From Nixon to Bush: The debt financing of American politics

If one were to designate the most prosperous post-WW2 decade in America, without question, it would have been the 1960s. The economy was growing. Neither inflation nor deflation was evident. The American households were still saving and America was still a creditor nation. But as is always the norm, good things never last.

The 1970s heralded the start of a tumultuous era for the American economy. Thenceforth America's growth was to be financed by ever increasing amount of debt. The chart above shows the yawning gap between America's debt and its GDP. It is as if debt grows geometrically but GDP arithmetically.

A detailed examination of the debt growth from 1971 provides an instructive view of how the US gradually surrendered control of its economy to outsiders, all the while without realising so. Why 1971? Because 1971 is full of connotations.


First, it marks the year the debt first outpaced the GDP since WW2, growing by more than 10 percent. Another momentous milestone, on 15 August 1971, occurred when Pres. Nixon severed the link between the US dollars and gold in order to stem the flow of gold to other countries, notably France. It paved the way for debt (and its corollary, the money supply) to start its relentless growth. If the gold link were in place, the gold reserve would have constrained any debt increase and the consequent GDP growth.

As the money supply rose, so was the pressure on commodity prices, simply because their supplies could not be hastily bumped up. Even now, it still takes 7 to 10 years for new supplies to come onstream. The 1973 Arab-Israeli War snapped the suppressed oil prices because by then the pressure for an increase had been 2 years in the offing. The trigger was the war but the root cause was the debt (or money supply).

The debt also fueled the inflation past the 10 percent mark in 1974 as the debt growth outpaced the slowing GDP. The oil price surge upended the economy with increased oil expenditure constraining spending in other areas. Stock market and property collapsed as debts growth slowed. Nixon sought to reduce the federal deficit, slashing it to $6.1 billion by 1974. The fed funds rate was raised to almost 13 percent by July 1974. The resulting recession in 1974 cost Nixon the presidency. He had to resign during his second term to avoid impeachment. Nixon wanted to control the debt but in the end the debt got him.

Gerald Ford who replaced him for the remainder of his term was beset by persistent inflation and high unemployment, a phenomenon known as stagflation. Actually towards the end of his term, inflation dropped to as low as 4.9 percent but the high unemployment killed his reelection hopes.

The debt again rose as Carter took up the presidency in 1977, corporate financial and non-financial debts being the main cause. Towards the end of his term, he sought to rein in the debt. Again the economy slipped into recession in 1980 as inflation crested at 13.5 percent. Like how it brought down Nixon, the debt showed no mercy to Carter. Out he went.

When Reagan came into office in 1981, Paul Volcker, the Fed Chairman, attacked inflation with a vengeance. He jacked up the fed funds rate to 20 percent. Inflation tumbled to 3.2 percent by the end of 1983. As debt growth slowed to 10 percent, the wrath of the public was heaped on Volcker instead of Reagan. Without the inflation debasement, the US dollars became a stable currency, much sought after by foreign exporters.

At the same time, the Japanese had made inroads into the US market and they were happy to be paid in US Treasury bonds. Reagan soon discovered that America could borrow to the hilt without the pain of inflation. The supply capacity constraint was broken by the opening of the Japanese manufacturing spigot. So America went on a debt and import spree. Sure enough, Reagan got his second term. Aside from the Volcker induced recession at the beginning of his presidency, Reagan never had to endure another recession. In short, the American public could have its cake and eat it too.

Bush, the elder, was elected in 1988 on the coattails of Reagan's popularity. But he was alarmed by the state of the government budget. He raised taxes in departure to his election promise of no new taxes. Despite this, he actually increased the budget deficits throughout his presidential term. Yet the debt growth slowed down to 5 percent turning the US into a net exporter by 1991. The cause was the Savings & Loan Crisis which had started in 1987 following the rapid debt growth during the Reagan years. The consequent deceleration in private sector borrowings contributed to the 1990-1991 recession and sealed Bush's fate. Like Carter, Bush was shown the door after just one term.

Clinton was elected in 1991 on the strength of his slogan, "It's the economy, stupid!" Of course, he did focus on the economy, that is on enlarging the debt. That contributed to his successful second term bid. Towards the end of that term, the dotcom boom kicked in. Businesses and financial institutions piled on increasing amount of debts deluded by their optimistic view of the future. Clinton disingenuously claimed credit for the government budget surplus, after continual deficits of more than 30 years. That feat was only possible because of the private sector's tremendous debt build-up.

The dotcom boom fizzled out and a short recession ensued in 2001 as Bush, the younger, came into office. But the debt kept its relentless growth, this time powered by the households and financial institutions. The new debts were related to mortgage financing. Bush saw to the growth of these debts throughout the eight years of his tenure. These massive debts however could never be repaid. Their unwinding falls on Obama's lap. How the process will unfold is the subject of another post, "Bernanke vs. The Market."

Bernanke vs. The Market

Stock indices all over the world have recovered from their lows in March 2009. Similarly, commodities have rebounded from their nadir at the beginning of the year. Everybody is quick to point to a recovery from recession. Not so fast. Indices and prices that move with a high volatility cannot be explained simply by fluctuations in supply and demand. Something with a more powerful force could have accounted for the movement.

If you travel in a moving object, things outside the object will fleetingly pass you by. Only a fool would imagine that the world is moving while he is sitting still. In like manner, if you believe that the volatility in the stock markets and commodity prices are due to demand and supply, then you've been taken for a ride.

First, we need a primer on demand and supply. Our common understanding of demand and supply is that price is the mechanism that matches demand and supply. If demand exceeds supply, price rises and vice versa. But this law overlooks one crucial element: the medium for the price. Nowadays it is fiat money, a currency with no precious metal backing. The value is decided by the authorities. Demand and supply can remain the same but if the currency volume is increased, the price will follow suit.

This is where Ben Bernanke comes into the picture because he's in control of the one tool that significantly affects stock markets and commodity prices: money printing or also known by its current euphemism, quantitative easing (QE). Herein lies the problem with Bernanke. Abraham Maslow's quote, "If you only have a hammer, you tend to see every problem as a nail", aptly fits him. Bernanke is using his hammer to maximum effect. He keeps pounding on all economic problems regardless of whether his hammering will bring the house down.

To understand the danger of Ben's knocking, let's have some basics on modern day money supply in the US. Why the US? Because the US is the primary locomotive of the global economy that even other large economies, such as China, Japan and Germany largely depend on its growth to drive their own progress. A good indicator of the money supply in the US is not the money supply computed by the US Fed. It's actually the total debt in the US. The official money supply reflects only the debts or loans made by the US banks (debts or loans appear on the asset side of the banks' balance sheets while the liability side is made up of deposits and checking accounts, i.e., the money supply). Not only is the banks' money supply incomplete, it has also been muddled by securitisation and the banks' hiving off the loans to off-balance sheet vehicles.

As debt plays an increasingly important role in the economy, it's useful to study the chart below from the NY Times. It plots the US debt growth from 1953 to 2009. The period 1971 to 2008 marks the growth of debt that surpassed the GDP growth. This period is described in detail in another post, "From Nixon to Bush: The debt financing of America."

Another chart below shows the ratio between the total debt and the GDP. What is interesting about these two charts is not the extremities to which they are heading. Since the future is more exciting than the past, we want to identify the patterns that will unfold. After all, anybody can rationalise the past regardless of how flawed their arguments are.

Looking at the first chart, you can can see a faint outline of a bell curve while the second clearly marks the shape of a developing S-curve. Now you know the relationship between the bell curve and the S-curve. For the mathematically inclined, the bell curve is a derivative of the S-curve. Both are laws of nature from which there is no escape. You can deviate but the laws will pull you back to their predestined paths.

Both curves indicate that the American debt explosion has run its course. The debt is already past its prime. The S-curve is plateauing and probably drooping over the coming years. The bell curve shows a major correction, a big downward shift after Bush's aberrant move upward. This shift spells disaster presaging a rating plunge for Obama.

His damage control, in the face of slumping debt positions of all other sectors, is naturally to accelerate deficit spending. The just released 2009 federal fiscal (year ending 30/09/09) deficit was $1,417 billion, amounting to 10 percent of US GDP. But how does this stack against the big picture? This chart from Forbes 02/11/09 shows Obama's deficit couldn't even cover the collapse in the finance sector debts. The total debt movement may go into negative territory this year.
So now we are left with Ben Bernanke's frantic bungling in the debt market. Bernanke thinks that the problem is liquidity. Because that's what Milton Friedman and Anna Schwartz identified as the cause of the 1930s Great Depression. They couldn't have been more wrong. The real cause for the Great Depression and the present one is not liquidity but capacity (see It's capacity, not liquidity, stupid).

Because of his misguided view of the cause of the crisis, Bernanke has pumped more than $1 trillion buying all sorts of debts, from Treasury bonds to asset backed mortgages to corporate papers. Before the crisis, Fed's holding of debts was $870 billion. Now it's $2.1 trillion. He thought that with more liquidity, the credit market would start moving. But surprise, surprise, it's not budging. The extra liquidity is being used not to create more debts but to speculate in stocks, commodities and bonds. Since this is a capacity crisis, nobody would want to borrow for investment because all over the world, there's surplus capacity. Only fools believing the rising stock prices as a portent of an improving economy will rush to invest. The wise use this opportunity to reduce their debts, cut expenses and sell off surplus capacity.

Bernanke will come to realise that when confronting the laws of nature, there are limits to what the Fed can muster. And for Obama, he will come to rue his appointment as President and be sensible enough to stop harping on his predecessor's legacy. The past presidents had to do what had to be done; they were under the yoke of the debt. Obama's job is to manage the debt transition from its growth phase to the maturity phase. There are no two ways about it; the laws of nature dictate so.

The potent mix of narcissism and nihilism

We've seen how recessions can be categorised as epidemic or pandemic. But those experiencing recessions have to undergo several emotional stages that will tax their resolves to the limit. This is true at the individual as well as at the macro level.

Such stages are similar for those being depressed at the loss of their livelihoods as those facing terminal illnesses. The stages have been well documented in the form of the grief model by Dr. Elisabeth Kubler-Ross in 1969, in her book On Death and Dying.

The model shown here essentially contains five stages though this chart - taken from Booz & Co's Strategy & Business website - shows eight. The five key stages are: denial, anger, bargaining, depression and acceptance.

As I've argued earlier, this recession is a pandemic recession or more correctly, a Grand Depression, much worse than the Great Depression of the 1930s. Most people still are convinced that the worst is now over. This is not surprising since they are mostly still at the denial stage. If you look at the chart, moving from the denial to the next stage, anger, is very difficult. The emotional response climbs from a low steady state to an agitated level. It's certainly a big hurdle to pass.

This refusal to face reality prolongs the recession. In fact, if we look back to the Dow Jones Industrial Average (DJIA) during the depression years 1929-1933 (see chart below from Bloomberg), we can notice that there are several rallies, seven as counted by some commentators, on its way to the bottom. The pattern is also obvious, everytime it went down, it tried to move up but every upward movement had less momentum than the preceding one. But one thing is clear, each year it closed lower than the bottom of the previous year. At its peak on September 3 1929, the DJIA topped out at 381.17. Within three years, it slumped to 41.22, just over 10% of its peak closing.

In the spring of 1931, they were also talking about green shoots. But these shoots wilted when the Austrian bank, Creditanstalt, then the largest bank in Central and Eastern Europe, collapsed in May 1931. Creditanstalt was not a run-of-the mill bank; it was controlled by the Rothschilds. The collapse triggered a global meltdown. Before that, it was thought the economic crisis was confined only to the US.

Likewise, today the widely held view is that the crisis is caused by the US subprime loans. That's just the early symptom; the real crisis is global excess capacity. No country will be spared. It's a matter of when. Its severity will be certainly very grim.

This crisis will over time disconnect the leaders of many countries from the led, each with diametrically opposing views of themselves and on the future economic outlook. The leaders and policymakers are imbued with narcissism, smug and confident that they have the means to end the recession. In the Kubler-Ross diagram, they are at the denial state.

If they manage to hang on to office, in due course they will cross the anger state. At this point, their politics of consensus and inclusion gives way to one of polarisation. Fortunately, during the last wave, the anger could be directed to the war in Europe. Now the US is too powerful for any nation-state to pick a fight. The anger has to be dealt with internally. The next two stages, depression and acceptance, are beyond the reach of the leaders because they would have been booted out at the anger stage. We would be witnessing frequent changes of leadership as voters become more dismissive of their leaders.

The man in the street buffeted by prolonged unemployment and weighed down by heavy debts, can no longer be reasoned to. He has reached the point of nihilism, a result of their anger, rejecting everything just for rejection's sake. President Obama will have tremendous obstacles pushing new initiatives, be they healthcare or defence buildup in Afghanistan. The odds are stacked against him succeeding.

With no recovery in sight, the mood of the unemployed will grow angry and, for those that have progressed to the advanced state, depressive. Anger fuels increased crime and violence. The depressed may succumb to suicide. The internal breakdown of the American society will be on a much larger scale than that wrought on Iraq and Afghanistan. The government needs to provide support for volunteering and self-help work that provide outlets for the unemployed to occupy their time and utilise their energy. This encourages their move to the acceptance stage.

Everyone must accept the reality that in an environment of excess capacity, there are simply no more new jobs. Only then can we move quickly to the acceptance stage. But we know that this is not going to be; instead, anger and depression - the state of both the mind and the economy - will be the order of the day.

The plague of recession

While leaders and policymakers have been trumpeting the end of the recession, are we really on the cusp of recovery? Knowing at which stage of the recession we are in is critical because we are dealing with millions of livelihoods throughout the world. A wrong judgment may mean the difference between getting on with or giving up on lives.

Recessions have much in common with plagues. Both create uncertainty and fear; uncertainty of being hit and fear of the severity of the affliction. A lot has been written on the history of plagues. But the one highly regarded is by the eminent historian, William H. McNeill.

Plagues can be categorised into several phases: epidemic, pandemic and endemic (note that by the time a disease is endemic, it's no longer a plague). To begin with, an explanation of the terms is helpful.

Epidemic, formed from two Greek root words, epi and demos meaning above and people, refers to an outbreak of a disease that spreads quickly to a large group of people within a specific location and within a specific time frame. Pandemic - pan for all - on the other hand, is far more virulent as the disease disperses over a very wide area, which now is synonymous with a global diffusion, and thus affects many, many more people.

Endemic - en for in - is the stage where the disease and host have adapted to one another. The disease, now less virulent, is commonly found among the people and aside from causing discomfort, is no longer fatal to the host. They have evolved towards a stable pattern of co-existence.

To better understand the cause of the present economic crisis, we have to undertake a forensic pathology on economic recessions in recent times. But first, a lesson in economic recession. An economic recession can be of two varieties: an inflationary one caused by a rapid increase in money supply unmatched by a corresponding increase in goods production, and a deflationary one caused by surplus goods production in an environment of rapid money contraction.

How can money appear and disappear in vast amount in so short a time? For this, we have to thank two modern innovations: credit banking, the major player, and the printing press which plays a supporting role. In our modern economy, credit represents more than 90 percent of the money in circulation with paper making up the balance. So it's very easy to inflate or deflate the money supply. Our familiar paper money doesn't suffer that much from this disappearing illusion, only the virtual money.

The other leg of the equation, goods production, has been playing an increasing role since the start of the Industrial Revolution. Actually, the technology waves triggered by the Industrial Revolution have unleashed the energy stored over millions of years in the form of coal and oil fossil fuel. This translates into a massive leap in goods production. Helping to wipe up these additional goods are the innovations in transportation and communication that move goods cheaply or make comparisons about prices widely available.

Generally such advances are synonymous with capitalism since they require substantial capital. More savings are channeled into investment capital further raising goods production. Eventually too much of a good thing turns harmful. Production exceeds consumption generating negative returns on the invested capital. In time the capital will be written off. This is the scenario of a deflationary recession.

What about inflationary recession? This occurs at the early phase of a technology wave. Demand is growing but production lags behind. The banks lend more to meet the need for more money to buy goods but production still can't catch up. More money translates into higher prices. Solving this is easy; you raise the price of money, that is the interest rate. Money supply reduces and things return to normal. Over time production rises to meet the increasing demand. The recession happens when the money supply is crimped. Jobs are lost as businesses retrench.

Of the two, deflationary is the more malign because reducing supply is much harder than increasing it. Businesses will continue running at a loss until many go bust. Recovery takes a long time.

To demonstrate that inflation prevails during the run-up to the crest of the technology wave while deflation as the wave matures, the US inflation for the years 1914 to 2007 taken from the Wikipedia site, shown below, would be instructive. The third wave ended around 1950 after cresting in 1920 (The story of the whole five waves will appear in a future post). You can observe that from the 1920s to the 1930s, the period was wrapped in deflation. In the 1940s, it would have been deflation had not the Second World War diverted the production capacity to arms production. Indeed traces of deflation still reared its ugly head at the end of the war.

After the war, the need for housing to house the American families in the suburbs fueled the demand growth. Highway construction was carried out on a grand scale and automobile sales correspondingly rose. A baby boom in the 1950s to the 1960s rounded off the demand growth story.

After 1950, the upsurge in demand raced ahead of supply until it reached the turning point in 1990. My future post will describe why inflation nowadays can only become an epidemic and a tempered one at that but deflation can transcend from epidemic to pandemic and eventually becomes endemic. Like its disease counterpart, the epidemic spreads from countries to countries while the pandemic comes in waves.

A yen for wisdom

An expert may have all the knowledge on any subject at his fingertips yet he may not have the wisdom. As a guide to tell a wise person and an expert apart, I've chosen an article, Japan's control on the yen, which appeared in the Think Asian column of the Malaysian newspaper, The Star on August 29, 2009. The author is Andrew Sheng, Adjunct Professor at the University of Malaya and Tsinghua University as well as a Director of Khazanah Nasional Berhad. He also sits on various prominent high-powered councils and boards. He sure is a heavyweight on his subject but his article is full of irrelevant arguments, or the proverbial trees instead of the insightful forest.

Let me summarise the pertinent points in his article. The article discusses why the Japanese yen fails to become a reserve currency. Several arguments, the trees, are advanced to support that contention. Among them are its volatility (unstable value), the low yield on yen denominated financial and real assets, and, lastly, the rise of the euro which adds another competing alternative to the yen.

Now, let's rise above the trees to see the forest. One point is enough to puncture holes in all of Mr. Sheng's arguments. For a currency to be a reserve currency, the currency's country must have a tremendous amount of current account deficits, i.e., it must be a global debtor, not just a debtor like most sub-Saharan countries. Only one country qualifies and it is the United States of America.

That is the crux of my argument. The detailed bits follow.

Of course, not every country can be a global debtor. For it to be a global debtor, it must be credible, not only economically but also militarily. In other words, it must earn its stripes. It is not an easy process because a country has to go through the mill. It must first be a creditor country, accumulating current account surpluses over the years. In fact, only in the 1980s did the US become a debtor nation. Thenceforth, its foreign debts could only move one way, that is upwards.

Since Japan is not a debtor country, there's not enough yen floating around for it to be adopted as a reserve currency. You may argue you can easily buy yen. True but for you to hold yen, you must give the Japanese something in exchange. The Japanese don't want your Malaysian ringgit or any other exotic currencies because they are not tradeable outside the countries' borders. They prefer the US dollar. Same goes for the EU. The more yen or euro you want to keep, the more US dollars the Japanese and Europeans must hold in return.

As for the volatility of the Japanese yen, it's not Japan's fault. Since many countries trade mostly with the US, they stabilise their currencies' exchange rates only with respect to the US dollar. Should there be a major fluctuation of these currencies vis-a-vis the US dollar, it's primarily due to a drop or a rise in their economic competitiveness relative to other countries exporting to the US. For example, the 1997 Asian financial crisis was precipitated by the rise of China which made all other East Asian countries non-competitive. Only when they devalued their currencies could they recover. George Soros wasn't the cause nor were capital controls a remedy.

The US does not have the luxury of setting its own exchange rate. It has to take whatever exchange rates set by the monetary authorities of other countries. When the Japanese ran huge trade surpluses with US in the early 1980s, the US had to bear on the Japanese through the 1985 Plaza Accord to get them to appreciate the yen vis-a-vis the US dollar. The yen doubled its value within three years. Gradually, the Japanese became non-competitive. Whatever it can produce, the Koreans and, eventually, the Chinese also can at much lower costs because of their cheaper currencies. With a population that's both declining and ageing faster than those of its competitors, Japan will be an economic basket case.

Since other countries do not target a specific exchange rate vis-a-vis the yen, the yen is bound to fluctuate (or more likely, appreciate) relative to their currencies. There is no benefit at all in borrowing money in yen even if no interest is charged; the borrowers will be hit by the increasing exchange rate.

The low yield on the Japanese assets are also beyond their control. Japan's economy has been in the rut ever since their bubaru keizai (bubble economy) burst in 1991. They tried various measures including zero interest rate policy but to no avail. Till today, policymakers can't figure out why Japan remains mired in a gloomy mindset for such a long time. Even when they had economic growth, the outlook wasn't cheerful. Actually, this phenomenon is a pernicious effect of globalisation. Similar situations can be found in resource rich countries, such as the major oil exporting countries. As it requires a lengthy explanation, I'll elaborate on this in a future post.

Finally, can the euro displace the yen? Actually, such a notion is implausible because neither can be reserve currencies. The euro's claim to reserve currency status is as much tied to Germany's current surplus as the yen is to Japan's. However both are only claims, not real entitlements. Neither has been a superpower and ever won't they be.

These arguments countering Mr. Sheng's assertions are intended to demonstrate how an eminent expert can suffer from blind spots. Being wise is not difficult; you need to build patterns in your thinking. Patterns include enduring laws which are simple yet escape the attention of experts. For example, one highly pertinent law is that the interest rate for a country cannot exceed its economic growth rate. Applying this to the Japanese case, we can naturally deduce that returns on yen denominated assets would be very low since Japan has been in recessionary mode for the past twenty years despite having intermittent growth. So to advise Japan to increase the yield on the yen denominated assets is indeed silly.

An expert may know all the tools of the trade but to know what tool to use and where to use it require wisdom.