The Phantom Menace: Inflated Expectations
Deficit Spending, Inflation, and the Ailing Finances of the United States of America
“[T]he kid who owns the ball is usually captain and decides when and where the game will be played and who will be on the team…Since the U.S. now owns some twenty-two billions of the world’s reported twenty-eight billions of gold, we think Uncle Sam is going to be the captain of the team or there will be no game.”1
NEW YORK WORLD-TELEGRAM (April 1943)
I apologize for the extended gap between my last newsletter and the current one. Over the past month, I had a full plate, having just joined Index Fund Advisors to expand our firm’s institutional presence, while simultaneously finishing the final proof of Investing in U.S. Financial History, which will be available on February 27, 2024. On a positive note, a benefit of the six-week respite was that it provided time to reflect deeply on several historical events that place the current financial challenges of the United States in a clearer context.
This newsletter draws heavily from a chapter, entitled “Inflated Expectations,” which concludes Part Five of Investing in U.S. Financial History. The chapter details a series of political, fiscal, and monetary policy missteps that the U.S. made in the decades following the end of World War II. The most notable were President Lyndon B. Johnson’s ill-fated Great Society, the escalation of the war in Vietnam, the failure of the Federal Reserve to tame inflation in the late 1960s and 1970s, and the entrenchment of federal budget deficits in the 1980s. These errors were costly, but not completely unexpected given the suddenness with which the U.S. ascended to the commanding heights that were formerly occupied by the British Empire.
Today, the legacy of these missteps continues to influence U.S. policy even though the passage of time has caused us to lose sight of precisely why. The objective of this newsletter is to revisit three issues that continue to shape financial decision-making in the 21st century. The first two seem to be receiving far too little attention, while the third is receiving too much.
Issue #1: The Deceptively Temporary Wealth of the United States
“The position of the United States after World War II was entirely abnormal and unsustainable. We came through the war unscathed. Our industrial power actually strengthened, while our potential competitors were substantially destroyed and needed our help to rebuild themselves.”2
Paul Volcker, former chairman of the Federal Reserve Board
On September 2, 1945, World War II officially ended with the formal surrender of the Empire of Japan. As Paul Volcker concisely explained in the above quote, the U.S. emerged as the world’s wealthiest nation. Moreover, the industrial infrastructures of nations across Europe and Asia lay in ruins, whereas the U.S. “arsenal of democracy” fueled massive expansion of its industrial capacity. In the 1950s, the U.S. enjoyed an extraordinary period of economic prosperity. Jobs were plentiful, poverty rates fell dramatically, and the middle class thrived. The combination of exceptional wealth and a vastly superior means to continue producing it explains why many Americans remain nostalgic about life in the 1950s.3
The challenge for the U.S., however, was that it was never realistic to expect this level of economic dominance to last forever. As Europe and Asian countries rebuilt their economies, the competitive gap narrowed; yet Americans’ perceptions of their competitive advantages did not adjust at the same pace. This created a strong bias toward “inflated expectations” of the future, which became hardwired into the American psyche by the 1960s.
Issue #2: Abandonment of Alexander Hamilton’s Secret for “Rendering the Public Credit Immortal”
“Let this session of Congress be known as the session which did more for civil rights than the last hundred sessions combined; as the session which enacted the most far-reaching tax cut of our time; as the session which declared all-out war on human poverty and unemployment in these United States; as the session which finally recognized the health needs of all our older citizens; as the session which reformed our tangled transportation and transit policies; as the session which achieved the most effective, efficient foreign aid program ever; and as the session which helped to build more homes, more schools, more libraries, and more hospitals than any single session of Congress in the history of our Republic . . . All this and more can and must be done. It can be done by this summer, and it can be done without any increase in spending.”4
President Lyndon B. Johnson
Inflated expectations lay at the root of several misguided decisions beginning in the 1960s. First, as the good times persisted, perceptions of poverty shifted. No longer content with poverty reduction, the American public and politicians demanded that it be eliminated entirely. After winning his first elected presidency in November 1964, President Lyndon B. Johnson embarked on an ambitious effort to eradicate poverty in the United States. Although well-intended, many policies were poorly conceived and clumsily executed. The costs of these programs sent the U.S. down the path of chronic deficit spending.
The shift in attitude towards the use of the public credit during the second half of the 20th century was much more striking than most Americans realize. In 1790, Alexander Hamilton warned Congress that the true secret of rendering a nation’s credit immortal was to ensure that “the creation of public debt should always be accompanied with the means of extinguishment.”5 During the nation’s first 175 years, the U.S. adhered to this principle, and public debt was issued in large quantities only during times of emergency, such as the War of 1812, Civil War, and the two World Wars.
The Great Society, however, constituted a critical first step toward the abandonment of this principle. Figure 1 clearly reveals this shift by showing federal deficits and surpluses as a percentage of GDP since 1792. By the 1970s, chronic deficits were the norm in the U.S., and federal spending has exceeded revenue in almost every year since.
Figure 1: U.S. Federal Budget Surplus(Deficit) (1792 - 2022)6
Issue #3: The Great Inflation and the End of the Post-World War II Era
“Once it was established that the key function of government was to solve problems and relieve hardships – not only for society at large but also for troubled industries, regions, occupations, or social groups – a great growing body of problems and hardships became candidates for governmental solutions…Many results of this interaction of government and citizen activism proved wholesome. The cumulative effect, however, was to impart a strong inflationary bias to the American people.”7
Arthur Burns, former chairman of the Federal Reserve Board
The Great Inflation, which lasted from 1965 to 1982, is one of the few events in U.S. financial history that can legitimately be labeled “unprecedented.” Neither before nor since has the U.S. experienced a sustained period of high inflation that lasted nearly as long. Postmortem analyses of the Great Inflation revealed multiple policy errors. One of the most important was intense political pressure on the Federal Reserve to prioritize low unemployment at the expense of price stability. This pressure stemmed, in part, from the desire to fund social programs associated with the Great Society, as well as a drawn-out war in Vietnam.
Presidents Lyndon B. Johnson and Richard M. Nixon were both guilty of excessive spending, and Congress was hardly an innocent bystander. The result was more than a decade of economic malaise during the Great Inflation years. Over time, the misery of inflation became unbearable, and Federal Reserve Board Chairman Paul Volcker boldly initiated a draconian policy of monetary tightening on October 6, 1979. After suffering a severe recession and an extended period of high unemployment, a new period of economic prosperity commenced by 1983. But tragically, President Ronald Reagan also failed to restrain the nation’s spending. After observing the resulting deficits, economist Herb Stein lamented “If now the most classical, hard-lined president in fifty years accepts indefinite deferrals of a balanced budget, who will any longer be inhibited by fear of deficits.”8
The Time Has Come for Tough Love in the United States
“I have thought it my duty to exhibit things as they are, not as they ought to be.”9
Alexander Hamilton, first U.S. secretary of the treasury
An oddity of the present predicament is that many Americans fear that inflation and Federal Reserve policies constitute the greatest threat to the nation. But the truth is that the Federal Reserve leadership learned their lesson quite well in the 1970s, and it is highly doubtful that they will repeat the same mistakes. The fact that Chairman Jerome Powell continues to use the phrase “until the job is done” to describe the Fed’s fortitude is notable. Paul Volcker used similar language to describe his commitment to price stability in the early 1980s.
On the other hand, politicians and citizens have not come to terms with the remaining two issues – the nation’s distorted perceptions of its own wealth and its chronic deficit spending. The simple fact is that the U.S. has spent and continues to spend more than it can afford. As a result, the national debt is increasing at a pace that is mathematically unsustainable. Figure 2 shows the Congressional Budget Office’s (CBO) July 2023 metrics of past, current, and projected public debt held by the public as a percent of GDP.
Figure 2: Past, Current, and Projected Total Debt Held by the Public to GDP (1993 - 2053)10
Proponents of unsustainable spending can now only resort to magical thinking to justify their arguments. Some hope that perhaps the U.S. can outgrow its debt problems, much like it did in the late 1940s and 1950s. But those times were different. The industrial infrastructures of many global competitors were in shambles, and several tailwinds (e.g., exceptionally high productivity growth and steady labor force expansion) are now headwinds. Others make the ludicrous claim that the U.S. can accrue debt forever because the nation possesses the world’s dominant reserve currency. This argument may work for several years (even a few decades), but empires eventually lose their reserve currencies once the world no longer views them as a risk worth taking. The Dutch suffered this fate in the late 1700s, and the British suffered it in the mid-1900s. The U.S. does not possess special immunity to this outcome.
It seems like the only realistic option is for the U.S. citizenry to acknowledge, confront, and overcome its misperceptions about its own wealth. Accomplishing this feat may rank among the most difficult financial tests since the nation’s founding. Afterall, the last time the solvency of the United States was called into serious question was in 1790. At the time, the debt of the former colonies and fledging federal government were in default. Alexander Hamilton resuscitated the nation’s credit by consolidating state and federal debt, establishing a reliable revenue source via the creation of new tariffs, and chartering the nation’s first central bank.
Will the United States Defuse its Fiscal Time Bomb?
So, will the United States defuse the fiscal time bomb? Financial history can only provide guidance on what the future may hold; it cannot reveal precisely what the future will hold. The nation’s track record strongly suggests that the impending test is passable, but success will require voluntary sacrifices that few Americans have experienced first hand. Americans must willingly and collectively relinquish title to their present wants so that the nation’s children can afford their future needs. My bet remains that the United States will pass this test — but with the important caveat that a difficult and treacherous journey almost certainly lies ahead.
Disclaimer: This is a personal newsletter. Any views or opinions expressed herein belong solely to the author and do not represent those of any people or organizations that the writer may or may not be associated with in a professional capacity, unless specifically stated. This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are not guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
Notes
Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order (Princeton, NJ: Princeton University Press, 2013).
Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership (New York: Random House, 1992), XV.
Mark Higgins. Investing in U.S. Financial History, (Austin: Greenleaf Book Group), forthcoming.
Lyndon B. Johnson, “Annual Message to the Congress on the State of the Union,” The American Presidency Project, January 8, 1964, https://www.presidency.ucsb.edu/documents/annual-message-the-congress-the-state-the-union-25.
Alexander Hamilton, The First Report on Public Credit, January 9, 1790.
Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, DC: U.S. Bureau of the Census, 1949), https://www.census.gov/library/publications/1949/compendia/hist_stats_1789-1945.html.
Arthur F. Burns, “The Anguish of Central Banking,” The Per Jacobsson Foundation, September 30, 1979, https://fraser.stlouisfed.org/files/docs/publications/FRB/pages/1985-1989/32252_1985-1989.pdf.
Steven Hayward, The Age of Reagan: The Fall of the Old Liberal Order: 1964-1980 (New York: Crown Forum, 2009).
Letter from Alexander Hamilton to Robert Morris, August 13, 1782, https://founders.archives. gov/documents/Hamilton/01-03-02-0057-0001.
“The 2023 Long-Term Budget Outlook,” Congressional Budget Office, June 2023, https://www.cbo.gov/publication/59331.