killer buffalo

Three decades ago, Alfred Kahn, then an economic advisor to President Carter, warned Americans that double-digit inflation and a stagnant economy might give rise to “the worst banana in forty-five years.”  Although Mr Kahn’s word choice was humorous—Mr Carter had instructed him to avoid the word “depression”—his message was entirely sincere; inflation can be a sign of waning faith in the domestic economy and a trigger to further erosion of faith in the economy and its currency.

The recent two-month stock market rally—only now beginning to falter—and results from the Federal Reserve’s bank “stress tests” have persuaded Treasury Secretary Geithner and Reserve Chairman Bernanke that America has avoided  the worst banana since the Great Depression.  Before passing such judgments, Mr Geithner ought to examine President Obama’s 2010 budget.

The budget resolutions currently in both houses of Congress are unlikely to reduce the $1.17 trillion deficit that Mr Obama’s plan forecasts.  If that federal deficit—the second largest ever—remains, it will be all but impossible to finance.

When the House and Senate settle differences in their budget resolutions and approve an identical plan, the budget will come into effect for the fiscal year that starts on the first of October and the Treasury will be responsible for bridging the gap between federal revenue and federal spending.  During normal times, faith in the U.S. government and an international need for secure investment allow the Treasury to finance the national debt through Treasury securities and government bonds with low interest rates—something that will prove difficult if China isn’t a returning customer.

Over the past two decades, the Chinese government has reliably invested its annual surpluses in U.S. Treasury Bills.  By doing so China secures its wealth and, more importantly, helps the U.S. government to continue running the deficits that allow Americans to afford Chinese imports; if the federal government were unable to easily finance deficits, it would need to raise taxes enough to remove them, thereby decreasing every taxpayers’ disposable income—much of which is spent on products manufactured in China.

If nothing else, this recession has shown China how much it needs American demand: since the U.S. recession began, China’s exports have dropped more than 18%.  And combined with its own domestic recession, this drop has produced China’s largest fiscal deficit in sixty years.

So China’s government needs to buy Treasury Bills so that the federal government can stimulate demand for Chinese exports, but China’s government can’t buy Treasury Bills because it’s as bankrupt as the federal government.

What’s Mandarin for “pickle?”

America has been in this situation before—where Congress ran massive deficits without sufficient demand for government bonds.  The time was 1978 and the result a 12% inflation rate.

Instead of raising bond yields to rates at which they would be purchased, the Federal Reserve decided to purchase long-term Treasury Bills, thus funding federal deficits.  In effect the Treasury printed money, put it in the hands of Congress, and promised that it would later re-purchase the money and remove it from circulation.  While issuing currency financed the federal budget it also created inflation, which functioned as tax on everyone holding the U.S. Dollar.  Since less affluent people tend to hold more of their wealth in the form of cash savings—instead of in a home, a car, or the stock market—the tax was regressive.

Mr Geithner should ensure that this doesn’t happen again.  He should testify before Congress, advising its members to minimize deficits in their budget resolutions and explaining to them why “free lunch,” at least in fiscal policy, is so elusive.  In a global outlook where the Treasury’s best customer—China now owns 24% of the national debt—has a deficit, Congress needs to decrease spending or create sufficient revenue to close its budget shortfall.  Otherwise Congress will unknowingly levy a tax on the poor.

That’s a recipe for one very bad banana.

-David Lamb

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