Back-to-back administrations in the late 70s and 80s were unable to prevent the specter of stagflation from taking over the economy. Although every macroeconomic policy under the sun was attempted, and both Carter and Reagan were undermined by sea change in America’s debt structure, the increasing sale of national debt to foreign governments to finance further deficit spending.
What is stagflation?
Stagflation is both stagnant economic growth and inflationary pressure (when the money supply artificially increases the value of one unit of currency). It is an unusual phenomenon because most weak economies do not produce enough growth to cause dangerous inflation.
The Cause of Stagflation
Stagflation occurs when the government expands monetary supply while the jobs market is weak. The money supply can be expanded by the printing of money or the sale of national debt, especially when there is no limit to the amount of money that can be printed. As it happened, automation was taking hold of the economy as early as the 1950’s. And the US government simultaneously sold massive amounts of debt to foreign entities.
When a foreign government buys America’s Treasury Bonds, they are essentially paying for America’s government spending, so that they can be paid back later with interest. This artificially empowers the government to spend money that the economy did not earn. America’s economy at the time was not structured to take advantage of the strong dollar created by foreign countries buying America’s national debt.
The Carter Administration
The Carter administration was, in many ways, the scape goat for stagflation in the later 1970s. Thanks to easy money policies of the Fed and the doubling of crude oil prices in 1979, the economy saw double-digit price increases and rising unemployment. Carter felt obligated to implement stricter price controls than Nixon had implemented, which only squeezed small and medium-sized businesses even more.
The Reagan Administration
Ronald Reagan won the presidency by promising a cut in taxes and regulation. Reagan pledged to a laissez-faire approach would re-ignite the consumer market.
Despite cuts in many areas, Reagan was unable to fight against the effects of foreign owned government debt. No amount of tax cuts could prevent the government from deficit spending. Under Reagan, the national debt nearly tripled from USD 997 in 1981 to USD 7.8 trillion in 1989.
Why were two administrations unable to turn the economy around? The answer can be found in the sale of national debt to foreign governments to fund deficit spending. By Reagan’s second term the economic recovery was fueled by cheap imports, credit card spending and a retail boom. At this point America’s citizens had adjusted and were taking advantage of the new economic possibilities of a strong dollar and government that borrows money from foreign entities. Reagan professed the virtue of a strong dollar.
Selling National Debt: The Secret Policy that Propelled Stagflation
Finding answers to explain why the American economy tanked in the 70s and 80s is difficult if you only look at the official monetary policy of the Fed.
The infamous 20% fund rate implemented by Volker in 1980 is heralded as a bold policy to save the economy from disaster. Ultimately, it transferred all the economic pressure to tax paying citizens and created a recession. All the while, the fed’s monetary policy sanctioned the sale of national debt to finance further deficit spending. The high interest rates made the dollar even more valuable forcing the American economy to import cheap foreign goods and transition the economy to depend on it for growth. The transition meant the upheaval of almost every citizen who had to figure out a new way to make a living.
Until the 1970s, foreign nations owned less than 5% of the national debt. As the American economy began to sag in the 70s, this percentage began to rise. By 1975 it was at 17%. Foreign governments are not stupid their strategy is to prop up the American economy with debt, so they can sell their cheap products now and eventually they will collect their debt with interest. Thirty years on, and the international ownership of US assets has increased dramatically.
Many consider post WWII a period of virtuous economic expansion in America. The national debt built up through the war was dramatically paid down through high taxes and an expanding economy after the war. The debt built up during WWII was owned by American citizens when the debt was paid back it went to the citizens who used the money to spend, expanding the economy. This is very different from the mess we find ourselves in today.
Five Reasons Foreign Owned National Debt is Addicting to the American Government
- Expanding the national debt allows for lower tax rates for the wealthy. The wealthy pay for the campaigns of America’s politicians. In essence, it’s almost impossible to be elected to higher office without the backing of wealthy sponsors who want lower tax rates.
- Lobbyists are paid by wealthy American’s to get congress to pass legislation important to their business interests. Congressmen often take part in the benefits that the businesses receive from the passed legislation. This is why many politicians leave office wealthier then when they entered office. Many tax loopholes are written into legislation by lobbyists, while it’s great for their business interests its terrible for the deficit.
- Low Interest Rates: When foreign countries buy American debt, they essentially hold off on buying American goods and services. This makes the American dollar go up in value since the American government is being paid for by another country. In a global economy, the government benefits because it keeps inflation down as products from other countries are less expensive. This allows the federal reserve to keep interest rates low and that allows the economy to grow from more borrowing.
- Debt is Cheap: As foreign governments buy American debt the dollar gains buying power which reduces inflation. Reduced inflation means the Federal Reserve can lower interest rates on loans. These interest rates represent the cost of borrowing money. A lower interest rates means the governments cost to borrow money is less. This makes running a deficit seem reasonable even attractive.
- A strong dollar benefits business in a global economy. A strong dollar allows businesses to take advantage of lower labor costs and lower costs of raw materials. In turn, businesses tell their lobbyists to promote a strong dollar which indirectly means deficit spending.
Like a Heroin Addict the Pain of Withdrawal will get Ugly
America’s dominance is now significantly based on borrowing from foreign countries. The deficit is paying for our military, wars and tax cuts. The wealthy are roaring like the 1920’s and our military is flexing its power all over the world. For some these are indeed roaring years.
But like a strung-out junkie, the high doesn’t last forever, the illusion of great wealth and power are not real when its paid for with borrowed money from a foreign country. Unlike the virtuous American own debt of WWII which ignited our economy when repaid, the current debt built up by our government will stifle and sniff out the American economy of the future. As the American economy is burdened with debt repayments less money will be available to expand the economy. Therefore, the economy will most likely shrink which means fewer jobs. Fewer jobs means lower pay. As the American dollar depreciates our dependence on foreign products becomes a liability that will set off inflation. The inflation will cause the federal reserve to raise interest rates. The cost of borrowing will go up which means the economy will shrink even further with even fewer jobs.
The real sting will be felt in the stock markets. Higher interest rates mean that buying debt will be more attractive then investing in stocks. Imagine, there will be little reason to invest in stocks when your savings account is yielding 7,10 or 15 percent in interest. This will mean that stocks trading at their current level of 20 times earnings will not be attractive until they are trading at 7, 5 or 4 times earnings.
Perhaps you are willing to wager that quantitative easing will once again save the day like it did in 2008 and the years that followed. If quantitative easing is tried while foreign governments are looking to debase the dollar, which would allow them to buy American products and assets at a discount, quantitative easing would only add fuel to the fire. Interest rates would indeed go down and the stock market would be artificially propped up once again. However, this would be at a steep cost to the value of the dollar which would see a dramatic decline relative to foreign currencies. The liquidation of American assets would begin just like it did for Greece when their debt burden become too big and unsustainable.
The last hope for America would be the great status of the American dollar as the default reserve of global trade. The truth of the matter is that the American dollar has been used to suppress the economies of foreign countries since the IMF was established at Bretton Woods. The IMF made loans that had to be repaid in dollars trapping dozens of third world countries with debt that they could never repay. However, a devalued dollar would allow these debts to be repaid at a discount and the rest of the world would be happy to dump the dollar burden that they have lived under for all these years. These repayments would actually trigger a further slide in the value of the dollar.
Nixon’s Deal with the Devil
The trouble began when Nixon took office. Global trade was taking off and America was buying. Countries like Japan, France and Germany were exporting cars and goods into America and the stock pile of American Dollars was piling up. At the time these governments had several choices. They could buy American products, they could buy American debt, or they could buy America’s gold reserves. Nixon did not want to sell America’s gold reserves and America’s products were too expensive. This left our national debt as the only alternative. When Nixon refused to sell the gold, he effectively made the dollar not have a gold guarantee. In essence, the dollar was worth a dollar and not worth any gold, this is called FIAT money or a free-floating currency.
The Federal Reserve IS the Devil
In Nixon’s defense America would have eventually run out of gold. The real culprit is the inflexible policies of the Federal Reserve. The Federal Reserve is owned and operated by commercial banks. Their main objective is to keep the financial sector healthy which is made up of the commercial banks, a glaring conflict of America’s interest. The banks benefit from the sale of debt. They make money from selling financial products like treasury bonds. Nixon’s greatest mistake was to not recognize that the federal reserve had put America’s economy in a box.
The Federal Reserve’s Impotence
Many people think that quantitative easing is a powerful weapon the Federal Reserve can wield to save America from a future financial collapse, a repeat of the Great Recession. The truth is that quantitative easing is a trick that only works as long as the dollar is held in reserve of our trading partners. The value of the dollar is completely dependent on the FX exchange which means international trade and money flows. If the dollar starts flowing back into America while the Federal Reserve is pursuing quantitative easing, then look out the ‘big fall’ will be triggered.
Many people condemn President Carter for his policies but the economy he inherited was already deep into borrowing from foreign countries. It was President Nixon that was in power when the trouble began. Reagan and Volker added fuel to the fire with tax cuts and sky-high interest rates. Now Trump is trying to repeat what Reagan has done with Tax cuts and interest rate hikes; it’s like letting the drug addicts into the pharmacy. This may very well set up America for the ‘big fall’ as the reckoning of debt payments come due. The tragic irony is that, when foreign governments come to redeem their assets, it will fall on the taxpayer who have to figure out how to foot the bill.
This will likely mean a very large portion of everyone’s work will be undervalued and funneled towards debt repayment and that sounds like pain to me. The only way to get real money into the hands of consumers is to simplify the inputs to the economy once and for all before our foreign debt bearers come to cash in on our years of exuberant borrowing.