The crisis atmosphere the Bush Administration is trying to foment around the budget deficit is being shrugged off by the financial markets for a good reason: The markets do not feel the burden of debt on the growing U.S. economy. There is no debt crisis, only an illusion of one created by inflation.
If we use the classical measure of debt obligations, we strip out the inflation illusion. In 1971, when the dollar was legally defined as one thirty-fifth of an ounce of gold, the U.S. debt was 11.6 billion ounces of gold. In 1990, with the dollar worth one-tenth as much in gold, the debt is 8.6 billion ounces. If we take into account the increase in population over that period, the per capita debt burden is even lighter: 57 ounces of gold for every American in 1971; 36 ounces today.
President Bush's Council of Economic Advisers is well aware of these arguments and in large part embraces them, understanding that there is in fact no budget crisis. They feel constrained to silence on the matter because the White House policymakers feel they need a sense of crisis in order to hammer out a budget deal.
It is absolute nonsense to bewail the debt burden we are passing on to our grandchildren. Quite the contrary, the currency devaluations of the Nixon and Carter Administrations cheated the government's creditors — for the most part our parents and grandparents — out of most of their savings.
It is also preposterous to blame Ronald Reagan for the tripling of the national debt, to $3 trillion from $1 trillion, when the cause was rooted in the Nixon-Carter devaluations and could not be avoided. This is because most of the $1 trillion debt that Reagan inherited had been issued when interest rates were much lower than the 15% long-term rate he also inherited from Carter. As the debt matured, refinancing pushed the costs of debt service higher and higher.
The real burden of debt did grow in the Reagan years, but that is because the massive dollar devaluations of the Carter years hoisted gold to more than $600 at the end of 1980. This meant the government's debt had fallen to less than 2 billion ounces of gold at that point. If the Fed had not deflated, thereby restoring some value to outstanding government bonds, interest rates would have remained over 15% and the national debt would now be a trillion dollars higher. If it had deflated more, it would have bankrupted so many private debtors that the national debt would have grown in real, rather than inflated terms.
Balancing the national budget under these conditions would have been impossible, and serious attempts to do so would have been fiscally irresponsible and self-defeating. This is why I have always opposed the idea of a constitutional amendment requiring budget balance. State and local governments have such requirements, which are now perversely leading to a wave of tax increases across the country. The real burden of state and local debt has in fact fallen even more sharply than at the federal level. In 1971, state and local debt was 4.5 million ounces of gold. Now it is about 2.2 million ounces.
The total outstanding national debt has been climbing as a percentage of GNP since 1980, as refinancing of past debt proceeds at higher interest rates. The ratio of debt to GNP is now 56.9% compared to 34.2% in 1980, but still well below the 125% at the end of World War II. As long as the Fed does not succumb to devaluation pressures in the future, this process will reverse itself in the next 20 years. As debt issued at high rates matures and is refinanced at low rates, debt service costs will automatically shrink the debt/GNP ratio, even if the government does not cut into defense or social spending.
We came to this understanding in studying Mexico's economy this past year. Mexican economists understand the phenomenon because their inflation experience has been several orders of magnitude beyond ours. The cycle of devaluations had sent debt-service costs soaring in Mexico, with the deficit exceeding 12% of GNP in 1988. As President Salinas has broken that cycle, debt-service costs have plunged, and the deficit is now running at 1% of GNP. The government economists in the Mexican government we are in touch with are watching the Bush budget crisis with amusement.
The danger in the phony crisis being fomented is that it forces the President in the direction of bad policy formulation. He has to sound like Herbert Hoover in talking about higher taxes and deep spending cuts. And at the same time, his economic team is beating on the Fed for easy money — just as Richard Nixon and Jimmy Carter did. This, of course, would simply send the price of gold up and the value of the dollar down, pushing up long term interest rates and the costs of debt service.
The President is prevented from actually taking really destructive policy steps by several factors. Foremost is his commitment to a capital gains cut as part of any summit deal. He could swallow a lot of the nasty little tax ideas that are floating around the summit if he could get a decent capgains cut. A second factor protecting the President is the general opposition to tax increases by a majority of House Republicans, who would soften only if Richard Darman got a clearly dynamic capgains cut as part of the deal. The third important factor is the Greenspan Fed's resistance to devaluation policy.
In the absence of a capgains cut, the Fed's intelligent handling of monetary policy this year is the best thing the economy has going for it. This is why the stock market advances this year have been concentrated in the high capitalization stocks, especially the new Nifty Fifty. Note the Dow closing at record highs this week while Nasdaq sells off, no doubt worried that a capgains cut seems a dicier proposition in this "budget crisis." The blue chips benefit relatively more from lower interest rates, because the lion's share of their capital gains are behind them. The low cap Nasdaq stocks have most of their capital gains ahead of them, which is why they will drag until the capgains rate is cut. Then, Nasdaq and the Wilshire 5000 will race ahead of the Dow.
George Gilder tells me venture capital has completely dried up for start-up enterprises below the Nasdaq level. Institutionalized capital is still flowing to young firms that established a footing prior to the 1986 tax reform, but new growth is smothered by the prohibitive capgains tax — which hovers menacingly over any future real and inflated gains. Yes, capitalism has defeated communism, but the U.S. capgains tax now discourages capitalism from being committed here. Most of the economists who advise the Democrats do not grasp this because they are neo-Keynesians, and in a demand model it is unimportant how money gets into the pockets of consumers. This leads to the proposition that capital gains should be treated as ordinary income.
How the "budget crisis" plays out in the next several days could be critical to the immediate future of American capitalism. We hope, with The Wall Street Journal, that Richard Darman (alias "Richard Stockman" in this morning's editorial) has something clever up his sleeve and somehow produces a palatable outcome. If not, the gridlock will have to be settled by pure partisan politics, and that's where entrepreneurial capitalism wins over class warfare.