The National Debt

PART I
DEFICITS and DEBTS
THE GOVERNMENT'S DEBT--AND OURS
1
"What Is the National Debt, Really?"
When I told a Harvard professor--not an economist but a psychiatrist--about my plans for this book, he brightened visibly and said, "What is the National Debt, really? You'll have to explain that." My purpose, then, is to try to explain such ideas as debt, deficits, and economic adjustment in terms that even a Harvard professor can understand. This is a formidable task, not undertaken lightly, but nevertheless with a sense of public duty as well as a sense of fun. I am not trying to prove anything; but I am trying simply to warn against what could turn into a financial and public catastrophe if we cannot learn to live within our means, provide for our future, and cooperate with our trading partners. This book might not have existed at all if fewer members of the economics priesthood had not secretly shared the attitude of Professor Seymour Harris. In presenting a new style of economics to the American public forty years ago, he wrote, "Many a citizen will never be able to understand fully the problem of the public debt, for it is too complicated for the average layman. On these technical matters he will have to accept the word of the experts."
Economists have been getting off lightly by posing as technicians in white coats, when in reality their useful discipline, stripped of its pretensions, is far from being as forbidding as it seems. It is not a science, and it is no more dismal (Carlyle notwithstanding) and no less ludicrous than most human behavior. It tries to bring order to one aspect of behavior by postulating an ideal type of rational man as if "Everyman were indeed Economic Man," in the neat oxymoron of another Harvard professor, Charles S. Maier, who is a political scientist. Arbitrating the demands of Everyman, especially when the world around him changes, is the task of politics, which is the study of how we want to live. The economic concept of adjustment to technical innovation or changes in the balance of financial power is really a term of art drawn from psychology. Any therapist will tell you that the longer individuals postpone their adjustment to change or misfortune, the more difficult and painful the process will be. This is a technical insight with a moral foundation: when the discipline of economics was invented during the Enlightenment, it was a branch of moral philosophy. In the nineteenth century, it began to be thought of as political economy for thinkers as disparate as Mill and Marx. There is an old saying: politics proposes, economics disposes. Economics defines limits. It is no accident that the most powerful economist in the United States, if not the world, Paul Volcker, the chairman of the Federal Reserve Board, says that his board is "caught in the position of sometimes reminding people of the limits." After a quarter-century of writing about political economy, I have become convinced that the discipline of economics is essentially politics with a few numbers to illuminate its ideas. But not too many. Beware of the man who, like the drunk with a lamppost, uses numbers for support rather than for illumination.
The best economists instinctively know all this and become statesmen. John Maynard Keynes, the brilliant economist who marked this century, changed the way we thought about our national and international economy and laid the intellectual foundations for the greatest period of prosperity the world has everknown. The British government raised him to the peerage for his contributions to wartime finance, but Lord Keynes nevertheless had modest, even humble aspirations for his discipline. In an essay entitled "Economics for Our Grandchildren," he looked forward to the day when most economic problems would be solved, and when economics would be a minor, technical discipline that would help us make painful choices, like dentistry. He wrote: "If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid."
One way to think about the phenomenal growth of the National Debt is to consider it as one price we pay for putting off a visit to the dentist. The flow of deficits we have been running throughout the decade as a nation and as individuals in what Volcker calls "a national binge of borrowing," has run off and collected into a huge swamp of debt. Mark that distinction between deficit and debt: one is what economists call a flow, the other, a stock. Think of deficits as a stream of borrowed money flowing steadily into a huge, stagnant pool of debt. When you run a surplus (which is increasingly rare), the stream flows out of the pool and lowers the level of debt. Some of the gross debt figures are so staggering as to be incomprehensible: 2 trillion dollars owed by the federal government, and rising; 1.5 trillion owed by American corporations; 1.5 trillion owed in home mortgages; 500 billion in installment credit; 300 billion owed in uncollectible debts by third world governments to American banks; and, for the first time since World War I, more owed to foreigners by everyone in America than they owe us. All of which makes that traditional debtor, the American farmer, a relative piker with only about 200 billion outstanding, except that about one-quarter of his debt has gone sour. Salomon Brothers, the huge Wall Street trading house, calculates that by the end of 1986 the pool of debt in the United States had reached $7, 871, 700, 000, 000. 00--just short of a nice round eight trillion dollars or almost twice the gross national product. That represented an increase in everyone's total debt to everyone else by about 11 percent during only one year.It also meant that the level of this debt swamp was rising at about twice the rate of the dollar value of everything produced by the country the year of 1986.
If our debts were to hold steady, even around those awesome levels, the rest of us could catch up with them by the process of economic growth that has come to be considered normal in the modern world. But our debts refuse to stand still. Debt of all kinds has almost doubled in five years, growing twice as fast as our annual income. Such shifts in economic behavior traditionally signal wars, depressions, inflations, or other upheavals. What is underway now, in peacetime and relative prosperity, is unprecedented: perhaps some sort of national delusion, like the South Sea Bubble. For many years, we owed about 40 percent more than we earned. That ratio now has grown to almost 70 percent, largely but not entirely because of the increase in the federal debt. This burden of debt can never really be laid down, because debts of such magnitude can only be paid off by massive transfers of wealth from spenders to savers, and that would stop the economy dead in its tracks. Instead, we will have to carry interest on it. And so will our grandchildren.
In coming generations, debt may simply turn into an ugly four-letter word: resentment over it may distort the way we think about, finance, and organize our society. Credit, which derives from the Latin verb credere, "to believe," is not a term of purely financial application. The word is allied to the quality of credibility, which lately has extended its use into the world of politics, not always in a positive sense. For, make no mistake, debt is not just a simple sinew of commerce but a fundamental relationship of civilization. It must be founded on trust between creditors and borrowers, even when they span generations. Debt is the foundation of capitalism: it is a social contract linking savers, spenders, and investors--the old and the young who together compose the flour and the yeast of society. Debt is the lubrication of society's dreams; it transfers wealth from secure savers to adventurous investors and offers the possibility of enriching them both. It gives a prudent government room for maneuver to helpits citizens in need, and a bold one the leverage to chance its ambitions.
One imaginative economic historian reckons that the foundations for England's foreign treasure were laid by Queen Elizabeth I wisely investing the profits from the expedition of Sir Francis Drake's Golden Hind in 1580. She paid off England's foreign debt, balanced the budget, and invested 40,000 pounds in the new East India Company. Compound interest on that sum would have increased it one-hundred-thousandfold by 1930, when Great Britain's foreign investments stood at about four billion pounds. Yet within a generation they were gone, and Britain was a debtor, its investments burned up in a war for survival.
However sad this tale may be, it bears considerably more nobility than the one we have to tell of America financing its consumer culture by borrowing from its friends abroad and its unborn children. This is a stock of debt with socially destructive potential. Normally, nations, just like companies or families, reduce their debt according to the same principle: by growing out of it. As any businessman knows, if his gross receipts grow faster than his interest costs, he is keeping his head above water. Borrowing to build something bigger or better creates jobs and improves people's lives, and it is the basic rationale for going into debt. That is what happened as we came out of the Golden Age of the postwar world: from 1955 to 1975 the National Debt was steadily reduced as a share of what the nation earned--not by paying off the money, but by amassing more wealth so the burden of debt became relatively lighter.
But then the world turned upside down. Inflation and its aftermath changed the rules. Lyndon Johnson financed the war in Vietnam with the printing press. Richard Nixon helped guarantee his reelection with the same blunt instrument, more subtly used. Poor Gerald Ford and Jimmy Carter, still trying to fine-tune a tradeoff between inflation and unemployment according to their divergent political predilections, were simply overwhelmed. When Ronald Reagan came to office, he brought with him a simplistic, old-fashioned plan to cut everyone's taxes, free up the country'senergies, restore its military strength, and then let nature take its course. The President is a romantic; that is part of his attraction and accounts for a great deal of his charm. He was thinking of the old-fashioned values bred in the limitless opportunities of another age, and he wanted to restore them. Like the frontiersman, he thought we could borrow ourselves rich. We now know, in some inchoate way, that we cannot. The purpose of this book is to explain why that is so and to introduce a sober measure of realism to the ordinary and puzzled reader.




The last generation in America has ridden on an economic roller coaster. First it went upward into inflation in the 1970s, and then down into debt. This left the country vulnerable to forces it can no longer be sure of controlling. Options are limited. Higher taxes are necessary, but they pose a dilemma. If they are imposed to slow the growth of debt, they produce an economy that is more financially stable but simultaneously has less spending power. That would make the economy more sluggish, but also make life in America less promising. Ideally, the air should come out of the debt balloon slowly, so that it does not land on solid ground with a thump. But that means the descent may take a generation. It may well stretch into our children's early adulthood and constrain their opportunities, their hopes, and therefore the tone of our society. Borrowing from foreigners has also constrained our political maneuver. In an extreme case of misrule and stubbornly persistent public illusion, it is not total fantasy to envision our country shredding at the edges like a third world nation, where things are not under our own command. So it is not impossible to discard the possibility that debtors and creditors will lose patience with each other, and that the air in the balloon will all come out with a big whoosh.
There is a fundamental difference between observers who transmit the information and analysis about the world and the people who make things happen without necessarily understanding why they worked that way. If they did ask themselves why, they might realize the risks and probably would never dare totake them. Inevitably, some of them fall off the high wire in real estate, finance, or other risky occupations. One position is that of the skeptic, the other of the believer. They go for the bigger reward, and they rise higher or fall farther; that is the way of the world. To those who see themselves exploring new territory, whether physical, intellectual, or ideological, the skeptic's caveats are a bore. To Mr. Walter Wriston, late of Citicorp, for example, the reservations expressed about his banking practices by Ms. Karin Lissakers, late of the U.S. government, had the annoying ring of a Cassandra. Had Mr. Wriston retained the classical teachings and wisdom of his father, who was president of Brown University, he would not have needed her rejoinder: "He forgot that Cassandra was right." Once in a generation or so, when memory fades of the last time the high wire itself collapsed, the Cassandras do, in fact, turn out to be right. Let us see, then, how long Ronald Reagan can galvanize our society and our credit markets, and whether we are able to do so alone. It is in the nature of life, and the democratic system, that he cannot stay in his bully pulpit spreading optimism forever.
2
Whose Debt Is It?
Almost every week of the year, usually on Monday, the United States government has to go out and buy money. Buy money? When they can print all they want? Well, no. Not if dollar bills are to retain at least some correlation with the value of the goods they can purchase. So the government actually borrows billions of dollars in the money markets to buy things that we want, but for which we cannot always pay with this year's taxes. One example would be something that costs a great deal but must be undertaken with great urgency, such as a war. Another would be something that repays its cost slowly, such as a hydroelectric dam or a cancer research laboratory. When the government buys money, it pays with nothing more than its own promise to pay back later. That is why its promise is called a government security; it is secured only by the full faith and credit of the United States. If the promise lasts for a decade or more, the security is called a bond; if for two to ten years, it is called a note; and if for one year or less, it is called a Treasury bill. Since Treasury bills are the promises that fall due most often, groups of them have to be renewed, or "rolled over," in thequaint terminology of finance, every week. All these promises yield interest, which is how the government pays rent for the use of the money. The rent, of course, is paid by the taxpayers. Like any prudent steward, the government seeks to pay the lowest possible rent.
Several weeks before the government knows it will need large chunks of new money, its operatives start sounding out the big Wall Street houses to determine what kind of rent would make it worth their while. One week in advance, the Treasury announces its terms; it is planning to sell, let's say, $15 billion in bonds and notes to accommodate people who want to park their money with the world's safest borrower for a few years, or perhaps for as long as thirty years to build up a nest egg for retirement. They usually do not buy directly from the government, although they can do so. Instead, they go to a bank or a broker who has bought the bond wholesale at the government's auction. Major bond auctions are important events in the world of finance, because they test the credit of no less than the United States government. They are conducted at least four times a year and usually are spread over several days, starting on a Tuesday. All of the auctions are conducted by the government's own banker, the Federal Reserve System, which has its headquarters in Washington and regional banks in the major commercial cities, such as New York, Chicago, San Francisco, Atlanta. But it is in New York where most of the money is sold, at the forbidding Federal Reserve Bank on Liberty Street in the center of the Wall Street district, which is the financial capital of the world.
Since the government's aim is to obtain use of the money at the lowest possible cost, it conducts a curious kind of auction. Those who promise to pay the most money for their bonds are in effect offering to accept the lowest rate of interest; they win the auction. Follow closely: if you buy a $10,000 bond for $10,050, and that bond pays 10 percent interest a year, you receive $1,000 a year. But the government in fact is paying a rent of only 9.95 percent a year because of the extra money it has received. So why would anyone pay a $50 surcharge for a $10,000 bond? Because if he believes that at the next auction the governmentwill only have to pay 9 percent interest--or $900 a year--a return of $1,000 a year will then look very nice indeed. By contrast, if you think that interest rates are going to go up, and next time the government will have to offer a rent of $1,100 a year for $10,000, you will not offer a surcharge but bid for your bonds at a discount. When the government's accounts are in order, its credit rating tends to be better, and the rent for its money lower. Interest rates on government bonds set the baseline for the cost of credit in the country, so these regular auction sales of the government's debt are one of the most important links between the government and the everyday economy, which also runs on credit.
When billions of dollars in bonds are sold like this in one day, huge amounts of money can be won or lost by guessing what the wholesale price of the bond ought to be, so that it can be resold later at a profit. Guess too low and try to make too big a profit, and you lose the auction because you will receive no bonds. Guess too high, and you have to resell the bonds at a loss to your customers, which means you lose the auction in a different way. This is not just some game for traders: the full faith and credit of the United States is not just an idle cliché. If everybody decides the government is either not to be trusted or trying to get away with too low a rent for its money, nobody buys bonds, and the government either goes out of business, borrows money elsewhere, or prints it up anyway. All of these things have been happening in Latin America for years.
So, it is just before 1 P.M. on a Tuesday. Runners dash into the New York Fed with sealed bids for a share of the bonds. Bids for billions in government securities during the year come from one group of about three dozen big buyers, and some of their names are as familiar to readers of the financial pages as Billy Martin and John McEnroe are to readers of the sports pages: Salomon Brothers; Goldman Sachs; Shearson Lehman. They are known as "primary dealers" because of their size and the amount of regular business they handle to keep the bond market turning over. As such, they rate special telephones at the Fed with direct lines to their offices. That allows each firm to phone in its bid atthe last possible moment to its man stationed at the special phone inside the Fed. In this way, they can avoid being trapped by any sudden change in the bond market. The Japanese, recent buyers in quantity of thirty-year bonds, are trying to join this select group of primary dealers. For the present, however, they must resort to such expedients as that employed on one recent auction day by Nikko Securities. Traders at its New York office parked the chairman's stretch limousine outside the Fed's huge iron front gates, opened up a line by the car's radiotelephone to their thirty-seventh-floor office a few blocks away, and sent in a runner with their bid in a sealed envelope at 12:56 P.M., just before the 1 P.M. deadline.
With the bids assembled, clerks slit open the sealed envelopes, and the Fed quickly starts allocating the bills, notes, and bonds to the winning buyers. Their accounts are later debited by computer, and the government's own bank account at the Fed is credited in the same way. The primary dealers have huge trading rooms, some of them a block long, to retail the bonds they have just bought. The prices appear on flickering monitor screens so mesmerizing to the bond traders that they rarely pause to look out at the stunning panorama of New York Harbor. The bonds are sold in huge batches to banks and pension funds, and a few may even find their way into the classic widows-and-orphans' portfolios. The big-name traders buy and sell among themselves in a perpetual auction: an insignificant piece of news such as the previous month's level of factory orders can affect their view of the economy, which in turn will affect their view of interest rates, which can add or wipe away millions in the value of the bonds within minutes. As the National Debt has increased, and as interest rates have become more volatile, so has the trading in government bonds. Ten years ago, the bonds changed hands twice a year; now they are traded on average once a month. They are hardly recognizable as bonds. No more gilt-edged engraving, even if the buyer insists. For that, he has to go into the retail market and buy an old bond. Except for short-term bills, new government securities now are just entries on a computerized master list.
Inside the Treasury in Washington, the bonds, notes, and bills are entered in the government's accounts. These, too, are stored on computer tapes. While the winning bids were being parceled out, each sale was reported on the Federal Reserve System's communications network, which is hooked into a floor full of computers in an unexciting federal building at 13th and C Streets SW, Washington, D.C. It stands in a windswept urban desert across from the Central Heating and Refrigeration Plant and is appropriately located in an annex to the Treasury's Bureau of Engraving and Printing, where they actually produce dollars. The computers belong to the Treasury's Bureau of Public Debt, and they are detailed to the Division of Public Debt Accounting, where they form the heart of its Financial Accounting Branch. It is these machines that mark the prices of the bonds received by the government as the Fed sells them, note the interest payable, and keep track of the National Debt. About forty people work in the Financial Accounting Branch, but the work of adding up the National Debt is detailed to three or four senior clerks in the Financial Reports Section. The task rotates among them because it is a taxing one, especially as the National Debt continues to grow almost beyond human comprehension. At any moment of the day, however, the section can capture the precise figure. For example, Mrs. Marsha Adams, a handsome black civil servant whose photograph has graced the national magazines, is able to walk down a corridor over some brown government-issue carpeting, open a door with a hand-lettered sign (PLEASE KEEP DOOR CLOSED), and tap a small computer terminal about the same size as those used by the millionaire Wall Street traders to shovel masses of that same debt back and forth among themselves. Out comes the latest figure. On January 5, 1987, the day Congress received history's first trillion-dollar federal budget, the National Debt was $2,218,428,901,299.50, or eight times larger than in 1956, the year that Mrs. Adams was born. When she finishes her work, she goes home to the suburbs in Hyattsville, Maryland, where she helps her schoolboy son with his arithmetic.
So the bottom line of the National Debt is, after all, only amatrix of electronic pulses in a computer, binary charges nestled in the atomic interstices of a silicon chip. They record what the government owes in the most ephemeral manner, as if written in sand. But financial obligations are by definition fragile things. Promissory notes, banker's bills of acceptance, and Treasury bills and bonds have always been called paper. Just paper, because that is what they used to be written on. That gives some indication of how they are simultaneously weak and strong. The computer across from the heating plant could blow a fuse and wipe out the records of the National Debt. The paper could simply be torn up. But the obligation, the debt, would remain. Debt is not a thing; it is a moral concept. By no coincidence is it called a bond, as fragile and as strong as the word implies, part of the skein of human relationships that make society. You cannot touch it or feel it, but you know it is real.
Such paradoxes make the National Debt one of those perennial mysteries, like the Holy Trinity or the Fourteenth Amendment to the Constitution, that are excessively vulnerable to the rhetoric of religious charlatans, political demagogues, presidential candidates, or a combination of all of them. Every presidential candidate from Franklin Roosevelt onward has campaigned on a promise to balance the budget and control the size of the debt. Roosevelt both set and broke the mold when he realized he could not keep his promise, which he made in a stump speech in Pittsburgh in 1932. The best way out, suggested his speechwriter and confidant, Judge Sam Rosenman, might be to deny that he had ever been in Pittsburgh. For as long as I can remember, deficits and the debt they left behind have been subjects best left to politicians and other cranks, while the rest of us have gone about our business of making, and sometimes losing, real money. The National Debt was something so forbidding in concept that it was paradoxically regarded as a trifle, despite its huge size. It has provided occasional employment for cartoonists who enjoy sketching taxpayers clad only in barrels en route to the poorhouse, or piles of pennies reaching as high as some celestial body.
But the size of the debt also has doubled in only about five years. During that period, the government's debt increased bythe same amount that it had earlier grown in only fits and starts during the entire history of the Republic. By any measure, it now is the largest in peacetime history--anyone's history. When Ronald Reagan assumed the presidency in 1981, the National Debt, then about one trillion dollars, would have stretched into a stack of thousand-dollar bills sixty-seven miles high, assuming someone wanted to print up all that money. In his first televised speech from the White House, he sought to horrify the ordinary citizen with the fiscal excesses of his predecessors by invoking that measure, which his staff actually went to the trouble of verifying with the Bureau of Engraving and Printing. "A monument to the policies of the past, which as of today are reversed," said the President. The President does not advertise that his monument now would be about 134 miles high, or that its sudden growth took place under the stewardship of the most conservative president of this century, the man who had built a brilliant political career late in life partly by denouncing deficit spending and attacking the National Debt with the zeal of a parson secretly maintaining an intimate emotional relationship with sin. Anything that grows so inexplicably and exponentially, whether it be supposedly benign phenomena like waterlilies and human births, or more threatening explosions like kudzu and cancer, deserves our full attention.
3
Vigorish
Borrowing and saving are two sides of the same coin. You can only borrow money that someone else has put in a bank to save. In modern times, governments used to borrow money in peacetime in order to run deficits during recessions. They could scoop into the national pool of savings and borrow because a stagnant industry did not want the money. That pool of money had been put aside by individuals for retirement and by businesses for investment when times turned better. It provided a natural limit to the appetites of borrowers and was curbed by interest rates, which are the price we pay for borrowing money. But why save when you can borrow? With our natural optimism reinforced by a tax system that still rewards borrowing more handsomely than any other, even after the most thoroughgoing reform in a generation, our savings rate is the lowest in the industrialized world. A generation ago, the country as a whole--individuals, businesses, and the government--saved about 18 or 19 percent of its earnings. The major European nations still do. Japan puts aside a positively masochistic 30 percent. But Americans save only half that, about 14 percent.
But now we have started moving into uncharted territory, at home and abroad. As individuals, we have been saving at about half our habitual rate, while the government borrows the difference on our behalf from foreigners. The Reagan administration's vaunted supply-side savings incentives have had little effect. We now save only about 3.5 percent of our personal earnings, leaving a smaller pool of savings for the government to tap. When the administration started to run up record deficits, no one of importance believed it could actually find all the money it would have to borrow. There just were not enough savings. The chairman of the Council of Economic Advisers, the chairman of the Federal Reserve Board, the blue-chip forecasters who point the way for Wall Street, the number-crunchers with their computers--all warned that the government, like a thirsty elephant, would crowd all the other borrowers out of the national savings pool. Not one of these gurus of capitalism foresaw that the more parsimonious Japanese and Europeans would willingly lend us a sizable share of their savings, as long as we paid them enough to make it worth their while. They were attracted by our high interest rates; America had become one vast money-market fund for the rest of the world. But no one imagined that the country would also be able to live with the high interest rates. The persistent economic and political imbalances that this situation created are an important part of the story of the National Debt. Now, for the first time since America succeeded England as the preeminent country of the capitalist world after World War I, we owe our foreign creditors more than they owe us.
Economists used to pooh-pooh the National Debt. They argued that spenders in one part of society merely owed it to savers in another, and we simply "owed it to ourselves." But now that we owe so much of the debt to each other, as well as a rising proportion to foreigners, paying the interest on it has become a major consideration in the government's national finances. The annual interest bill now comes to about $140 billion. In the space of five years, interest payments as a share of the budget have doubled, to 15 percent. That may not sound like much until yourealize that the amount the government pays in debt interest has risen from one-third to one-half of what it pays for our military establishment. Since we have financed the greatest peacetime defense buildup in history on the never-never, those figures are not entirely unrelated. The government's relentless demands for credit have also driven up its long-term price; it is no news that interest rates have tended to go up rather than down in the postwar period, especially during the first half of the 1980s. Interest paid by short-term Treasury bills averaged 2 percent in the 1950s. In the early 1980s, they yielded an astounding six times that, then gradually slid back to about 6 percent. High rates add to the cost of financing the debt. As rates rose, interest on the debt grew four times faster than the debt itself. Thirty years ago, interest paid to the public on the debt accounted for only a sliver of the gross national product. It now has almost trebled, to 3.8 percent of the GNP, twice as high a proportion as in 1978. The federal government now spends more on debt interest than on income security for the poor.
Who pays the interest, anyway? Not just big companies; all the corporate income tax collected in 1986 would not pay two-thirds of the interest bill. So it is not some sort of irrelevant shell game of shuffling money back and forth from rich companies to rich bondholders. The interest is paid by everyone. At the start of the decade, one dollar out of every five paid in personal income taxes was spent on interest payments on the National Debt. In five years, that proportion has increased to two dollars out of every five. Interest payments already eat up the rough equivalent of all the individual income taxes collected from everyone living west of the Mississippi River. As for the future, it is always problematical, hence the first rule of financial forecasting is: give a number or a date but never both. Physicists can forecast both because there are far more constants in the physical universe than in human behavior. Einstein could predict precisely how the sun's light would bend when it passed near a planet, but financiers cannot even predict the prices at next week's government bond auction. But let's be bold. After all, like Einstein,we're moving into such uncharted territory that we need to get our bearings.
Each year that the government runs a deficit of $200 billion, the taxpayers pay for about four-fifths of the budget, and lenders make up the difference. Averages can be deceiving, yet they help in understanding financial flows of such magnitude that no one person can ever pick them up and handle them. If you average out each deficit of $200 billion among the country's approximately 100 million taxpaying workers, each one ends up being responsible for $2,000 worth of the deficit. Or turn it around and put it another way: each one of them (you, us!) managed to postpone paying $2,000 in taxes and borrowed the money instead. Pretty clever, especially since it will never have to be paid back. As long as the credit of the United States holds good, it can be borrowed, rolled over, and reborrowed. With interest, of course.
At what cost? At 10 percent, the interest on one year's deficit works out at only $200 per person. Not bad. Less than the annual charges on the MasterCard. Beats paying $2,000 extra to the IRS, until it starts to add up. Even then, five deficits at give-or-take $200 billion each (there's Ronald Reagan's extra trillion, all sixty-seven miles of it) add up to an additional $1,000 in interest per person. Relax, all that extra money isn't going to come directly out of your pocket, since the federal government receives only about half the revenues for its budget from individual income taxes. So the IRS will need to add only half of that additional interest to your tax bill. Go ahead, make a deal with the revenue agent before he decides he has a court case. You owe an additional $500 in income taxes for that five-year spending spree--except that you owe it for every taxpaying year for the rest of your life.
If you're a 27-year-old yuppie who voted for Ronald Reagan, you deserve each other. From now until retirement (not at age 65 anymore, but at 67 under the latest Social Security reform), you will have to pay extra income taxes totaling $20,000 as the morning-after bill for that glorious spending spree. Of course,that leaves aside the $20,000 for the other trillion dollars of debt you're already paying, along with the matter of how the rest of the interest costs will be spread out among cigarette and liquor taxes and among corporations, and finally how some of the rising payroll taxes for Social Security will go into Treasury bonds to help roll over the debt. Twenty thousand dollars bought a very commodious house at the end of World War II, or, if you were so inclined, a Rolls-Royce. With inflation, both cost much more, but debt incurred at that time is worth far less. Lifetime levies of such magnitude means that the people who have to pay them may prefer an inflation that makes it cheaper for them by devaluing the currency in which they have to pay it back. They may prefer that forty years from now $20,000 will buy only a cup of coffee, and two government bonds of that amount are only good for wallpaper. That's one way to escape from a financial hangover.
Now that we have an idea of who pays the interest, who gets it? The interest on the National Debt is transferred from ordinary taxpayers to the rich, who hold a disproportionate amount of the Treasury's notes and bonds (the government's IOUs), or the old, for whom the bonds are held in Social Security trust accounts. Because of political promises made to this largest and most conscientious of voting blocs, Social Security benefits have risen twice as fast as real wages in the past thirty years. The per capita income of retired families has about pulled even with that of working families. The old in America no longer live in a pocket of poverty; many seem to be living off their money market funds. In 1982, half the interest income counted by the Internal Revenue Service was reported by people over the age of sixty-five; a decade earlier, the elderly had accounted for only one-fifth of the interest. In the charts on how people earn their share of the national income, a sharp change has taken place in the share for earnings from interest. From 1970 to 1984, employees' compensation declined slightly but hovered around 75 percent of the total. Corporate profits after taxes improved less than one percentage point, despite all the hoopla about revenue favors tobusiness in the 1981 tax bill. But the share of income from interest almost doubled from a range of 5 to 6 percent in 1970-75, to a range of 9 to 10 percent from 1980-85.
If these trends continue, we risk the creation of a rentier class partly dependent upon high interest rates for its continued comfort. In France in the 1880s, about four million people, or 10 percent of the population, held bonds--rentes in French. When the government decided to exchange new bonds for old at lower rates, these rentiers formed themselves into a political bloc and forced the government to maintain the high rates for a number of years. It was then, and would be now, an intergenerational and interclass tug of war, with the federal government's balance sheet as a political battleground.
Federal Reserve Board economists surveying the personal wealth of all American families found that in 1983 they owned $93 billion in Treasury securities. But the top 1 percent--all the families earning over $150,000 a year--owned $40 billion worth, or almost half of them. The top one-half percent, those earning $280,000 or more, owned a startling one-third of the total, an even sharper concentration of the government's wealth among individuals. That meant about 320, 000 families owned $30.8 billion of the National Debt, an average of about $100,000 per family, yielding about $10,000 a year in interest, all paid by the taxpayers. This stock of Treasury securities held by the rich and the super-rich is larger than the $34 billion held by U.S. pension funds, which are set up for the middle class. This concentration is unlikely to change over generations, since 80 percent of household wealth in America is inherited.
The largest single holders of the debt, however, are the government's own Social Security and other retirement, unemployment, and Medicare trust funds. These funds, which now hold about $300 billion, are really an elaborate accounting device designed to ensure that when the sick, the old, and the unemployed claim their portion, it is there. It almost wasn't there in the recession year of 1982, because the contributions from the payroll taxes of wage earners could not match what the politicians had promised their parents. The system was overhauled andpayroll taxes were raised. While income taxes decreased under the Reagan tax cuts, payroll taxes had to be increased sharply. Their contribution to federal revenues has quickly tripled to one-third, producing a surplus in the trust funds, which are invested by law in Treasury bonds.
The government forecasts that the trust-fund surplus will double in the next five years. If the deficit is erased by then, it will have been accomplished largely on the backs of workers and their employers dutifully depositing payroll taxes in the government's trust funds. But meanwhile, the Medicare fund is likely to run out of money early in the 1990s. The same choice will face the country as existed with Social Security earlier in this decade: severe economies in treating the elderly or further increases in payroll taxes. When the young awaken to the implications of this, a public policy debate could turn into ugly intergenerational warfare. The most obvious target for Medicare economies is in the care of the terminally ill. Medicare spends one dollar in every five on patients during the last six months of their lives. That proportion can be reduced by pulling the plug earlier, or it can be financed by raising payroll taxes. Which? How many people have watched an aged parent in a lingering death, longing for relief? From pain? Or from expense?
Although few fiscal dilemmas pose quite such stark alternatives, none of these financial and political storm signals is going to turn toward calm anytime soon. Even if the federal deficits start shrinking, government interest payments will continue rising, and, by the end of the decade, they will level off at somewhere between $160 and $180 billion (depending on whose entrails the forecasters examine). Congress can vote to cut defense and has improved the fiscal situation considerably by doing so. But it cannot legislate a cut in the National Debt or the interest on it, short of defaulting on it. Lower interest rates cannot offer very much help either. About half of the federal debt is locked into bonds with a lifetime of five years or longer, yielding their lucky, or prudent, holders 10 percent interest or better. And if (but more likely when) interest rates move up, the Treasury gets hit quickly with the rising cost of short-term borrowing.
The most awesome quality about these numbers is that they can take on a life of their own, whether on the most imperial or intimate scale. The miracle of compound interest works in favor of savers but with equal force against debtors. In 1560, Philip II of Spain, who was then singlehandedly directing the largest empire theretofore assembled, reported that his royal indebtedness was seven times his total revenue. By 1574, he was paying more interest to his bankers in Italy and Germany than he was collecting in taxes; his Italian creditors continued carrying this potential rival because they knew he would waste his treasure on military rather than industrial adventures. Right they were. In 1588, the dour and obsessive Philip, misjudging the world from his refuge in the Escorial, made one final thrust to save Spain's fortunes by launching the Spanish Armada against England. We know how that came out. Spain, still nominally the richest and most powerful country in Europe, fell into a rapid decline from which it never recovered. On a personal level, the phenomenon has been described by Senator Daniel Patrick Moynihan, recalling his boyhood on the West Side piers of New York. He compares it to the usurious "vigorish" (actually a Mafia term lately shortened to "the vig") and describes its operations as follows:
If you were broke on Monday morning, no problem. You could borrow $20, with $30 to be paid back on payday, which was Friday. If you didn't have $30 on Friday, that was no problem. You could pay $40 on Wednesday. The extra $10, then $20, was called "vigorish." It kept mounting. Sooner or later your family bailed you out in a big scene, or you ended up in St. Clare's Hospital. That is what the U.S. federal deficit is all about. Not spending; interest.
Such homely comparisons between personal and federal finance have been frowned upon by the grand panjandrums of national accounting since they began playing around seriously with publicdeficits in the 1960s. But now the incongruities of federal finance refuse to be ironed out. The Congressional Budget Office began warning in its February 1985 Economic and Budget Outlook that "the most insidious danger of persistent large deficits is that they may result in a runaway accumulation of federal debt." The CBO was cautious not to predict that it would actually start running away, but the agency has demonstrated how a combination of slow growth, low taxes, and high spending could make it happen. Put simply, if the National Debt grows faster than our national economy, we reach a point where the mounting vigorish becomes unbearable. It becomes politically impossible to cut spending further or to raise new taxes. The continuing drain to pay ever-higher interest leaves fewer savings to invest in new factories to increase our wealth, and, consequently, the government's tax receipts also grow more slowly than its spiraling debt. Unease or worse sets in, and government bondholders start dumping them and turning their bonds into cash at whatever price they can get. Floating new bonds then demands a prohibitively high rate of interest. The government begins to resemble a business that borrows simply to finance last year's debt and this year's interest. The bankers start thinking about reorganizing their clients' debts under Chapter 11 of the bankruptcy laws (and their clients start thinking about bankruptcy), but governments aren't supposed to do that.
They don't. In the days of Philip II, the Spanish Hapsburgs clipped the coinage as an expedient, and the Armada was Philip's last throw of the dice. Now governments print money to inflate their way out of debt. The money raises the national wealth, at least on paper, but the debt, also on paper, is smaller. Such paper expedients work for only a time, as the nations of Latin America have recently had occasion to learn. When a cup of coffee costs 20,000 pesos, the Argentine government finally has to wipe the slate clean, devalue the peso right out of existence, and find some other name for its discredited currency. Homely metaphors still hold good even in international finance. In earlier generations, the United States sent in enforcers knownas Marines, and a spell under guard in the tropical equivalent of St. Clare's Hospital was not unknown for debtors. The world now is a more civilized place, and the family of nations has helped bail out the errant debtors. Their bankruptcy has not yet been financial, but it has been moral. If we teetered on the same precipice by refusing to face the reality of our commitments, which is to say our debts, our bankruptcy also would be moral.
4
How It Got There
The nation was born in debt. The first deficit, totaling $1.4 million, occurred at the dawn of the Republic in 1792. Superficially, our view of the National Debt seems quite different from today's. It was only in the 1930s that the government took a major role in stabilizing the economy and began to spend money in order to pull us out of slumps by our own bootstraps. That was when the budget became the fulcrum of the national economy. But the argument over the function and therefore the fiscal role of government is as old as the nation. Follow the story carefully; let the past instruct the present.
From 1789 to 1930, there were only forty-five deficits, an average of one every three years. Almost all of them were associated with the country's major wars, when governments traditionally borrow to finance a national emergency. The first deficit crystallized the great debate of the era between Thomas Jefferson, the author of the Declaration of Independence and the defender of the then-revolutionary concept of the rights of man, and Alexander Hamilton, the illegitimate West Indian who was the country's first financial genius. Would the new nation remaina homeland for Jefferson's incorruptible yeomanry, or would it industrialize and fall under the sway of "the mobs of great cities"? Hamilton championed industrialization by using the government's taxing power and its right to run up debt as a "useful illusion" of its political credibility. He wanted to advance the economy in ways that Keynesian economists of today would hardly find strange. Long before, he had written Robert Morris, the wartime superintendent of finance: "A national debt, if not excessive, will be to us a national blessing." Hamilton knew there was no way the new nation could raise money for industrial development until it established its public credit and financed the war debt of $79,124,465 that he inherited as the first Secretary of the Treasury. In the process of doing so, the thirteen states would also learn how to operate as a commercial and thus a political union. As he told Congress, "Credit is an entire thing; every part of it has the nicest sympathy with every other part; wound one limb and the whole tree shrinks and decays."
Jefferson disagreed. He wanted to pay it off, but for moral rather than economic reasons. He argued that "the laws of nature" made it unfair to impose the debts of one generation upon another, and he therefore proposed that the debts be paid off in nineteen years, or one generation less one year. Since the debt was then equivalent to 40 percent of a year's income, Jefferson's dictum would have condemned the post-Revolutionary yeomanry to virtual servitude as it repaid the nation's creditors by annually skimming off 2 percent of the national income, plus interest, of course. Jefferson's real target seemed to be Hamilton, whom he accused of furthering his "monarchical" ambitions by using the debt "to corrupt and manage the Legislature." The gravamen was that federal money would purchase political loyalty. This was long before the first reclamation project was even conceived for a congressional district, long before the new Capitol was built, or before its first lobbyist had to register.
Congress, jealous of its power to tax and spend, refused to grant Hamilton a public hearing to present his plan for funding the debt. So he sent it up in writing, then retaliated by sending his annual appropriations request in lump sums. With no opportunityto examine the requests, Congress had little choice but to rubber-stamp them. The elders fired back by setting up the House Ways and Means Committee for permanent oversight of public money, a thorn in the side of administrations to this day. Hamilton nevertheless prevailed. He reorganized the country's chaotic finances by floating long-term bonds, selling off lands in the West, and issuing a charming but alas now extinct form of annuity known as a tontine. Named after Lorenzo Tonti, a wise Neapolitan who invented it, this form of annuity splits up the interest among the surviving holders, who gamble that they will be among the last few left to profit from this ghoulish lottery. The quarrel drained and embittered him. Upon leaving the Treasury, he wrote a friend in 1794: "Believe me, I am heartily tired of my situation and wait only the opportunity of the quitting of it with honor and without decisive prejudice to public affairs."
George Washington's role in this dispute is both obscure and familiar. He issued regular appeals for the government to redeem the National Debt, but he seems to have been as dilatory as Congress itself in agreeing to raise the tariffs on wine, spirits, tea, and coffee that were needed to pay the interest on Hamilton's bonds. In a passage in his Farewell Address worthy of Polonius, he urged his successors to borrow sparingly, but seek peace with a strong military, and nevertheless pay off war debts to avoid "not ungenerously throwing upon posterity the burdens which we ourselves ought to bear." This Reaganesque policy of trying to mix high defense spending with prudent debt management sounds like rousing good stuff from the soldier-president who founded the nation. But the bottom line was that after twelve years of Federalist government under Washington and John Adams, their expenditures to fight off Indians, pay tribute to Barbary pirates, build forty ships for the navy, and start work on the new capital city, left Jefferson a National Debt of $76 million when he succeeded them as the third President. The sum was almost exactly what Hamilton had inherited from the Revolution.
From the moment he was inaugurated in 1801, Jefferson set the pattern for the nineteenth century by trying to liquidate the National Debt. Even though he had to borrow $11 million forthe Louisiana Purchase, he had paid off $25 million of public debt within six years. The principal aim of government finance then was to retire the federal debt by earning surpluses, not always to the advantage of the economy. Assisted by westward expansion, the United States ran a surplus from 1816 to 1836. Andrew Jackson's Treasury Secretary, Roger Taney, proudly announced that as of January 1, 1835, the United States "will present that happy, and probably in modern times unprecedented, spectacle of a people substantially free from the smallest portion of debt."
This fiscal utopia was unnatural, unjustified, and consequently short-lived. Customs duties, which were the main form of taxation, had already been reduced. Instead, Jackson's government depended on the continued sale of virgin public lands for new revenues. Until the bubble burst, that satisfied planters and speculators alike. Cheap credit boosted prices by fueling speculation. To limit the powers of the federal government by starving the Treasury, Jackson's populist administration decided in the election year of 1836 to divide a surplus of $37 million among the states. The first two installments were paid in gold, the third in devalued bank notes, and the fourth not at all. A recession had cut imports, and tariff revenues accordingly plummeted. The surplus vanished, and the land speculation boiled over into the Panic of 1837.
The surplus did not become a problem again until the 1880s, when hard-money Republicans of the Gilded Age squeezed the economy, reducing the Civil War debt and living standards with it. Once again, the surplus era ended in crackpot financial theories, this time the free coinage of silver, and the financial panics of the early 1890s. The surplus came back again during the happier but more ominous 1920s. General H. M. Lord, the director of the Bureau of the Budget, reported in 1927: "Despite persistent efforts to reduce revenue by cutting [income] taxes to a point barely sufficient to meet our annual demands, we seem helpless in the face of the country's continuing prosperity. Reduction in taxes has come to be almost synonymous with increases in public revenue. At the end of each year we are called uponto determine what to do with the surplus millions." Lord served Calvin Coolidge, whose partiality to commerce is memorialized by his classic assertion that "the business of America is business." No wonder that Silent Cal is Ronald Reagan's favorite president. Reagan keeps Coolidge's portrait on the wall of the Cabinet Room and argues against raising taxes by asserting that tax cuts always raise revenue, just as they did in Coolidge's day when Dutch Reagan was a teenager.
Is history trying to tell us something? That surpluses are bad and deficits are good? That Keynes and Roosevelt were right and Hoover was wrong in trying to balance the budget in the middle of a worldwide depression? Neither. It tells us that politicians usually fight in the trenches of the last ideological war even while the battlefront of the present one shifts around them. But the issues hardly change. Hamilton and Jefferson defined the two opposing ideological strands in American life. Hamilton borrowed unashamedly to create the industrial and military underpinnings that would defend the country against its enemies. Jefferson scorned his Big Government policy. For him, "that government which governs best, governs least." His ideological successor was Jackson, the frontier general, who ran the central bank out of Washington because he favored cheap and unfettered creation of credit by country banks for little people. The result was a financial crash. The ironies of history are exquisite. The Democrats, today's party of Big Government, venerate Jefferson and Jackson. The Republicans, who lean toward Jeffersonian rhetoric when it suits them, owe their birth to Abraham Lincoln, who put the nation through a Civil War to preserve a strong central government that oversaw America's economic emergence into a world power. Franklin Roosevelt, a Democrat, conserved and expanded that role of government. And what about Ronald Reagan? He seems like a Jeffersonian in thought but a Hamiltonian in action. But that is getting ahead of the story, into an area that Marx might call The Contradictions of Capitalism.
Even after the Crash of 1929 or the Great Inflation of the 1970s, Herbert Hoover (while in office) and Ronald Reagan (like Roosevelt, while campaigning) insisted on a balanced budget.They argued that it was essential for reviving business confidence and restraining inflation. Hoover and a Republican Congress followed this idea right out the window in 1932, when the GNP contracted by 15 percent. Victims of past obsessions, they quadrupled income tax rates and made them retroactive. Taxpayers had to dip into savings to pay, and the drain on the banks helped pull the plug on the banking system. One of Roosevelt's first acts as president in 1933 was to close the banks for a week to reorganize them.
Roosevelt cautiously introduced the concept of "compensatory finance," which meant compensating for a slack economy by government spending. Keynes gave it a theoretical justification and helped save capitalism. He fully accepted the capitalist laws of supply and demand, but he discovered that they could end up balancing in such a way as to leave the economy operating only at half-speed. His remedy was the simple application of money to fill the gap, either government bonds to make the rich feel wealthy enough to spend, or highway projects to give the poor jobs and money to spend, too. And if the bureaucratic imagination was bereft of ideas for new projects, the government could simply bury banknotes in old coalmines, fill them up with garbage, and let people find them. Mind you, this was to be neither charity nor socialism. Keynes's idea was to start recirculating idle wealth on the basis of prudent public finance: "Leave it to private enterprise on sound principles of laissez-faire to dig up the notes again, the right to do so being obtained, of course, by tendering for leases of the note-bearing territory." As long as money was idle, which surely it was in the Depression, the idea worked. Although it took a war to pull both the nation and the world out of the Great Depression, when Roosevelt tried to balance the budget, the economy slumped.
Once buinessmen saw how well this policy worked, they dropped their scruples. In the 1950s, Republican businessmen quickly embraced the idea of economic stimulus. Herbert Stein, the country's leading conservative economic historian and one of the Republicans' best economists, wryly notes that then, as now, it offered a ready-made rationale for what businessmen always wantto do, which is to reduce taxes. Their real opponents entering the 1960s were not the few remaining hands-off Hooverites but the minority of hands-on public spenders in the Democratic Party. These Democrats saw deficits as a means to increase the task of government and hence the quality of public welfare over the claims of private affluence. The social reformers were led by the Harvard professor John Kenneth Galbraith, who was reviled by conservatives like Stein as an intellectual dandy. Galbraith caught John F. Kennedy's ear with his style and sardonic charm, but he lost the argument to the President's pragmatic New Economists and was happily consoled by appointment as Ambassador to India. There he kept a diary, collected Indian miniatures and felt at home because, as he recognized even before departing, "I enjoy stating moderate positions in abrasive form."
These Keynesians finally made deficit spending more fashionable than Galbraith had ever been able to do in his best-selling books. To distinguish themselves from classical theorists who worried mainly about how prices were set in the marketplace, they called their ideas the New Economics and worried mainly about how the government could stimulate enough action to keep the marketplace going. Kennedy's economic witch doctors were led by Walter Heller, an articulate professor from Minnesota, ever a state of rationally optimistic American expansionism. He quickly recognized that cutting taxes was the only politically plausible way to stimulate the economy. Heller argued that the economy was being dragged down by high taxes that created a gap between what it was doing and what it should do. Result: factories operating below capacity, people out of work, and the federal budget in deficit. But cutting taxes when the budget was in the red seemed anathema to simple folk, and there are many such in Congress. Hadn't President Eisenhower's Treasury Secretary, George Humphrey, warned against the dangerous impossibility of trying to "spend yourself rich"? In his fear of inflation, Eisenhower had tipped the economy into three recessions, one of the principal reasons Kennedy had won the presidency. Kennedy did not want to lose it in 1964 because of a fourth slump, so he decided to peddle the medicine of a tax cut. The proposalwas mired in a skeptical Congress when he was assassinated in 1963, but then it was passed quickly into law almost as a national expiation. Deficit finance was thus converted into public dogma as a monument to the martyred President.
A cut of $11 billion in personal and corporate taxes went into effect in 1964, when the budget was $6 billion in deficit. By the following year, unemployment was down to its target, inflation was quiescent, growth was up, and the resulting increase in federal revenues cut the deficit to a mere billion. This was the apotheosis of Keynes. Time magazine put him on its cover, the first dead person ever to achieve this secular canonization. Heller was invited to give the Godkin Lectures at Harvard in 1966 to explain his fiscal wizardry. Proclaiming that "economics has come of age," he said: "One finds it hard to imagine a future president spurning professional economic advice and playing a passive economic role." Yet that was precisely what was already happening. It was high noon for the New Economics.
While Lyndon Johnson was publicly committing the revenues produced by the New Economics to the social welfare programs of his Great Society, he was also secretly supplying the military to fight in Vietnam. The buildup for the Vietnam War was concealed from his economic advisers. They suspected it was underway, tried in vain to prove it, and nevertheless argued for a surtax to pay for it. Their advice was spurned. In bureaucratic slang, they were being cut out of the loop. The Pentagon sent regular spending estimates to the Council of Economic Advisers marked "for internal use only." Arthur Okun, the youngest and most irreverent of these advisers, scribbled underneath: "but not to be swallowed." When the public finally was forced to swallow the truth, it was too late. From the start of the Vietnam buildup in 1965 to its height in 1968, military expenditures rose 47 percent. Transfer payments, the best measure of government money transferred through Social Security and welfare programs, rose 51 percent during the same three years. In 1968, the deficit jumped to $25 billion. It was to be followed by a virtually relentless march of deficits straining the economy beyond its limits and igniting the Great Inflation of the next decade.
5
Sisyphus
The more rigorous aspects of the New Economics can be found even in the Bible. The idea of putting aside something in fat years for lean is primitive Keynesianism. In the modern world, it means raising taxes during periods of economic euphoria. Politicians living only within the horizon of the next election are usually not interested in hearing Biblical wisdom, even in modern dress. Like the plague, they have avoided raising taxes ever since Congress belatedly placed a special surcharge on income taxes in 1969 to help finance the Vietnam War. The result was a slump in 1970. Politicians do not easily forget such things and will seize any available rationale to avoid them. In 1971, Richard Nixon produced a budget to expand the economy before his reelection. He justified the stimulative deficit by declaring, "Now I am a Keynesian." Ronald Reagan has not even bothered to seek theoretical justification for his deficits; he just blames Congress.
Patriotic souls who prudently wish to send along a little something extra with their income tax to help reduce the National Debt have been gently reminded by the Commissioner of InternalRevenue on their Form 1040 that he will look upon it kindly, but only as a mere charitable contribution. Thus, the naive restraints of debt retirement no longer are taken seriously, and deficits not only have become a way of life but also a tactical handmaiden of policy. For Johnson, they sanctioned a guns-and-butter policy that permitted the proliferation of government programs. For Reagan, they turned out to be the cutting edge of a policy to reduce Johnson's Great Society programs by starving them of tax money, but the policy still ended up in guns, butter, and debt.
Historically, debts of the massive proportions now being carried by the United States usually are associated with headstrong princes bent on conquest or democratic societies determined to resist them. But at least half of our $2 trillion National Debt is the bill for a spending spree that has continued during half a decade of ideological skirmishing over the size and role of government. During the same period, the governments of the industrial nations of Western Europe went through the same debate over the relative merits of public versus private welfare. Their welfare spending having reached the limits of fiscal prudence and public tolerance, they changed direction through electoral debates and enlightened public discussion. Not even as ferocious an ideologue as Margaret Thatcher was willing to force the issue by cutting taxes independently of cutting spending, and she even warned a visiting American Congressional delegation against it shortly after Ronald Reagan came to power. In the nations of Western Europe, public spending as a share of national earnings reached its postwar zenith in 1983. In 1984, it quietly began a relative decline, moving down by one percentage point as prosperity took hold. European society as a whole had decided to spend more of its wealth as individuals rather than through the state.
By contrast, the federal income-tax cuts proposed by the Reagan administration deliberately emasculated the government's revenue powers in order to curtail this spendthrift's "allowance." This is a favorite metaphor of the President's that reveals wheregovernment stands in his scale of adult values. Measuring the ensuing gap between income and outgo does not demand a knowledge of the calculus of exponential numbers, only simple arithmetic. But, as Bertrand Russell once said, "People would rather commit suicide than learn arithmetic."
In the United States, we now produce goods worth about four trillion dollars a year. The federal government spends or redistributes about one trillion, or one dollar out of every four. Some dollars go to buy bombers with expensive toilet seats, some to prevent the old from falling into poverty, some to cancer research. After climbing for four years, Washington's share of our money crested at about 24 percent in 1985. If you add in all the money spent by states and cities, the proportion is closer to one-third. On a world scale, that is relatively low; the Swedes spend almost two-thirds of their national income through their government, the British and the Germans about three-fifths, and even the Japanese almost one-third. But the point is that the proportion of our income the federal government spends is actually higher, by about two percentage points, than it was when Ronald Reagan arrived in Washington pledging to shrink it. It is four percentage points above the postwar historical norm. The change in priorities wrought under Reagan, by accident and design, explains why.
In the process of deliberately doubling the amount spent on defense, and then being forced to triple the amount spent on interest, most everything else had to stand still or, as with programs for the poor, contract. Nevertheless, because of the Reagan administration's great tax-cutting experiment in 1981, income tax and most other receipts have increased more slowly than spending. The one exception is the Social Security tax, which now extracts about half again as much as it did from workers' payrolls before the system was reformed to save it from bankruptcy. After five years of fiscal fanfare, the bottom line is a flow of federal revenues at or just slightly below its historical postwar norm of 18.5 percent of GNP. This adds up (or more precisely, subtracts out) to a federal deficit of between 5 and 6 percent of GNP. Theresult of this gap between revenue and expenditure is that one dollar out of every five that the government now spends has to be borrowed.
There is no precedent for this. No U.S. government has ever gone right on borrowing at such a rate during a period of peacetime expansion. Even at its height in 1968, the Vietnam War deficit reached only half the proportion of the national income as the deficit in Reagan's most spendthrift year. The Vietnam deficit also lasted a much shorter time; by 1969, the budget was heading into surplus. This time, to find the money to finance our consumer boom and our military buildup, we have been forced to borrow abroad, since Americans do not save enough money of their own to lend the government all it wants. Three cents of every dollar spent in the United States is borrowed from foreigners. That is three cents of every dollar everyone spends. Three cents of every dollar that passes through everyone's bank account, not just the government's bank account. The largest single lenders are the Japanese, who are also the industrialized world's most assiduous savers and prefer our bonds because they will pay a high interest rate for their own retirement.
During World War II, at least one dollar of every two spent by the government was borrowed from its citizens for a great cause. We emerged from the war in 1946 with the federal government owing $241 billion to its various public creditors, or 113 percent more than the nation earned that year. No one worried, not only because of the characteristic optimism of the period, but because the debt went around in a closed society, like water boiling, condensing, and then raining down in one of those sealed glass chemistry flasks. Economists argued that "we owe it to ourselves," and, further, that the debt would be no burden on succeeding generations because our children would simply shuffle the interest payments around among each other. (From poor taxpayers to rich bondholders, apparently, as we do now, although no one ever puts it that way because the government started the vicious circle by borrowing on behalf of the poor taxpayers in the first place.) During the early postwar period, these arguments stood largely unquestioned by the economicsprofession because the motives of politicians were seen as benign. A rare exception was James M. Buchanan, a Virginia professor who argued that politicians were more like private entrepreneurs using public funds to promote their electoral interests. The grandson of a governor of Tennessee, he may have known more about real life than his professional colleagues. In the 1950s and 1960s, he was dismissed as a crank; in 1986, he was awarded the Nobel Prize for economics.
The principal reason for public complacency was that the National Debt stabilized under Truman and Eisenhower. The budget was balanced except during part of the Korean War and some of the Eisenhower recessions. But those deficits were small, and the country grew out of debt, which plateaued while the gross national product doubled. Like Alice when she ate her cakes to fit through the door to Wonderland, the debt kept growing smaller relative to the increase in the national wealth.
That relationship represents the ratio of debt to GNP. It charts the relationship between what we owe and what we earn. It is the standard measure of the appropriate weight of the debt, just as a family's annual income sets its mortgage limit (or used to, in a more prudent era). Because of postwar growth, the National Debt declined to the equivalent of 58 percent of GNP within the decade after the end of World War II. It continued declining steadily to 24 percent of GNP in 1975. Then it started climbing again as deficits rose, but it stood only two percentage points higher when Reagan took office. After that, it took off, and federal debt now equals about 41 percent of our annual GNP. This debt ratio, like Latin America's in the previous decade, can hardly do anything but continue to climb until at least the end of this decade. By that time, the United States will have run budget deficits for twenty consecutive years unless adjustments are made on either the revenue or the expenditure side of the ledger. This political confrontation certainly awaits the next administration, if it has not already entrapped this one.
There is also no sign that the pulse of the real economy will respond to the exuberant finance of the Reagan administration and provide new stimulus to grow out of debt, as it did in theimmediate postwar era. This was the misconceived gamble of the supply-siders in the Reagan political entourage. But growth in this decade has so far averaged only about 2 percent a year. During the 1970s, growth of the economy averaged around the traditional upward trend line, which is 3 percent. In the 1960s, it had reached an unprecedented 4 percent, which is unlikely to be repeated. This steady decline in the growth of the national income carries an ominous message outside the realm of government finance. It means that although we live closer to the borderline of recession, we have less insurance against it.
In the eight postwar recessions, smaller debt ratios gave the government room to borrow something to prime the pump. The increase in the overall debt was hardly noticeable, and the deficit insurance it bought quickly restarted the economy, which would then pull ahead and decrease the debt-GNP ratio again. But as a government and as individuals, the United States now is mortgaged to its eyeballs. A healthy economy with growing room to spare, just like an energetic individual with an idea, usually needs only a short, sharp injection of borrowed cash to get started. But now the unprecedented weight of debt is more likely to slow the economy. A deficit of $200 billion could easily increase half-again in the next recession. Any government prowling through the world's credit markets looking for that kind of money would send interest rates rising at the worst possible time. The size of the deficit we are already running sets financial limits on borrowing. The psychological weight of debt inhibits our traditional sense of risk. Americans have always imagined themselves and their country as Promethean. But the classical figure America begins to resemble is not that mythical Titan who snatched fire from the gods, but Sisyphus, the damned soul in hell. His avariciousness earned him the eternal punishment of rolling a marble block up a hill, only to have its huge weight roll down upon him as soon as he reached the top.
6
Keynesians, RATs, and Why We Really Borrow
Some ingenious economists still argue that government deficits hardly matter in the real world, thus helping to prove the old Washington adage that where you stand is determined by where you sit. When big budget deficits began just in time to create an election boom for Ronald Reagan in 1984, administration apologists produced studies purporting to show that deficits had no connection with interest rates. This was tantamount to saying that the largest borrower in the nation, indeed, in the world, had no effect on the price of credit, inflation, or other things that go bump in the night. In trying to give respectability to such huge deficits, these boosters were aided by the existence of a theoretical no man's land that no economist has been able to take and hold. For no theory has been able to trace the precise effect on the economy of selling government bonds to finance deficits, any more than doctors can fully explain how most medicines work, accurately predict what they will accomplish, or foresee all their side-effects. Human behavior is no less mysterious than human biology.
For what it is worth, Keynesians believe what seems to beobvious: that government bonds represent wealth to the people who buy them and happily clip their interest-bearing coupons. They feel richer, so they go out and buy new cars or new clothes. That creates jobs and raises output. Never mind about repaying the bonds when they fall due. This government will be out of office, and we all may be dead by then, anyway. The original guru of this theory of government deficits was Professor Abba P. Lerner, a Keynesian who argued in the 1940s that the National Debt was no burden because it produced a circular exchange of income within a closed society. That was the we-owe-it-to-ourselves argument. As long as we did, the only people who objected were labeled cranks or old fogies, like Professor James M. Buchanan, who attacked Lerner's theories as "the new orthodoxy," or President Eisenhower, who worried about our grandchildren inheriting the debt. Professor Buchanan's reputation has since been redeemed by his Nobel Prize, and President Eisenhower has been similarly rediscovered by historians. But meanwhile, Keynesian finance justified itself by prosperity unparalleled in history. Raising the money in the bond market was a cinch for the Treasury. So why worry?
This line of reasoning has recently been carried to what one hopes will be its ultimate conclusion by Professor Robert Eisner of Northwestern University, a lifelong Keynesian fiscal specialist. Mark another distinction here, that between fiscal policy and monetary policy. It even confused John F. Kennedy, who devised a mnemonic to help him remember the difference between fiscal and monetary. It was the letter M. It also stands for money, which helps control the economy through its availability for business and other loans. That leaves the other main arm of government policy, which is not monetary but fiscal; it works through the federal budget (the letter F) by spending on public works, helping the poor, and taxing ourselves to pay for it.
As a fiscal specialist, Professor Eisner characteristically worries less about raising money for the government than making sure the government spends enough of it to keep the action alive in the marketplace. In a recent study, he concentrated on the government's accounting methods, and rightly found them somewhateccentric. Unlike a corporation, most municipalities, or indeed the industrial nations of Europe, the U.S. federal budget makes no distinction between, on the one hand, operating expenses for salaries or paperclips, and, on the other, investment for projects such as roads, airports, or national parks that legitimately can be expected to profit society over the years. The reason for this is probably ideological: in America, the government is not supposed to own anything that smacks of profitable enterprise, which is reserved for the private sector. Only in America do we socialize the losses of Chrysler or Lockheed and encourage them to capitalize their profits.
This accounting critique has merit, but Professor Eisner carries it one step further. He argues that if the government did its accounts properly, it could call on a sizable stock of assets to offset against the debt, at least on paper. Voilà! The national accounts would be back in the black. If potential bond buyers could be convinced of this, the government would never have trouble raising money. This is an intriguing conceit until one asks whether these public assets could ever be cashed in to turn the red ink to black and draw down the National Debt. How about a sale-and-leaseback deal with Disney for the Grand Canyon? Or an outright sale of the Bonneville Power Administration? The Reagan administration has actually proposed selling off the Grand Coulee Dam in its 1987 budget, but there has been no rush of buyers. This idea is about as helpful as selling off the Crown Jewels to help Mrs. Thatcher balance the books. And a good thing, too, says the Professor, since getting rid of dams or national parks "would be as bizarre as suggesting that a family sell its $100,000 home to make its $50,000 mortgage disappear." But it certainly does provide a nice feeling to know that the books are not as unbalanced as they seem. Here is a huge stock of assets that offsets the stock of debt and even the annual deficit itself, if only the accounts could be arranged properly.
Such sensible bookkeeping then begins to lead Professor Eisner awry. By a series of calculations correcting for inflation and for a measure of the government's assets, he reckons that, far from stimulating the economy during most of the postwar period,the federal budget was actually holding back the nation's economic growth. Only with the arrival of good, solid 200-billion-dollar deficits that you could almost smell and feel under Ronald Reagan, he argues, has the federal budget deficit really stimulated the economy. There is no doubt a large element of truth in this, although these calculations hardly seem necessary to confirm the evidence of one's own eyes. They pose only one problem. Theories not only must provide sound guidance to the future, but validate the past as well. The Professor finds that during the tearaway inflation years of 1977 to 1980, a nominal budget deficit was supposedly holding back the economy. How's that again? Other members of his profession have caught him on this in testimony before the Joint Economic Committee of Congress. What would have happened to inflation, already in double digits, if the country had run even larger and more stimulative deficits under Jimmy Carter? Perhaps we ought to try a different theory.
Economists of a different persuasion known as "rational expectations" propound their theory from an opposing political nest. Known within their profession as RATs for short, and centered at the University of Minnesota with its freethinking traditions, this group has been trying to supersede the Keynesians. The RATs argue that government bonds do not really represent wealth. Instead of making their owners feel better, as the Keynesians believe, the RATs argue that government bonds make their owners feel worse because they know the government eventually will have to collect taxes to come up with the interest, either openly or by printing money. They suggest that everyone stays awake nights wondering how to protect himself and his descendants so they will be able to pay their share of the interest on the accumulated debt. Out of intergenerational altruism and foresight, these prudent souls then set aside the money to cover the debts of their children. Voilà! Their saving cancels out the effect of the deficit spending. "The key insight of rational expectations is that private agents change their decision rules when the government changes its policy," says RAT guru Thomas J. Sargent in the bloodless language that modern economists seem to prefer. The convenient corollary to the RATs' thesis is that since people supposedly planahead so rationally, they make government management of the economy not only unnecessary but harmful. The conclusion is that by their concerted actions in bidding bond prices up or down in the market, investors conspire to outwit the Treasury. This automatically irons out the ups and downs of the business cycle.
Professor Eisner and the RATs have developed intriguing if excessively narrow explanations for human behavior. This is a characteristic failing of economics when it tries to pose as a science (which is a point we will take up in the second part of the book). These serious social scientists, who forget that their assumptions about economic behavior grow in part from the history and society that shaped them, represent extremes in a serious mainstream argument over whether the deficit mechanism has been blunted by overuse. Eisner, a product of the 1930s, still credits a benign government, in all senses of that word, and argues that it is rich beyond its dreams. If it is short of cash to stimulate the economy, it only needs to borrow some more. The RATs, having watched politicians first cheat the country in Vietnam (Sargent was obviously marked by his military tour as a systems analyst at the Pentagon), and then cheat savers by inflation, claim that the tide has turned. The people who buy the government's bonds can force its hand by making credit prohibitively expensive when they fear it is going to devalue their savings by inflation. They watch Congress and the Fed playing a game of chicken over whether the Fed will print money to finance the deficit, and supposedly they know how to get out of the way by demanding a huge price in interest for their money. And if the government cannot sell bonds at a reasonable price, the RATs argue, it also can never afford to run a deficit large enough to boost the economy. So it should not even bother to try.
Despite their helpful insights, both cannot be completely right, and in fact neither is. If one of them were, the history of the past five years would have been very different. If the RATs are right, rational people should have nullified the Reagan tax cuts by socking away the money against the inevitable day when the deficit will have to be repaid by higher taxes. Precisely the opposite happened; we spent as if there were no tomorrow. Butevents also prove that there is an element of truth in both strands. In the late 1970s, the then-unprecedented deficits of the Carter presidency flowed like water into the sand because bond buyers literally went on strike, as the RATs' theory said they would. Only the Federal Reserve's record interest rates lured them back. Result: recession in 1982. The deficits had backfired. Here Eisner's Keynesianism argues that the Reagan administration still should have no trouble selling bonds because the money always comes from somewhere. He would be right, or anyway half-right. Half of it came from foreigners. They bought bonds instead. But they insisted on being rewarded for the risk by receiving the highest interest rates since the United States had to bid on world markets for money to finance its economic development in the late nineteenth century.
Such extremes in academe signify mainly that the economy is moving into uncharted territory, and that there are more things in heaven and earth than are dreamed of in economic theory. In one sense, the RATs' thesis is eminently true for Latin America. But a new theory is hardly needed to explain why no rational citizen there will lend his money to governments with such notorious financial reputations. (Instead, they might try explaining why New York banks were irrational enough to lend them the money anyway, a hilarious episode in the historic accumulation of debt that will be examined shortly.) In the United States, mainstream economists are not ready to turn to theories more suitable for Latin America, at least not yet. But they do see the deficit as a huge black hole swallowing up tomorrow's savings for today's consumption. They cannot calculate how long the process can continue before it swallows the country's economy as well. The classical danger is called "crowding out": voracious government demand for credit crowds out industry's demands for money to invest for expansion, and the economy falters.
So far, crowding out the demand for credit in the United States has been avoided by luring money from foreigners. But this is becoming increasingly difficult and expensive, and there is in any case a price to be paid for that later, as we have to earn the interest on their bonds. Martin Feldstein, who publicly quarreledwith his own administration while serving as chairman of Reagan's Council of Economic Advisers, has suggested a black-hole scenario of supercrowding out: deficit-caused inflation that runs ahead of the supply of money and sends interest rates so high that they squeeze the entire economy and not just industrial borrowers. But in fact this eminent Harvard economist has no clear theory of what will happen if the United States continues to take in the world's savings to finance its deficit. He can only say that the prognosis is definitely malign.
The question that all these academics really are addressing is whether it is better for a government to borrow or tax when its promises outrun its resources. It is as old as the invention of government debt. A simple way to address the real issue is to ask whether a taxpayer would prefer to hold a $10,000 government bond or a cancelled check for his tax payment to the U.S. Treasury. The answer may seem obvious, but that only demonstrates that neither deficits, nor borrowing to pay for them, have gone out of style. Two centuries ago, Adam Smith railed at governments that had "enfeebled" themselves by passing their debts on to their successors and cheating lenders who received no guarantee that the money would be spent wisely, since governments could always tax their hapless citizens in recourse. He wrote: "When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid." David Ricardo, the wealthy London stockbroker who laid the foundations for logical analysis in economics in the early nineteenth century, reasoned that the burdens of taxation and debt were equivalent, at least in theory. In the long run, the cost to the citizen is the same whether he pays the costs at once in taxes, or in installments by paying off interest and principal. But common sense told him that in fact they were not equal. Taxpayers are hardly rational enough to save and cover their own or their children's tax payments. If government borrows on their behalf, they will spend more now. Taxes enforce public saving. Borrowed money is spent. We know from the consumer boom of the Reagan era that this is precisely what happens.

Copyright © 1987 by Lawrence Malkin