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Part One
THE NEXT BUBBLE AND BOOM
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Chapter 1
The Explosion of Debt and the End of the Super Bubble
How We Got Here
The road to bankruptcy is not an easy one. It can take years if not decades or generations to arrive, especially when you look at the United States with its vast resources of wealth. To fritter that away is not an easy thing. However, the amazing thing is how fast the United States has done it. Many other superpowers, such as the Roman and British empires, took hundreds of years to fritter away their wealth and power from when they became superpowers. The United States became the worldâs superpower during World War II and is on the verge of bankruptcy only 70 years later.
In this chapter, we will show you how the United States has wound up in this condition. We will explore how the country created its debt problem internally by expanding government. We will examine how this has led to inflation. We will see that foreigners allowed and even helped to trigger U.S. reliance on debt to finance its needs. We will also show you why access to this funding may end.
The Start of the Problem
In the 1930s, Franklin Delano Roosevelt began the welfare state with an avalanche of government programs. Many saw these programs as short-term solutions until private spending and the economy bounced back. As such, the U.S. government was still small by modern measures. At that time, the expectation was that government intervention would lessen over time and eventually shrink back to former levels. FDR even tried to get the books back into balance in 1937. It had more to do with the public mentality than economic theories. Despite or perhaps due to the frugality of the publicâs own spending habits, many did not agree with the federal government living beyond its means for an extended period of time. The U.S. government never really got carried away with spending during the Great Depression. Therefore, the internal spending of the government was still modest as compared to modern government budgets.
The SixtiesâThe Expansion of the Welfare State
The mid-sixties and early seventies were really the key eras in the turning point of the American economy. In the mid-sixties, we saw a huge expansion in the size of the federal government. The role of the government in the daily lives of Americans increased dramatically in scope.
Some of this was born out of confidence in the government itself. People believed government intervention would result in increased prosperity for the U.S. economy. After all, the expansion of government under FDR seemed to get the economy out of depression in the thirties. Plus, America had now won two world wars against Germany and the space program was a smashing success. And due to the lack of competition in the global economy postâWorld War II, the U.S. economy boomed and seemed to have a never-ending source of funds and prosperity.
The major shift came under Lyndon Johnson. Johnson was a war hawk and a social liberal. He decided that he would fight wars against both communism in Vietnam and poverty at home. Programs such as Medicare and Medicaid were put into place. Government spending soared as Johnson increased social spending dramatically to fight the so-called War on Poverty. U.S. voters increasingly realized that they could vote themselves more things from the government.
Programs such as Medicare and Medicaid have turned into a spending nightmare, sucking the life out of the U.S. economy while steadily increasing its national debt. For example, the actual increase in expendituresâcompared to the initial estimates at the timeâhave run anywhere from 500 to 1,500 percent over budget over the past 40 years, depending on the study. (We will discuss this more later in this chapter.)
The United States began to run structural deficits. A structural deficit is a deficit that is permanent because the expenditures that cause that deficit are permanent government expenditures (see Medicaid or Medicare) as opposed to a one-time expense (e.g., like a stimulus package). Aside from a few years in the sixties, the United States began to run a budget deficit nearly every year. During the fifties and sixties, the United States had all sorts of extra expenditures, which led to an explosion in spending and deficits. The United States had to pay for wars in South Korea and Vietnam and also make payments for Medicare and Medicaid. Finally, it had to come off the gold standard and there was huge inflation in the seventies to catch up with the printing of money and the spending done in the sixties.
According to www.usgovernmentspending.com (including states and local governments), total government spending as a percentage of GDP was 3.05 percent in 1900. Therefore, total government spending was approximately 3 percent of GDP. By 1940, this had increased to 20.5 percent of GDP. During World War II, due to the military buildup, the total of government spending became half the size of the economy as its spending accounted for over 52 percent of GDP in 1945. After the winding down of the war effort, the total of government spending stayed at a relatively small size throughout the fifties. By 1965, total government spending was just over 26 percent of GDP. This meant that the government made up just over one-quarter of the total economy. This was not the tiny total of 1900, but it was still small total government expenditure, especially when compared to the size of federal governments of other developed nations. The effect of Johnson was immediate; by the end of his term in 1968, total government spending was over 30 percent of GDP.
However, the problem was not so much Johnsonâs immediate spending but rather the future impact of that spending. Spending that was instituted in the mid-1960s has left a permanent legacy for future generations of the U.S. government. Usgovernmentspending.com estimates that total government spending will be nearly 44 percent of GDP for 2011.
The budget deficit for fiscal 2009 was over 11 percent of GDP at $1.42 trillion. The only budget deficit in the history of the United States that was larger was in 1945, when the United States was expanding spending due to World War II. That year, the budget deficit was just a little over 20 percent of GDP.
Now that we have so much so-called âessentialâ spending, such as for social programs and military, it would be a major undertaking to reduce the structural deficit and shrink the size of government.
At some point the debt problem will become bad enough that the United States will be forced to cut spending as it will not be able to finance its deficits. History teaches us that when a nation falls into or near the brink of bankruptcyâmarked by high inflation and unemployment rates and social unrestâit usually takes a significant leader or drastic changes to the economy and government to get it out of such a mess. Things can get ugly as this occurs. For example, when New Zealand came out of fiscal insolvency in the eighties, it deregulated the economy, privatized government-owned industries, and streamlined the economy. The same goes for the United Kingdom in the early eighties, when the British economy became dominated by socialists and union leaders. A showdown eventually culminated in coalminer strikes as Margaret Thatcher âbrokeâ the unions in the United Kingdom in an attempt to rein in their power and get the country back to fiscal responsibility.
However, at the moment there is no political will in the United States to cut the deficit. In Britain and other European countries there is a debate at the moment about whether to cut spending and raise taxes because of the debt situation due to the impact of various financial crises. However, in the United States all we hear is talk of fiscal stimulus, more âjobs,â health-care reform, public bailouts, how to revive credit growth, and Tiger Woodsâ libido. There is no talk of tightening belts to deal with the coming debt crisis. (Currently, Tigerâs belt loosening and tightening appears to generate more talk than any other issue.)
The coming national debt crisis is the most important issue in the United States at the moment. However, virtually no one is talking about it.
The End of the Gold Standard and the Beginning of Inflation
From 1873 to 1934, the United States was on a gold standard. This meant that a certain number of dollars would buy an ounce of gold. The intention of the gold standard, whether it is admitted or not, was that the number of dollars in circulation could not be increased indefinitely. It was intended to create a stable exchange system. For example, if $500 equaled one ounce of gold under the gold standard, it meant that roughly $500 of money should be in circulation for every ounce of gold that the government had in reserves. This system was designed for the sole purpose of keeping governments financially stable. Essentially, governments could not print paper money unless they had the mandated ratio of gold to dollars in their reserves. In other words, the government had to add 10 percent more gold to its reserves if it decided to circulate 10 percent more currency or increase its expenditures by 10 percent. That is the gold standard in theory.
In 1971, the United States went off the gold standard. The system became a completely fiat system, meaning the dollar was linked to nothing. The government could print as much money as it wanted with no limitations. The central bank had begun to print more and more money to pay for ventures and the pressure was too much for the pegs at $35 an ounce to hold. This created inflation because they printed more paper money than they had gold in their reserves. After the United States went off the standard, the dollar was linked to nothing.
It is no accident that on this purely fiat money system we have seen a huge increase in government spending and consequently the amount of debt in the economic system. The United States started down that treacherous road of increased government spending with the growing size of the welfare state and later when it had pay for wars in Vietnam and Korea.
The fiat money system has also resulted in financial bubbles, which have been caused by excessively loose monetary policies. From 1933 to 1971, when the United States was pegged to gold, there were no financial bubbles. The Fed during that period of time thought that its mandate was to control inflationâin other words, to stop the punchbowl from being spiked when the economy and financial markets got overheated. The gold standard helped it to do this by keeping in line the number of dollars that could be in circulation (e.g., if it wanted to go crazy printing, the government would have to add gold or reserves to its vault to justify this printing). However, after 1971, the Fed could print as much money as it wanted. As a result, in the 38 years since the abolishment of the gold standard, there have been no fewer than four major financial bubbles, including:
1. The commodities and inflation bubble of the late seventies
2. The stock market and technology bubble of the late nineties
3. The real estate and leverage bubble of the 2000s
4. The current bond market bubble (and the coming debt and second inflation bubble)
The reason you get these bubbles in a fiat monetary system is simple. The gold standard acts as a discipline mechanism that prevents governments from spending too much and the Fed from printing too much paper money and creating too much credit. When the Fed can print all the money it wants, this creates massive dislocations and therefore creates massive bubbles.
With no discipline on spending programs, spending is unchecked and goes wild.
Domestic Government Spending + Expenditures Abroad = Bankrupt America
As we will learn in this section, government spending on domestic social programs and expenditures overseas is out of control. This is worrisome as the decline of most empires is characterized by an overextension of spending both at both at home and abroad.
Medicaid and MedicareâThe Black Holes of Domestic Spending
Government programs are a perfect example of when monetary policy meets political policy. When the government can print money for these programs and has no accountability for the limits of spending on them, spending gets out of control. Most government programs are well intenti...
