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July 12, 2009

Will the Democrats Massive Borrowing and spending Binge Kill the US Economy?
by Gerard Jackson

Any reasonably intelligent person understands that if the demand for a product increases then (all things being equal, as the economist would say) its price will rise. The same holds in the case of borrowing, except for congressional Democrats. These people seem to think that economics laws are a vicious Republican plot.

Poll figures are now showing that the American public is growing alarmed by the Democrats' utterly reckless fiscal policy. Unfortunately, few people understand just how grave the danger really is. In less than five months Obama increased the national debt by more than $800 million and lumbered the economy with a $1.8 trillion deficit that looks like growing even bigger. (I still get silly emails from Obama cultists who were evidently screaming into their computer monitors: "Bush did!!!!" Pathetic doesn't begin to describe these people). In 2003 Thomas Laubach, the US Federal Reserve's senior economist, produced New Evidence on the Interest Rate Effects of Budget Deficits and Debt, a paper containing calculations for long-term interest rates based on historical evidence. He concluded that

a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points

As the US deficit has rocketed from 3 per cent to 13.5 per cent one should therefore expect long-term rates to rise by at least 2.5 per centage points. In addition, he believes that a 1 per cent rise in the ratio of debt to GDP will raise future rates by 4 to 5 basis points. It appears that recent movements in long-term rates support Mr Laubach's thesis. The 20-year treasury bill stood at 3.22 per cent on 2 February: by the 8 July it had risen to 4.13 per cent. It was the same story 10-year treasuries which rose from 2.46 per cent on 2 January to 3.33 per cent on 8 July while the 30-year mortgage rate had risen to 5.32 per cent by 2 July as against 4.78 per cent for 2 April. The government's insatiable demand for funds looks very much like it is driving up long-term rates very quickly.

Obama supporters with their fetish for big government can always claim that economic conditions in Japan refute Laubach. Japan has increased its national debt by a colossal amount and yet interest rates remain ridiculously low. These critics overlooked the economist's caveat: All things being equal. Just as the price of the a monetary unit (its purchasing power) is determined by the supply and demand for it, the same holds for all other economic goods. For example, though US car production has dropped car prices have not jumped. Why? Because demand fell.

The same holds for Japanese interest rates. They have not been driven up government borrowing because the private demand for loans has virtually collapsed. A similar situation prevailed during the Great Depression. Despite Roosevelt's spending and borrowing interest rates remained low -- but so did business borrowing with the result that there was a great deal of capital consumption.

Professor Higgs calculated that from 1930 to 1940 net private investment was minus $3.1 billion. (Robert Higgs, Depression, War, and Cold War, The Independent Institute, 2006, p. 7). Arthur Lewis calculated that from 1929 to 1938 net capital formation plunged by minus 15.2 per cent (W. Arthur Lewis, Economic Survey 1919-1939, Unwin University Books, 1970, p. 205). Benjamin M. Anderson estimated that in 1939 there was more than 50 per cent slack in the economy. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, pp. 479-48). It ought to be obvious that where a process of capital consumption is underway -- as it was in the 1930s -- one should expect to see a rise in the average age of plant and equipment. This is precisely what happened as shown by the table below.

So where we have a situation in which extremely low interest rates reign while government borrowing has massively expanded we should expect to find -- as in Japan -- that the personal demand for loans. particularly by business, has plunged. In other words, critics have been looking at only part of the equation. It just so happens that most critics of Obama's spending mania have also overlooked a vital point -- the crucial role that interest rates play in raising or lowering the standard of living.

If the government's fiscal policy imposes high long-term rates on the economy then prospective highly time-consuming projects, the ones that do so much to raise real wage rates, would have to be abandoned. Moreover, existing projects of the same nature would be eventually phased out. This is called capital consumption. What this means is that the quantity of savings necessary to prevent the capital structure from contracting are no longer available. As Hayek observed:

[I]t is quite possible that, after a period of great accumulation of capital and a high rate of saving, he rate of profit and the rate of interest may be higher than they were before -- if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted tp form, or if the demand for consumers' goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving. (Friedrich von Hayek, The Pure Theory of Capital, The University of Chicago Press, 1975, p. 396).

Added to this is Obama's lunatic energy policy that amounts to a massive tax on production. Once that is also taken into account one is left looking at economic carnage.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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