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Deficits, interest rates and the US economy

Gerard Jackson
BrookesNews.Com

Monday 5 April 2010

Now that it appears that Obama's reckless spending and borrowing binge has dethroned US Treasuries as the world's safest investment haven market players are contemplating a future in which interest rates must continue to rise if the government's lust for spending is to be met. Strengthening this fear is the government's rising debt burden, unsustainable deficit spending and a colossal amount of unfunded liabilities that are impossible to finance.

So instead of addressing these problems Obama and his merry band of irresponsible Democrats imposed a gigantic and largely unread health bill on the American people. Only a fool would think that the markets would ignore this monstrosity. However, the real question right now is when will the markets revolt?

In the meantime, the argument prevails that the deficit will in itself be enough to drive up interest rates. A contrarian view is that the statistical evidence proves that inflation is the real driving force behind higher interest rates, not deficits. In fact, not only does the so-called statistical evidence prove nothing of the kind it can lead to the dangerous conclusion that it is perfectly safe for a government to continue accumulating deficits in the happy belief that they will not have a detrimental effect on investment.

The conventional view assumes that if the supply of and demand for capital as expressed through the interest rate is in equilibrium then any addition to demand must raise rates. It follows that by increasing the government's demand for loans deficits will raise rates and in doing so drive out marginal investments. This is call "crowding out".

However, if an increase in savings were to offset the additional demand for savings then no crowding out would occur even though private investment would still be lower than would otherwise be the case. But it needs to be borne in mind that the argument that deficits do not raise rates is not based on the assumption that the supply of savings will increase.

So how do we explain the so-called statistical evidence? Simple enough. The Fed drives down interest rates and keeps them down by allowing the banks' fractional reserve system to keep expanding credit even as the government is running a deficit. What in effect is happening is that the banks are creating phony savings. This is called inflation. Eventually prices begin to rise, current account problems develop and bottlenecks appear. At some point rising prices result in a price premium emerging which causes interest rates to rise.

We can now conclude that in the absence of monetary expansion deficits would certainly have exerted an upward pressure on interest rates*. Moreover, we can also see that the so-called 'cheap money' policy actually resulted in higher rates. To blame inflation for this situation in order to exonerate deficits and increased government borrowing is to reveal a total ignorance of the inflationary process and the true nature of interest.

Unfortunately the errors do not stop with what we may call the deficit-interest rate fallacy. The failure to understand the nature of inflation has led some to the egregious error that a recent rise in treasury yields has been a blessing for the US economy because it now means that "King Dollar" is holding down inflation. Exchange rates can never hold down inflation, only tight monetary policy can do that.

In addition, inflation disturbs exchange rates and distort the pattern of internationals trade. "King Dollar" is not a blessing but a curse. Behind this misguided opinion is the erroneous belief that a strong economy must always have a strong currency. Hence a rising currency must be evidence of a strengthening economy. Not so. Professor Ludwig von Mises recalled how in 1919 a banker had claimed that the Polish mark should never have dropped to 5 francs because

Poland is a rich country. It has a profitable agricultural economy, forests, coal, petroleum. So the rate of exchange should be considerably higher. (Ludwig von Mises, On the Manipulation of Money and Credit, Free Market Books, 1978, p. 20. The article was first published in 1923).

Mises went on to say of those who preached that the state of an economy should determine its exchange rate:

These observers do not understand that the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and the demand for, money. Thus, even the richest country can have a bad currency and the poorest country a good one. (Ibid. p. 21).

We are living in a highly inflationary world. This means we are in a permanent state of monetary disequilibrium which is reflected in unstable exchange rates. I suggest that "King Dollar" is not only the result of inflationary forces but is also overvalued. It is this overvaluation that reduces the prices of imports while penalising exports. In the meantime, the banking system is sitting on $1 trillion dollar of excess reserves just waiting to flood the economy.

Now one can argue that overvaluation is impossible on a floating exchange rate because supply and demand always bring rates into equilibrium. This argument falls to the ground once it is realised that it ignores purchasing power parity. Dr Frank Shostak nailed this opinion when he noted:

The so called floating exchange rate does not really belong to a free market. In a truly free market we would have a gold standard. Under the current floating exchange rate system the central banks' monetary policy continually causes exchange rates to deviate from the underlying rate as set by the relative purchasing power of money. So in this sense the rate of exchange can become either overvalued or undervalued.

Given the America's horrible fiscal condition I cannot see how higher interest rates can be avoided. The demands now being made on the economy by government must result in a significant reduction if not an actual end to the rate of capital accumulation exceeding population growth. This can only mean a general fall in real wages. furthermore, I do not doubt for a moment the government or a government will be driven to use inflation to engineer a very large partial default.

*Even if a depression brought about a collapse in the demand for business loans accumulating deficits could still retard recovery even if they appeared not to affect the rate of interest.

Gerard Jackson is Brookesnews' economics editor



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