Budget collapse: too much free money

A view from America, previously published at The American Spectator.

The super-committee of Congress is the latest group to confess abject defeat by the Treasury budget deficit. Who can be surprised by this total failure? During the past generation Congress has made as many as fifteen legislative attempts to control government spending — aimed ultimately at a balanced budget. The most notable efforts were those sponsored by the all-time budget hawk, Senator Phil Gramm of Texas. But every administrative and legislative effort by the authorities, no matter how well-intentioned, has collapsed. Why is this so?

Nobel economist Milton Friedman believed the solution to the budget deficit problem was to deny Congress tax revenues. So he advised Congressmen and Presidents to oppose all tax increases — thereby denying bloated government the funds with which to increase spending. But Friedman’s advice has failed, too. We know this because marginal tax rates have been reduced from as high as 70% in 1964 to 15-20-39% in 2011 — depending on the type of income. But congressional spending has nevertheless increased every year — such that, today, only 60% of the Federal budget is financed by taxes, the remainder by Treasury debt. Total direct Federal debt is now about equal to total U.S. output.

The intractable budget deficit and the inexorable rise of government spending has a simpler explanation. Congress and the Treasury are in possession of several open-ended charge accounts — “permanent credit card financing” — with no limits. With its charge cards the Treasury can borrow new credit (money) from the banking system — much of what it needs every year to finance the ever-rising budget deficit.

A look at the current Federal Reserve Balance Sheet shows that the Fed has created about $1.7 trillion of new credit (money) with which to purchase Treasury debt. Foreign central banks have created about $2.7 trillion of new credit to purchase U.S. Treasury bonds. This global, electronic, money-printing exercise has financed almost 30% of the total direct debt of the U.S. Treasury. In 2002, Ben Bernanke, now Chairman of the Fed, did not mince words to describe this process:

[U]nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…. [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

He might have added that these “no cost” dollars, printed by the Fed, are the enablers of the perennial U.S. budget deficit.

But the Fed is not the only credit card used by the Treasury to finance the budget deficit. Because the dollar is the world’s reserve currency, foreign central banks also finance U.S. budget deficits (as the custody account of the Fed balance sheet shows). Domestic and foreign commercial banks, too, supply vast amounts of new credit to the U.S. Treasury because domestic, foreign, and international bank regulators, such as the Basel authorities, define U.S. sovereign bonds as high quality assets for which bank reserves are not necessary. Therefore financial institutions can qualify their overleveraged balance sheets by loading up on Treasury Securities. Indeed, only 10-20% of the total direct debt of the U.S. Treasury is now owned by the non-bank, non-government private market. Given the reserve currency role of the dollar, the Federal Reserve and foreign central banks have been given every institutional incentive to finance the U.S. budget deficit. Beginning with World War I, every monetary discipline has been removed by domestic and international authorities, such that runaway government spending everywhere relies on the ultimate credit card — newly created money in the banking system.

The simplest solution to the government spending problem in Congress is “to tear up” its credit cards. The way to do this is not with ad hoc and unavailing administrative patchworks, all of which are nullified by world banking system credit made available to the U.S. Treasury. Instead, the effective democratic solution is authorized by the U.S. Constitution — in Article I, Sections 8 and 10: — whereby the control of the supply of dollars is entrusted to the hands of the people — where it stayed for most of American history, especially from 1792 to 1914. This was America’s longest period of rapid, non-inflationary, economic growth — almost 4% annually, with the budget under control except wartime.

Congress need only mobilize its unique, Article I, constitutional power “to coin money and regulate the value thereof.” From 1792 to 1971 Congress defined by law the gold value of the currency such that paper dollars and bank demand deposits were convertible to their gold equivalent — by the people (1792-1914) and/or by governments (1933-1971). Congress should exercise this constitutional power to restore dollar-gold convertibility, because of the proven budgetary and economic growth benefits of a dollar as good as gold.

First, the discipline of convertibility would automatically set the limit on Treasury access to its Federal Reserve credit card. If the Federal Reserve created more money than participants in the market wanted to hold, people would get rid of the inflationary excess by promptly exchanging paper and credit money for the gold equivalent. But under the true gold standard, the Fed and the commercial banks would be required by law to maintain dollar-gold convertibility at the statutory gold-dollar parity — or suffer insolvency. In order to maintain dollar convertibility to gold, the Fed and the commercial banks must reduce the quantity of money and credit, including credit to the Treasury — thus controlling government spending increases and inflation.

Second, the empirical evidence of American economic history also shows that convertibility to gold stabilizes the value of the dollar. The same evidence shows that a stable dollar also stabilizes the general price level over the long run. For example, under the gold standard, the price level in 1914 was at almost exactly the same level as it was in 1879 and in 1834. There was no long term inflation, even over an 80 year period! But from 1971 — Nixon’s termination of dollar-gold convertibility — until 2011, the purchasing power of the dollar (adjusted by the CPI) has fallen 85% in a 40 year period.

Third, gold convertibility of the dollar leads to a vast outpouring of savings from inflation hedges such as commodities, farmland, art, antiques — almost anything perceived to be a better store of value than depreciating paper currencies. Stable money also creates incentives to save from income. Combined with the global release of trillions of hoarded, inert, unproductive inflation hedges, convertibility triggers new savings which would pour into the productive investment market. The new investment would give rise to a general economic expansion — through new business, new products, new plant and equipment, creating thereby a renewed demand for labor to work the expanding production facilities.

The restoration of a dollar worth its weight in gold provides not only a missing and necessary brake on government spending, but a stable dollar supplies the missing steering wheel by which to guide the immense, hoarded savings into long-term productive investment. Dollar convertibility to gold is the simple, institutional financial reform which terminates the fear of rapid inflation — thus transforming unproductive, store-of-value hedges into real investment capital with which to inaugurate a new American era of rapid economic and employment growth.