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Jewish World Review March 14, 2000/ 7 Adar II, 5760

Lawrence Kudlow

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Reduce Debt, Derail Economy -- CONTRARY TO WHAT WE HEAR from the White House, the Treasury, the Fed, the Congress and presidential candidates, the best level of U.S. government debt is not zero.

Indeed, neither today's Federal debt nor the debt of the past two decades has been a problem for the health of the U.S. economy or inflation or interest rates. If Federal debt is so bad, why has our economy boomed the last 17 years?

This historic boom is directly connected to President Reagan's tax cuts and deregulation, along with the Volcker-Greenspan disinflation.

Treasury Secretary Lawrence Summers and others have advanced the mantra that debt reduction will bring down interest rates, which are already near historical lows. But interest rates fell substantially during the 1980s, even as the debt grew in order to finance the defense buildup necessary to defeat Soviet Communism and the broad-based tax cuts required to jump-start the economy.

Call it an investment in peace and prosperity. Interest rates fell from around 14% in 1981 to roughly 6% today because inflation, the major determinant of interest rates, dropped from 14% to around 2%.

Over the past two decades the rising Federal debt has not killed lower inflation, lower interest rates, record-setting economic growth or low unemployment.

Over the next few years the Congressional Budget Office estimates that unified budget revenues will average around $2.1 trillion, while net interest expense will run slightly above $200 billion. This generates a 10-to-1 coverage ratio that would make any private company proud. On the world scene, the 20% U.S. debt-to-GDP ratio projected by 2005 would be the lowest of any industrial country by a considerable margin.

Actually, eliminating the Treasury debt held by the public could generate considerable economic harm. Without Federal debt, the Federal Reserve's ability to conduct monetary policy would be impaired, since Fed purchases or sales of Treasury debt are the primary tools to expand or contract the money supply.

True, the Fed could substitute the debt of government-sponsored enterprises such as Fannie May or Freddie Mac. But this preference would put private mortgage insurers at an even greater financing-rate disadvantage. Also, other borrowers would clamor for Fed purchases. Why shouldn't the central bank purchase the bonds of steelmakers or auto companies? Potential political conflicts for the Fed are mind-boggling.

Also, foreign central banks park their excess dollar reserves in interest-bearing Treasury debt. Without U.S. debt, the whole international trade payments mechanism would be upset. The dollar's reserve currency status would be undermined. Global dollarization that is leading toward international financial stability would be stopped.

Foreign governments would be forced to sell dollars and instead invest in euros or Japanese yen. A sinking dollar would generate higher inflation and interest rates, thereby harming domestic economic stability.

Ironically, Treasury buybacks of the debt will benefit foreign investors substantially more than main-street Americans. Nearly 40% of the $3.2 trillion marketable Treasury debt is held by private and official foreign accounts. Ten percent of the cash proceeds would accrue to Japan, 8% to Britain, about 4% to Communist China, and over 2% to OPEC. Only 4% of the cash would go to U.S. households.

Nor will debt reduction prevent more rapid spending. Since the emergence of surplus tax revenues two years ago, Federal spending has shifted into high gear -- rising more than 5% (twice the inflation rate) during the past year. It had actually been declining in the mid-1990s. In fact, interest rates have actually gone up since the emergence of budget surpluses.

What's more, eliminating the marketable Federal debt will not strengthen the Social Security system. Social Security is a separate problem, caused mainly by the fact that the worker-to-beneficiary ratio has dropped in recent decades from 16-to-1 to nearly 2-to-1. As a result, future payroll tax revenues are projected to fall short of baby boomer retirement benefits.

Contrary to what most politicians are telling the public, new incentives from across-the-board marginal tax-rate reduction -- including lower payroll tax-rates and personal retirement accounts -- would be the best medicine to strengthen Social Security. Lower tax-rates would increase employment, productivity and capital formation, thereby raising the volume of payroll tax revenues available for benefit coverage.

IRA-type personal retirement accounts generating a roughly 10% historic stock market return would reduce Social Security payout obligations for the Gen-Xers and sub-Gen-Xers.

By funding retirement benefits for future generations, this market investment approach would wipe out the so-called unfunded future liability of the Social Security system.

There's nothing wrong with paying down a modest share of Treasury debt, especially the high coupon paper issued during the 1980s.

Perhaps a $750 billion debt reduction plan to reduce budget interest expense in the years ahead would be reasonable. But obsessive debt reduction should not be permitted to block tax cuts.

Broad-based tax relief to overcharged taxpayers is the best way to insure that economic power and social responsibility remain in private hands. Tax revenue surpluses should be returned to the entrepreneurs, small businesses, workers and families who earned them in the first place. They will, needless to say, spend and invest their money more wisely than government.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
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12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow