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The federal deficit: the real issues.

Behind the fuss and fury over current U.S. budget deficits looms a crucial paradox that frustrates our economic pundits, financiers, and politicos.

On the one hand, the United States has been relying more and more on budget deficits to keep the economy afloat. Washington has operated with red ink in 23 of the past 25 years, thus providing a prop to an economy that has been sliding into stagnation during much of the post-Second World War period. One of the most astute and outspoken business economists, Albert Wojnilower of the First Boston Corporation, hit the nail on the head when he said: "I think the budget deficit is what stands between us, is a large part of what has stood and will be standing between us and a depression with a capital D." (Barron's, November 8, 1982)

On the other hand, the stimulation generated by unending and ever more red ink is self-limiting. Deficits piled on top of deficits provide fuel for new inflationary spirals and help sustain high interest rates; and at the same time they set in motion forces that eventually arrest growth and lead to a new business decline. In short, today's capitalism finds itself on the horns of a dilemma: it can't live without deficits and it can't live with them.

This impasse has led to a great deal of confusion and even more obfuscation. Unable tr unwilling to face up to real causes behind the unending flow of red ink, the conventional wisdom has turned on the deficit as the root of all evil. Capitalists don't invest, interest rates are high, prices go up--all because of the deficit. The truth lies elsewhere; growing and persistent deficits are not the cause but the product of stagnating investment, high interest rates, and the inflationary pressures of monopoly capital.

In a period of vigorous economic growth, budget deficits to be balanced by surpluses. Deficits are normally produced by recessions, since tax collections contract as unemployment grows and profits fall while expenditures rise to meet increased unemployment benefits and welfare payments. This process is reversed during recoveries, with resultant budgetary surpluses. This wave-like motion of government finance characterized the early stages of the long period of post-Second World War prosperity. Deficit years alternated with surplus years from 1947 through the 1950s. But that changed as the wave of prosperity began to taper off in the 1960s. Deficits, swollen by spending for the Vietnam war, began to be the order of the day. Still the deficit remained relatively small.

As stagnation set in during the 1970s, however, a new pattern emerged: deficits not only became a fixed feature of the U.S. economy but kept growing in importance as a stimulating factor in the upward as well as the downward phases of the business cycle. And it was in the 1970s that the financial community and the academic experts began to focus on the deficit as the alibi for the economic slowdown. Private investment (and hence economic growth) was constrained, it was and still is claimed, because savings were sufficient to finance both the deficit and capital investment. The deficit was supposed to be crowding out the supply of funds that would otherwise be used for capacity expansion and new jobs. But this was putting the cart before the horse. It was, in fact, the faltering of capital investment that set the stage for ever larger deficits and other government policies designed to fill the gap in effective demand.

The story is told in Table 1. The key to what happened is the steady decline in the rate of growth of investment in residential construction, nonresidential structures, and producers' durable equipment, as shown in column 2. From one five-year period to the next the rate of growth in investment declined markedly. And as the investment slowed down, the deficit (adjusted for price increases) kept rising rapidly (column 3).

In the 1960s capital investment was still strong and the deficit as a percent of fixed investment (column 4) was small. But note how rapidly that percentage kept mounting during the 1970s and thus far in the 1980s, reaching over 24 percent in the last four years. The implication of Table 1 is quite different from the current illusion that the deficit is "crowding out" investment. The real relationship is the opposite: the ever-growing deficit was not able to arrest the course of stagnation. And the pressures brought about by stagnation in turn were such that an expanding deficit became more and more essential to forestall a major depression.

But "crowding out" is not the only dire consequence for which deficits are the alleged cause: they are also routinely being blamed for high interest rates. We will show below that the basic cause of the upward trend in interest rates has an entirely different origin. This is not to deny that deficits do in fact contribute to sustaining high interest rates, but the really significant relationship between the two variables runs in the opposite direction, i.e., from the level of interest rates to the size of the deficit. The steady diet of deficits has produced a phenomenal rise in the accumulated federal debt--from $382.6 billion in 1970 to $1,381.9 billion in 1983, or a 261 percent expansion. A large portion of this debt is in short-term securities that must be continuously refinanced at ever higher interest rates. The combination of an exploding debt and mounting interest rates has made "the cost of servicing the U.S. debt the fastest rising component of government spending." (Business Week, January 16, 1984)

To appreciate the full significance of the growing interest burden, it is worth noting that the increase in interest payments on the federal debt since President Reagan took office exceeds all of his administration's budget cuts in health, education, and welfare programs. This point was highlighted in a NEw York Times (February 5, 1984) report on the 1985 budget:

Under Mr. Reagan's 1985 budget, sent to Congress this week, the government would pay $116.1 billion in interest on the debt, or $47.4 billion more than the amount spent for the same purpose in 1981. The Congressional Budget Office estimates legislative changes since January 1981 have reduced Federal spending on social welfare programs $39.6 billion below what it would otherwise have been in 1985.

For the four-year period from 1982 through 1985, the Congressional Budget Office estimated the cumulative total of all savings in social welfare programs at $110 billion. That is less than the $124 billion increase in spending on interest paymetns required over the same four-year period. Thus, savings in domestic programs have been swallowed up by higher interest costs.

The data on interest payments in the budget are given in Table 2. There we can see that these payments on the federal debt rose five-fold in the past ten years--from $21.7 billion in 1975 to $108.6 billion in 1984. This growth has far exceeded the rate of increase in total expenditures. A comparison between the two is made in the last column of the table, where it can be seen that interest payments as a percent of federal expenditures almost doubled, from 6.6 percent in 1975 to 12.4 percent in the current fiscal year. This trend is bound to continue if present policies are unchanged. With projected deficits in the range of $200 billion a year, the Congressional Budget Office estimates that the federal debt will climb another $1,000 billion in five years. Assuming interest rates of 10 percent, that would mean an interest burden in excess of $200 billion a year (more than the government now spends on social security). In other words, if present trends continue, the interest share of the budget may before long reach 25 percent--a doubling of that ratio in the next five years as compared with a doubling in the preceding ten years.

But are the high interest rates that impose such a heavy burden on the budget inevitable? What happened during the Second World War proves beyond a shadow of doubt that they are not. In the war years from 1942 to 1945, the average annual deficit was 23 percent of Gross National Product, and of course that was a time when available economic resources were stretched to the limit. Yet the interest rate on three-month Treasury bills in those years was less than one-half of 1 percent, and on highest-grade corporate bonds it was less than 3 percent. Thus far in the 1980s, in contrast, the average annual deficit has been only 3.8 percent of GNP, and there has been plenty of slack in the economy (at least 10 million unemployed and a quarter of manufacturing capacity idle). Yet the average interest rate has been over 11 percent on three-month U.S. Treasury bills and 13 percent on AAA corporation bonds.

Why this startling contrast? The fundamental reason is a whole series of changes in government policy. The Roosevelt administration was determined to minimize the cost of carrying the war debt, and to this end Federal Reserve and Treasury policies were concentrated on keeping the interest rate below a set maximum. The practices of postwar administrations, to put it mildly, have been just he opposite. Credit expansion and a burgeoning financial sector played a unique role in prolonging the postwar wave of prosperity. But the reforms of the banking system enacted during the 1930s often stood in the way. Washington, bending to the pressures of the financial community, gradually dismantled the apparatus created by the New Deal to control the banking system and to keep a lid on interest rates. With the barriers removed, interest rates soared to amazingly new heights, and these higher levels became embedded in the financial system.

The upshot of the mushrooming financial sector, supported by the progressive deregulation of the credit system, can be seen in the accompanying chart that depicts the course of interest rates on three-month Treasury bills from 1945 to 1983. The wavelike motion of the line on the chart reflects cyclical changes in the demand for credit. But what is noteworthy is the underlying upward trend. While each recession brings down interest rates, the ensuing recovery more than compensates for the preceding decline and leads to a new peak. Behind this pattern is a combination of factors: an unrelenting expansion of debt, a proliferation of financial institutions, and the removal of government controls.

The policies implemented by the New Deal forbade interest payments by banks on insured checking accounts. Furthermore, the Federal Reserve Board and the Federal Deposit Insurance Corporation set maximum rates of interest that banks could pay on insured savings deposits. The reason for these regulations was to prevent a recurrence of the banking disaster of the 1930s. Fierce competition during the 1920s had led banks to keep on raising interest payments to attract deposits. But to earn enough to cover these interest payments and still make a profit, the banks extended risky high-interest loans. The onset of the 1930s depression produced a multiplicity of defaults, especially by the high-risk borrowers, and a consequent inability of banks to return depositors' funds.

The memory of the resulting banking crisis weighed heavily on the minds of government officials and Congress. Hence, although controls were eased shortly after the end of the war, the basic New Deal laws and practices remained in effect. But the pressures of a ballooning financial system eventually broke through the barriers. The number and type of unregulated financial firms multiplied. Seeking to compete by offering higher interest rates, they drew deposits away from commercial and savings banks. The insured banks, faced with a loss of profit-making opportunities, counteracted by devising ways of getting around government restrictions. For example, they introduced the "repurchase agreement" instrument, which enables banks to compete for funds from large depositors by selling government securities in their portfolios with a guarantee to buy them back at a fixed time and price, thus assuring an attractive return to those who in this way lend money to the banks under the guise of buying securities. These contracts were not subject to the Fed's reserve requirements, nor, more importantly, to the Fed's interest-ceiling regulations. Another innovation was the negotiable certificate of deposit issued in large denominations and at higher interest rates than the maximum set for savings deposits.

What followed was a flow of deposits and investments back and forth from one financial firm to another and from one money market instrument to another. Hence despite regulations designed to restrict competition and reckless expansion of credit, fierce rivalry ensued.

In this way the imperatives of competition drive the banks and other financial institutions to play the game by raising interest rates to attract funds and then charging still higher rates on the loans they make. Here is a simple illustration of what takes place. A money market fund offers high interest rates than can be obtained at a bank. Deposits then begin to move from banks to the money fund. In order to replace the lost deposits, the banks offer large certificates of deposit (CDs) with still higher interest rates. The money market fund then buys the CDs, enabling them to hold on to their investors. This kind of circular flow of funds both swells the financial sector and at the same time keeps the interest rate jumping from one peak to another.

All this has been happening with Washington's open or tacit approval, often given under the threat of an imminent financial collapse. The growing reliance of the business community on debt and the aggressive expansion of the financial sector have given rise to a number of near-crises in financial markets. Sometimes these were caused by a temporary drying-up of the supply of credit when corporations needed to continue borrowing to service past debts and to keep their heads above water. There were also times when bankruptcies or near-bankruptcies contained the potential of a chain reaction that would cause disaster in financial markets, as for example Penn Central in 1970; Franklin National Bank and a number of real estate investment trusts in 1974; the Hunt Brothers, First Pennsylvania Bank, and Chrysler in 1980. At each of these critical junctures, the Fed acted to save the banks by feeding funds to them to improve their liquidity, liberalizing interest rate restrictions, and legitimizing the devices already adopted by banks to get around regulations.

Finally, Congress put its stamp of approval on deregulation, for all practical purposes lifting whatever barriers to competition and climbing interest rates remained. As a consequence of the Depositary Institution Deregulation and Monetary Control Act of 1980, interest-rate ceilings were removed on all bank deposits except for accounts less than $2,500 maturing within 31 days. The Garn-St. Germain Depositary Institutions Act of 1982 permitted banks to open money market accounts competitive with money market mutual funds. The door has thus been fully opened to the competitive struggle over the entire spectrum of financial firms--the kind of rivalry that stimulates the expansion of credit and keeps interest rates in the stratosphere.

Set against this history, it certainly makes no sense to identify the government deficit as the culprit. This is not to deny that financing present and contemplated deficits will contribute to sustaining high interest rates and may help push them to even higher levels. But the underlying process is at work regardless of deficits. At bottom the reason for the highest interest rate levels in the past century is located in the financial superstructure that has emerged in recent decades--one that evolved with the collusion, if not the encouragement, of past and present administrations, Democratic as well as Republican.

Washington not only helped remove the lid on interest rates but has gone along with an explosion of speculative markets and activity that are exercising an important influence on the structure of interest rates. This upsurge in speculation is summarized in Table 3. Back in 1960 the buying and selling of contracts involving bets on the course of future prices was confined to commodities, primarily such agricultural products as soybeans, grains, and livestock. The total number of such contracts traded in the traditional futures markets amounted to 3.9 million in 1960. But that was peanuts compared to what has been happening in the past ten years. In the second half of the 1970s, in a context of deepening stagnation, futures markets were established in precious metals, foreign currency, and financial instruments, to be followed in early 1980 by contracts on future fluctuations in the average of stock prices. The phenomenal outburst of speculation can be seen in the almost fourfold increase in the number of futures contracts traded, from 36.9 million in 1976 to 140 million in 1983.

Especially noteworthy is the flowering of the futures market in financial instruments. The latter include Treasury bonds, negotiable CDs, and Government National Mortgage Association (Ginnie Mae) mortgage-based securities. The technical differences among these need not concern us here. What is relevant is that they are all vehicles for gambling on the future course of interest rates. The amount of money advanced by speculators is relatively small because of the narrow margins required. But the volume of financial instruments traded and subject to speculative fluctuations is enormous. Thus the value of the 28.1 million contracts turned over in 1983 on financial-instrument futures amounts to over $7 trillion, or close to $28 billion a day. In these circumstances the question of how much deficits influence interest rates is removed from the realm of objective analysis of supply and demand factors and transferred to that of the subjective fantasies of speculators. Similarly, the "crowding out" issue takes on a different dimension. According to Business Week (September 15, 1980):

Swarms of U.S. and foreign investors, both institutional and individual, are rushing into futures because of the small margin required and because of the variety of contracts being traded. By doing so, they are shifting their dollars away from the traditional capital-formation mainstream--out of investment and into something close to out-and-out gambling.

The U.S. economy, it seems, has reached a stage where, to use Keynes' image, production has become the bubble on speculation rather than speculation being the bubble on production.

Practically all recent discussion of the alleged evils of deficits leaves out what really matters, i.e., the origin and purposes of the deficits. The Reagan-designed deficit mess stems from the simultaneous reduction of taxes on the rich and a monstrous expansion of military spending. At the same time, welfare expenditures have been severely reduced on the pretext that the deficit needs to be contained. The result is a more regressive distribution of income, a dismemberment of New Deal reforms, and a wasting of human and economic resources--not to mention the worldwide devastation that the expanded weaponry can wreak.

But this is not the way it has to be. Deficits can be socially useful and constructive if incurred to provide jobs for the unemployed, strengthen health and education services, construct decent housing, protect the weak and elderly, and restore the country's disintegrating infrastructure.

But, we shall be asked, wouldn't a benign defict also contain the potential for renewed inflation and turmoil in financial markets? Perhaps, if nothing else were done. The fear of deficits rests on the implicit assumption that everything else in the economic system is sacrosanct and only deficits are subject to manipulation. Private ownership of profit-making banks, a huge financial superstructure, and aggressive expansion of these institutions are taken as part of the natural order of things. Similarly it is implicitly assumed that the enormous waste of credit to finance mergers of large corporations, to promote tax-avoidance schemes, and to fuel speculations is unavoidable.

What is true is that the contradictions of capitalism cannot be resolved, let alone, eliminated, without transforming the system from one of production for profit to one of production for use. But this doesn't mean that all reforms are impossible. Much depends on circumstances and on the understanding, organization, and militancy of the vast majority of the people who are victimized by the present system. The rich historical experience accumulated during the periods of the Great Depression and the Second World War has demonstrated that public control over finance and prices can minimize many of the complications incident to large budgetary deficits. But for this the mass of the population would have first to free itself from the blinders imposed by the dominant ideology and unite to fight for its own interests.
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Publication:Monthly Review
Date:Apr 1, 1984
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