On May 1, 1981, a three-month Treasury paid 16.3 percent. For the whole of 1981, 2.5 percent of the gross domestic product went to pay just the interest on the federal debt. In 1981, the total money supply was equal to 69 percent of the gross domestic product (GDP).
Too many dollars chasing too few goods resulted in inflation of 8.92 percent in 1981. That was considered a sufficient economic emergency for the Federal Reserve to deliberately force the economy into a recession in order to combat the greater threat of inflation.
Today, the three-month Treasury pays a sleep-inducing 2.25 percent and inflation seems to be in a long-term band of between 1.5 and 2.5 percent. But it is starting to trend up a little, and the Fed has begun to very cautiously raise interest rates just a little at a time. If that seems like deja vu, it might remind you of the late 1970s.
If we are on that path, then in two years we may be heading for an economic crisis that dwarfs the one from the early ‘80s. For this perilous situation, we can thank economic theories that promised prosperity would result from increased social spending.
How Can We Fight Inflation?
Here’s the thing about inflation and fighting it: In the short term, raising interest rates actually accelerates inflation. From April 1977 through April 1980, the Fed very cautiously raised interest rates, just a little at a time, hoping to gently rein in inflation. Instead, inflation took off like a bull out of a rodeo chute.
The Fed responded by accelerating interest rates with panicked leaps, adding as much as a percentage point a month for several months between 1980 and the peak in 1981. Interest rates on three-month Treasuries jumped from 7.07 percent in June 1980 to 16.30 percent in May 1981.
Currently, the federal debt is at 103.83 percent of the GDP. In 1981, it was around 30 percent of GDP. Remember that in 1981, the total money supply was 69 percent of GDP? Today, it’s around 90 percent of GDP.
Picture this: There’s a stack of privately held money that’s almost as much as all the things that can be made and sold within a given year. The people who hold onto that money are content with keeping it in low-interest bank accounts, their mattress, or a safe. Sure, they might lose 2 percent of the value to inflation every year, but that’s more than worth it because the cash acts as a hedge against uncertainty.
The higher inflation gets, the more expensive it is to hold cash. High inflation makes it more likely that these stocks of money will be spent or converted to assets, pushing prices up even higher. It’s like a fire and it feeds on itself accelerating with panic buying. Only by paying recession-inducing higher interest rates on bonds and bank accounts can saving cash become economical.
Here’s where we are today: If everything goes according to plan, the Congressional Budget Office (CBO) calculates that, by 2020, more than half of all personal income taxes will be required to just service the national debt, and those interest payments will exceed our military budget. However, if inflation kicks off, we have much more privately held money sitting on the sidelines now than we did back in 1981. If people become afraid to hold cash because inflation is eating it up too quickly, the tsunami will be unstoppable.
How We Got Here
Before you start raising taxes to “fix” this problem, let’s review how we got here. Following theories advocated by influential economists such as Nobel Laureate Paul Krugman, the government responded to the 2008 recession by dutifully injecting $4.5 trillion in stimulus and $831 billion in increased federal spending into the economy. The federal debt swelled from 73.48 percent of the GDP in January 2009 to its peak of 105 percent in October 2016.
All of this massive spending and borrowing produced an anemic sub-2 percent economic growth as far as the eye could see. In contrast, the President Trump tax cut yielded the stunning economic boom we’re in today. Not only did this economic plan cost much less than the Krugman-approved plans, it actually yielded higher government revenues, leading to a 2018 collection of $3.973 trillion in taxes over the $3.76 trillion collected in 2017. In other words, we’re in a boom after taking an action on which the government made a profit.
I’m a fan of moderately higher interest rates and low taxes. I took all of the macro-economic classes that “proved” the government could grow the economy with low interest rates and higher taxing and borrowing to spend on social programs. Those theories are wrong. We now have the successes of the Ronald Reagan and Trump tax cuts bookending the Krugman and Obama failure to prove it.
I like moderately high interest rates because they make it harder for zombie businesses to stay alive with cheap borrowing and accounting gimmicks. The Japan of the 1990s has taught us that zombie companies tie up resources that newer, more nimble companies could exploit to make the country more prosperous.
I like low taxes because running a business should be about profit, not juggling loans and stock buy-backs. Low taxes and moderately high interest rates encourage people to get into the work force and save more.
Meanwhile, cheap student loans and high taxes do the opposite. Do you know any professional students who postponed entering the job market because of the availability of student loans? When taxes are high and interest rates are low, it protects money-losing companies and makes it harder for new companies to accumulate wealth. When taxes are low and interest rates are high, zombies die, and innovation thrives.
The Likelihood Of a 1980s-Esque Debt Crisis
If inflation reaches ‘80s levels and the Fed responds by increasing interest rates to ‘80s levels, the United States will undergo a jarring debt crisis. The CBO says that half of all personal income taxes will be required to service the government’s 2020 debt at 5 percent. How much will be required if the Fed is forced to raise interest rates to 16.3 or 20 percent? Again, I like moderately higher interest rates, not those chaos-inducing rates.
If that happens, some combination of three things will happen: inflation will be allowed to rage, banana republic-style; taxes will have to be increased to insane levels; or something will have to be done about the gigantic entitlement problem America has. Just ask Greece what happens when you try to tax your way to debt freedom: It creates a death spiral in which the government crushes an ever larger portion of the economy. Growth and limited spending are the only answers.
New workers (mostly young people and immigrants) are the first to suffer when the job market tanks, as it will if the debt crisis materializes. These are the kind of people who place their hopes in socialists like Alexandria Ocasio-Cortez. Yet Reagan said that a job is the best social program. Unfortunately, jobs go away when taxes are high. As you listen to Democrats promise more, more, and even more entitlements to Americans, consider the true high cost of all of the “free” entitlements we already have.
Behind door number one is runaway inflation. Behind door number two is death-spiral austerity. Interested in door number three? Door number three is prosperity. To get there, we need to get America producing and growing the pie. Prime working-age labor-participation is still below 1999 highs. We have eight years of sub-normal growth to make up. We still have debt-addled businesses that pay no taxes but tie up land, labor, and capital in their operations.
The Fed is right to be raising interest rates to ease non-producing ventures off the playing field to make room for the more viable businesses. But we need to cut taxes and regulatory burdens like it’s the national emergency that it is. That will require government bureaucrats and Washington politicians to surrender some of their power and money. It’s a sacrifice I’m willing to make.