To be fair, the gloomy budgetary picture is not entirely Obama’s fault. His is just the latest administration unwilling to tackle serious fiscal challenges. While bailouts and stimulus programs compounded the problem, its source is the big three transfer programs — Social Security, Medicare, and Medicaid. Together, these programs consume approximately 10 percent of U.S. gross domestic product. By 2052 they will reach 18.2 percent of GDP and, assuming tax collections remain at their long‐term levels, will absorb all federal tax revenue collected by the government. In other words, no discretionary spending and no defense spending will be possible by 2052 unless tax revenue increases or the government slashes benefits to these three programs.
BREAD AND CIRCUSES
An inevitable crisis seems the almost certain outcome of America’s deficits and debts. The massive increases in transfer spending, coupled with steady growth in discretionary and defense spending, mean that large deficits will haunt America for the foreseeable future. Deficits occur when government expenditures exceed tax revenues, leading to higher interest rates and crowding out private investment. They generate unpredictability in policy, as they herald rising taxes. Since deficits cannot be left unpaid, governments normally finance them by issuing bonds that promise to repay the principal (with interest) over a period of time.
Most troubling, deficits add to our already high federal debt. Publicly held debt currently stands near 60 percent of GDP and, according to the Congressional Budget Office, will rise to 90 percent by 2021. As debt rises, interest rates rise, taxes on future generations rise, and politicians inflate the currency to hide their profligate spending. To pay off this debt, the government must run surpluses, which occur when tax revenues exceed spending. If the government is unable to generate surpluses, a third and far more dangerous option can be employed to eliminate long‐term debt: debasing the currency.
Debasement is the “pretend payment” of debt that occurs when governments inflate their currency by printing money. It’s a problem of nearly every government, from the “bread and circuses” of ancient times through today. In the 18th century, governments debased their currencies by trimming metal coins and recirculating them. By making a coin worth less in real terms, governments throughout Europe were able to spend beyond their means. “The honour of a state is surely very poorly provided for,” Adam Smith wrote in 1776, “when in order to cover the disgrace of real bankruptcy, it has recourse to a juggling trick of this kind.”
Today, paper money limits governments’ ability to physically trim the edges of metal coins. But by printing money to pay off debts, governments debase the currency and ultimately erode its purchasing power. Simply put, they are using a slight variation of the same “juggling trick” to achieve their ends: by pushing the debt problem into the future, they hide the full cost of repayment to the public.
As a result, the symptoms of debasement are not always easy to recognize. Yet several recent indicators have been revealing. The Federal Reserve’s balance sheet, for instance, has expanded from its long‐established level of $800 billion to $2.9 trillion. This expansion in the money supply helped fuel a bond market rally that resulted in artificially low Treasury yields. The Fed’s direct interventions into the mortgage‐backed security market have held mortgage rates at record lows as well. By purchasing toxic assets private investors weren’t interested in, the Fed artificially expanded the money supply. As more money entered the system, prices rose and each dollar lost some of its value.
Inflation is always and everywhere the result of monetary expansions, and its pernicious effects are becoming palpable. Commodity prices are all nearly twice as high as they were in 2008. Prices for education and health care continue to rise rapidly. Consumer price increases, when food and energy are included, are well above levels a central bank would normally be comfortable with. And prices for technologies like cell phones, personal computers, and televisions are not falling as rapidly as they should be.
The distortions in these prices indicate that debasement is already taking place — and it stems from problems that economists have been warning about for decades.
Historically, the public accepted deficits and debts only in response to major wars and huge economic crises. During World War II, for example, public debt increased to nearly 109 percent of GDP. Yet after the war, the government made a concerted effort to pay down the debt, reducing it to 50 percent of GDP by 1956 and 24 percent by 1974. The experience of the last 30 years, however, shows that deficit spending is no longer an emergency response to catastrophe. In 1980, America’s total national debt stood at $1 trillion. Over the next three decades, it grew 14- fold — without a major depression or world war. Deficit spending has become business as usual, and we’re quickly approaching the point where repayment is impossible.
HOLDING A TIGER BY THE TAIL
Politicians are unable to address our current fiscal challenges in part because they rely on flawed Keynesian arguments to justify their spending. Simplistic Keynesianism argues for greater government spending when the economy softens, followed by spending cuts when the economy returns to growth. But this rests on the crucial assumption that politicians act benevolently, in the interest of the overall economy. It assumes politicians will exercise fiscal restraint.
The historical record since Lyndon B. Johnson’s “Great Society” suggests otherwise: politicians, regardless of party, do not follow Keynesian assumptions. Instead, they spend during the bad times and during the good times. There are, of course, good public choice reasons why politicians cling to Keynes: he offers an economic justification for promising everyone everything! Politicians therefore achieve success through a simple mantra: “Spend ‘em if you got ‘em, and spend ‘em if you don’t.”
Government officials don’t want to lose popularity by raising taxes and cutting spending. Instead, they employ juggling tricks to give the illusion of paying their bills. The Treasury finances government expenditures by floating bonds to the public, and the Federal Reserve steps in as buyer whenever the Treasury is unhappy with the market interest rate. The process is referred to as monetization, but really it’s debasement, and it stems in part from the fact that it is difficult to keep the Fed and the Treasury separate.
In fact, some have said that the idea of a separate Fed and Treasury is utopian, that the two offices within government will remain forever entangled. The 1974 Nobel Prize winner in economics, F. A. Hayek, called the monetary and fiscal policy dance an exercise in “holding a tiger by the tail.” In 1969, while discussing the broad, inflation‐borne prosperity affecting Venezuela and much of the Western world, Hayek said: