3illustrates the rate of change in the discount rate compared to that in thefederal 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 1year lagging basis. This relationship tended to expand between 1977 and 1981 due tothe sharp rise in the overall level of interest rates themselves. As time passed, thelagging period between the interest expenditures and the interest rate itself tended toshorten. As a result, changes within the discount rate have a much more immediateimpact upon the total interest expenditures in today's financial climate.
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We can also see inFigure #4that the average interest rate on the national debt did notexceed 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 giventhe present set of circumstances, a 25% increase in the average rate of interest on thetotal national debt could easily be the MINIMUM consequence by 1998 with a distinct

Figure #4

Figure #5
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possibility of reaching a new record high between 1998 and 2003. If we consider thatshort-term rates are capable of doubling from the 1993 low by 1996 and the amount of2-year or less paper accounts for more than 45% of the national debt (Figure #2), thenthe shortfall in the deficit could be very shocking as it exceeds $60 billion at roll-overtime in the 1995-1996 fiscal year. The seriousness of our Debt Crisis is well illustrated

by the maturity viewpoint expressed inFigure #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 ofthe 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 JimmyCarter, caused more serious long-term damage than the short-term benefits of reducinginflation. The drastic rise in interest rates may have killed demand for capital in theprivate 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 thesubsequent 8 years of Reagan, the budget was balanced between social and defense

spending, but the interest expenditures reached $1 trillion. The lag between the currentinterest rate and its effect upon the interest expenditures was clearly present despiteattempts by the Democrats to rewrite history. As a percent of total receipts, interestexpenditures reached the 27.14% level in 1991. The sharp decline in rates combinedwith the shifting of the national debt short-term under Clinton has resulted in interestexpenditures as a percent of receipts falling back to 25.36% for 1993.

Figure #6

Figure #6provides a look at the US interest expenditures as a percent of total federaloutlays. Here again, we can see that the steep advance in this percentage view began
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under Carter in 1978. The peak was reached at 21.6% during 1991 and only a modestdecline 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 sendthe 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. Thedamage that the Clinton administration has already caused by shifting the funding moreshort-term has only yet begun to work its way into the marketplace. Clinton essentiallyreversed the trend of extending the maturity of the national debt which had been thebasic policy since 1976 (Figure #4). Clinton's use of interest expenditure savings to fundmore social spending has failed to produce any significant economic advantages andmay now result in a market-driven, forced shortening of maturity going into the end ofthis century.

Figure #7

When we look at the yield-curve (Figure #7), the Clinton intervention becomes quiteclear. Short-term rates basis 1yr bills actually reached their historic low at 2.746%
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during September 1992 going into the presidential elections. Following the Clintonvictory, 1 year rates jumped to 3.343% by the end of November 1992. 1 year ratestended to gradually increase throughout 1993 closing that year at 3.598%. During thissame period, 30 year bonds rates fell from the election high of 7.63% to 5.965% for theclose 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 ratesfell only about 1.65%. The only clear benefit was a reduction in current interestexpenditures that was pumped into social spending.


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If we now look at how fast short-term rates have risen, we CANNOT solely blame theFed. The shifting of the debt from long- to short-term funding has resulted in asharply 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 arebeing pushed toward higher rates due to the Clinton manipulation. As rates rise, this willcause 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 toreach the 12% level as early as 1996, but no later than 1998. While some might thinkthat this projection is insane, the y should keep in mind that the Orange Country defaultis merely the tip of the iceberg. Any additional problems that arise in US municipalscombined with problems in Mexico and Canada could easily lead to wholesaleskepticism in government debt worldwide. This type of atmosphere will only propel this


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trend into an exaggerated move toward higher rates. The government will thereafterlower rates into the 2007 peak to reduce their borrowing costs, but volatility will riseagain between 2007 and 2011. Subsequently, the continued rise in debt should becomepainfully obvious to government and they should the reverse policy seeking long-termfunding once again going into 2015.


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Again, there will be many who would argue that a panic in government debt marketswould never happen. In fact, this is the precise thing that has ALWAYS happenedwhenever 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 allabout greed and speculation, the truth of the matter is that it was about a massiveworldwide default in government debt! All of Europe permanently defaulted on its debtwith the exception of a 6 month moratorium in Britain. All of South and Central Americapermanently defaulted as well as most of Asia. The German bond default of 1931involved $12 billion alone and it took the BIS (Bank of International Settlements) until1937 to calculate the total debt that was permanently wiped out. This stands in starkcontrast to the peak in broker loans on the NYSE in 1929 which had stood at only $6.5billion.


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The truth about 1929 has been largely hidden by many economists who painted ascenario of greed to further their socialistic goals. Nevertheless, the blunt fact remainsthat the amount of money ever invested in the stock market in comparison to that ofbonds is far less than 10%. In fact, leading into 1929 the ratio of bond to equityinvestment ran 16:1. Today, the total amount of capital invested in the world bondmarket is nearly 20:1 when compared to equities. As a result, a stock market crash maybe capable of creating a recession, but only a collapse in the bond market is sufficient towipe-out enough capital formation in order to create a major depression.(Source: BIS, NYSE, Wall Street Journal, Time Magazine, Memoirs of Herbert Hoover1952)The evidence is quite clear when it comes to HOW BOND MARKETS TRADERELATIVE TO CONFIDENCE. During the Financial Crisis of 1931 as nation after nationabandoned the gold standard and defaulted on their debts, both the currency and bondmarkets were going crazy. Figure #8 illustrates an important point about bonds andinterest rates. Here we can see that even though the Fed lowered the discount rate,the US treasury bonds still collapsed! Contemporary newspaper accounts reflectedthe view of that era as one of distrust. If nation after nation was defaulting and the US


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was the last nation still honoring its debts, it was assumed that a US default would alsotake 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 inpart 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 withgovernment debt being issued in Europe. The yield spread between US and Germanbonds was nearly 7% at times. In an effort to help lower interest rates in Europe, thecentral banks banned together for the first time in history in an attempt to deflect capitalflows from the United States back toward Europe (Figure #8). The individual powers ofthe Federal Reserve branches were usurped into a single national policy as reflected bya single discount rate. Previously, each Federal Reserve branch set its own discountrate as a means of solving regional capital flow problems within the nation which had


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been identified as the cause of the Panic of 1907. Once the powers were concentratedinto a single Federal Reserve, the discount rate was lowered in 1927 in hopes thatcapital would be deflected toward Europe for the higher yield. Instead, the suspecteddebt problems within Europe, which had been previously only rumor, were taken to bereal. 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 theyhad misread as a purely domestic speculative bubble (Figure #10).

Figure #10
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Figure #11


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As bond markets fell and stocks rose between 1927 and 19(*9, the yield curve in theUnited States also inverted as a consequence of the Fed's actions combined with agrowing lack of confidence within public sector debt overseas. The decline inconfidence within government debt also sparked a massive shift in investmentcapital from bonds into the stock market (Figure #11). This trend is unfolding againtoday in a gradual manner as it once began in 1927. As concern over the quality ofgovernment debt builds in today's environment, capital will shift toward private sectorinvestment. This trend will be especially self-evident between 1994 and 1996.In our historical research of net capital movement on an international, regional andpublic vs. private sector flow basis, it is abundantly clear that capital begins to graduallymove away from the investment area that comes into question. The initial stages of thiscapital movement is ALWAYS gradual and at first confusing to the contemporaryanalysis of the day. Nevertheless, as capital begins to shift, shortages build in the sectorof concern. As a result, the financial crisis that follows NEVER appears in the blink of an
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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 centralbanks 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 ofthe US trade deficit by making US goods cheaper overseas. They FAILED to realizethat by lowering the value of the dollar, not only do exports decline in value in the eyesof 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 theinvestment horizon in Japan and worldwide. The Japanese use to buy up to 40% of allUS Treasury bond auctions prior to 1987 and in the post-87 era they account for lessthan 3%.

Figure #12


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There MUST be a concerted effort made at this point in time to shift the national debtback into a long-term funding mode. The marketplace is already sensing disaster on thehorizon as evidenced by the gap narrowing between AAA corporate paper and that oftreasuries. Any attempt to increase the size of 30 year bond auctions will be met by adrastic 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 fromlong-term into short-term following the Crash of '87 (SeeFigure #12). This is why short-term rates fell in an exaggerated manner while long-term bond rates declined onlymarginally. The second shift is evident by the fact that the bond market fell by more than30% while the Dow Jones Industrials continued to move sideways despite higherinterest rates.The pattern of capital flight is again the same today as it has been in every historicalsituation where government debt comes into question. If government FAILS torecognize these warning signs and continues to ASSUME that ALL THINGS REMAINEQUAL, 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 lastNovember 8th is indicative of the concerns that are building. Not only can we not affordpolitics as usual, we can also no longer afford the management of our national financesas usual.Since the capital concentration within the United States, which took place as a result ofWorld War I and II, both the marketplace and American politicians have been mistakento assume that government debt is automatically regarded as secure and at the top ofthe shopping list of demand. The evidence is quite clear that the preference betweenvarious government sectors and that of the private sector debt issues is not written instone. There have been varying cyclical trends that swing back and forth depending

upon the confidence within the demand side of the equation. The Orange Countydefault is but one example of how changes int the perspective of risk is now entering theequation. Unless a serious reversal in government spending takes place, theassumption that demand will never change is an unrealistic assumption. Governmentcannot simply continue to borrow with impunity. At some point along the way, all thingswill NOT remain equal and demand will drift away from government securities and movetoward 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 thathas 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 tomaturity. As an incentive to hold these issues to maturity, the interest itself should beTAX FREE. The denominations should be small, perhaps starting at the $1,000 level. Allimmediate savings in interest expenditures should be applied to retiring debt in thecurrent fiscal year. This will help reduce interest rates and also help bring our debt that iscurrently held offshore back onshore. Most foreign citizens do NOT pay taxes on USinterest earned on our government debt. While the Democrats will argue that this will
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benefit the rich, the Republicans should respond by stating that they are providingAmericans with the same benefits as foreign citizens.

2. A Tax-Amnesty should be called with a 1 year window. Anyone who has cash incomethat 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 undergroundeconomy 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 theDemocrats argue that this will benefit the criminal rich, a simple point should be madethat 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, aMINIMUM 10% reduction in government personnel should be implemented with a legallimit being impose d at 25% of the civil work force by 2000. In addition, any cost of livingincreases on government pensions should be eliminated on persons collecting morethan one pension from the government. Ideally, CPI increases on government pensionsshould be completely eliminated. If interest rates continue to rise at the current growthrate, the point at which revenue will be unable to meet entitlement payments will arriveBEFORE the year 2000 - instead of 2030 as current government reports suggest. Suchgovernment 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 uponthe nation income and the productive forces of a modern society. This suggests that wesimply must reduce not merely regulation, but also the size and cost of government as apercent of the total gross domestic production. We must launch a major effort to reducegovernment by enacting a ONE AGENCY - ONE REGULATING AUTHORITY policy. Forexample, in the financial sector there are two agencies that regulate the investmentindustry - the CFTC and SEC. These two agencies should be merged into one therebyeliminating two administrative staffs, accounting and management not to mention fieldagents. 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 countlessoverlapping examples between the Department of Agriculture and National Parks,Wildlife and the EPA, etc. The list is simply endless. A massive consolidation that followsthe premise of ONE AGENCY FOR ONE PROGRAM will reduce the cost of governmentby 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 reductionin the number of court cases and over regulation can be handled. The one NEWgovernment body that does need to be created is a separate panel of judges that willdetermine the constitutionality of any new regulation or interpretation on the part of anagency before that regulation or interpretation is enacted. Currently, a private citizencannot challenge a new law until that law inflicts harm on an individual. Once a harm hasbeen 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 thefinancial resources to challenge a new law or interpretation, the government wins bydefault. This is simply immoral within a free society. Therefore, a new body must beestablished where all agencies are compelled to seek the approval of that panelBEFORE inflicting harm on the population at large. This will reduce the number of casesthat are causing a backlog in the courts and thereby reduce the mounting pressure toestablish more courts at the expense of the taxpayer. This new agency would have finalauthority over ALL agencies and perhaps should be part of the Supreme Court. Any new


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REGULATION or INTERPRETATION that goes into effect would therefore already beclarified as to its Constitutionality.

6. To eliminate the pork-barrel politics that has propelled the budget crisis, NO bill in theHouse or Senate should be amended with any proposed spending or state mandate thatis not directly related to the nature of the bill in question. In other words, no grants tofavorite 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 thisdebt crisis from destroying society. If we FAIL in these measures, keep in mind that thecollapse of Russia did not come about because of ideology. Russia collapsed becauseof poor economic management and fiscal irresponsibility. This will be the fate of theUnited States. We can already see the regional tension building over social differencesand illegal immigration. When economics plays into the equation, those regionaldifferences become magnified until they emerge as the battle cry for change and, attimes, even separatism and ultimately revolution.

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