Asia Nikkei Business – April 10, 1995

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April 10, 1995

The Consequences of the Worldwide Currency, Debt and Political Crisis

by Martin A. Armstrong, Chairman of Princeton Economics International Japan, Ltd.

The drastic political change that took place last November in the United States is more than merely a shift in power from Democrats to Republicans. The people of the United States have become increasingly angry with government at all levels. The vast amounts of tax revenues that are wasted in the name of the people have enraged tax payers nationwide. The old Democratic slogans of continually blaming the rich are falling on closed minds as people increasingly realize that the problem is not the upper-class but the political-class.

The Republicans have picked up on this nationwide sense of frustration and are actually trying hard to keep their promises for once. The first 100 days will see the House Republicans pass everything that they had promised while the Senate Republicans may not provide the same track record. The Balanced Budget Amendment failed to pass the Senate by one vote helping to set in motion the immediate currency crisis. It is questionable whether a Balanced Budget Amendment will actually pass. This could very well become a plank in the 1996 Presidential Elections. Still, the Democrats are fighting hard by constantly trying to lie to the public about everything with the help of much of the liberal press. This campaign against a Balanced Budget by the Democrats could do more for insuring the party’s ultimate collapse in the long-run.

My sense of Newt Gingrich is that he is an honest man with a true vision who is desperately trying to change the nation for the better. The central core of his agenda is to relinquish federal power and hand as much of it back to the states. This is something that the governors are in favor of at this time. However, the Democrats are determined to keep as much power in Washington even if this is bad for the nation as a whole or against the will of the people.

The clear and present danger to the political process in the United States as well as in all industrialized nations, including Japan, is none other than the growing debt crisis and the towering instability in world capital markets. As concern over debt builds in smaller nations, capital flight has set in motion a sequence of international monetary pressures. From New Zealand, then Australia and off into Europe attacking Italy, Sweden, Spain and even France, capital has been forcing fiscal and monetary change where the people and their politicians have previously refused to act. This debt crisis is now spreading to Canada where a major moratorium if not a temporary default is extremely likely by 1996. Even the bailout of Mexico has yielded far less success than politicians would like to see and capital’s vote of confidence shows anything but stability ahead…

The driving force behind the debt crisis is the alarming increase in the net interest expenditures within all governments budgets. With short-term rates doubling in the past year along, pressure is mounting on governments worldwide. Over the past two years, governments have shifted the funding of their national debuts extremely short-term. In the US, Clinton shifted the national debt to the point that 33% is now funded 1 year or less. This resulted in a $50 billion interest savings in the first year. Multiply that by 5 and add the $250 billion tax increase and you arrive at this so-called $500 billion deficit reduction over 5 years. The problem that emerges is the fact that not one cent in real spending was reduced. Now that short-term interest rates have doubled, the increase in interest expenditures will be nearly $60 billion in 1995. The crisis for the Republicans will be a rising deficit that the Democrats will blame on tax reductions. This will be a Democratic ploy to hide the very source of the problem caused by the Democratic short-term shifting of the national debt as a means of reducing the immediate budget deficit while avoiding real reform and spending cuts.

The US is not alone. Virtually every nation has participated in this same manipulation. Canada, for example, will be unable to reduce expenditure and/or raise taxes fast enough to match the increase in interest expenditures alone within this year’s fiscal budget. Regardless of political determination or central band intervention, international capital is forcing reality into the political scene on a global scale. Politicians, unfortunately, refuse to act or even listen until this international capital disruption forces a crisis within government debt itself. This will most likely prove to be the case not merely within the United State, but throughout all major industrialized nations including Japan.

There is little doubt that the reservoir of capital in off-shore markets has been growing at an alarming rate. It is now widely estimated that nearly $4 trillion resides in such off-shore and untaxed markets. As taxes have continued to rise, capital has been forced off-shore from virtually every economy including Japan. Governments will attempt to shift all the blame for the rising volatility and instability within the capital markets particularly addressing the foreign exchange traders. However, such blame is not merely unwarranted, it is an attempt to blame capital for the unsound finance and political corruption that has emerged on a massive global scale. If governments had not been so power and tax crazy, capital would have remained contended at home.

The current price destruction process in Japan is another victim of this unsettled global capital movement. While our models do warn that the yen could rise significantly going into April reaching a maximum level of 76 against the dollar, such pressure is being applied throughout the international markets. This rise in the yen is forcing a restructuring process in Japan and a true deflationary atmosphere for the Japanese consumer as the cost of imports collapse yielding real competition. At the same time, capital is fleeing most Euro nations concentrating in Germany adding pressure on the budgets of all European nations. This international capital pressure will ultimately force rising interest rates in the United States, restructuring in Japan and Germany and political turmoil everywhere else only to be followed by an explosion in public debt worldwide going into 1998.

Unfortunately, the political changes that are taking place in the United States are still not enough to stop the volatility that is building in the world capital markets by itself. There appears to be no government on earth that even comprehend what is unfolding no less the consequences that lie on the horizon as we approach 1998. The Democrats, as is the case among most socialist parties worldwide, refuse to compromise and insist on all or nothing approach. This will merely insure that the current global capital market crisis will not be stopped before facing change where compromise has been unwilling to surface. The failure of government itself to truly understand the global trends that have been set in motion, will most likely result in a further political disintegration process with blame being hurled at opponents rather than a true unbiased assessment of the consequences of poor judgement on the part of government as a whole. Within the United States, this simply means that the US political system will become much more fragmented as power intensifies within the growing third party movements as the Democrats seek to derail the Republican agenda of reform and the Republicans fail to fully understand the consequences of the debt crisis and the increased volatility in capital market movement.

This shift in political power is not unique to the United States. We are also witnessing a growing regional disparity trend that is causing political uncertainty in the US, Canada, Japan, Germany, England, and throughout Europe as well as in China and Russia. All of these current changes and/or future changes in political trends are being sparked by the growing unsound finance within the governments of the industrialized world as a group.

Society must come to realize that government debt by itself is not the complete issue at hand. What is much more important is how and why that debt is being used. Government spending that is directed at tangible improvements within society creates jobs whereas social handouts and interest expenditures reduce the benefits of government spending within the economy by draining national wealth and productivity. Borrowing from ourselves is a wonderful slogan, but when much of that debt resides in the hands of nondomestic lenders, interest expenditures become a mechanism for the exportation of national wealth rather than an economic stimulus..

Historically, whenever capital becomes uncertain and skeptical about the finances of government, volatility rises and capital moves swiftly in search of stability. This is one reason why the US share market has been rising to new record highs even though the bond markets of the world have declined 25% over the past year. It is widely known that when a share market crashes, bonds rise on a flight to quality. What is often not understood, is that the same process works in reverse when bond markets crash, capital flees to the share market and commodity sectors.

Central banks have been rendered ineffective in the traditional battle against inflation because the greatest demand for borrowing has been shifted from the private sector to that of government. When interest rates are raised in hopes of bringing down demand, it may have an effect upon the private sector that is always forced to live within its means, but it has never had an effect upon government. For this reason, intervention by the central banks has had little long-term effect upon the modern capital markets of today and could arguably play a role in accelerating the debt crisis within the public sector on a global basis.

While the Japanese share market may still drop below the 14,000 level going into April or as late as May/June, the capital flight from the public into the private sector will also materialize in Japan going into 1996. This suggests that when a new low in the Nikkei 225 unfolds, we will most likely see a reaction high in the JBGs simultaneously. The capital markets are effectively bringing and end to the deflationary trend in Japan that will then be followed by an inflationary trend that will peak in 1998.