LETTERS TO THE EDITOR: Lesson in deflation from the last US debt pay-off
Financial Times; Feb 6, 2001

From Mr Warren Mosler and Ms Eileen Debold.

Sir, Amity Shlaes correctly observes that "no economic theory can suit all periods" ("Surplus to America's economic requirements," January 30). The more precise observation would be that current economic theories represent a fixed exchange rate paradigm, even though big currencies have been floating for nearly 30 years. Ms Shlaes describes the confusion over the US fiscal surplus in terms of politics, yet there is an equally important economic argument.

The idea that debt is somehow "bad" and a surplus somehow "good" is a throwback to a fixed exchange rate framework. Managing a fixed rate currency requires a government to maintain a given level of reserves to assure convertibility. In this model, an excess supply of local currency leads to excess demand on reserves, often leading to currency devaluation. Taxes in the fixed rate model serve to remove convertible currency that could drain reserves. Government spending leads to a reduction in reserves, but by selling government bonds the exchange of convertible currency for securities defers convertibility until the bonds mature. A government surplus with a fixed exchange rate requires the non-government sector to "sell" the reserve currency to the central bank in exchange for local currency to discharge tax liabilities, building reserves at the central bank.

But the world's biggest economies abandoned this system ages ago. With floating - or fiat - currencies, the risk of losing exchange reserves is not applicable, because the government does not guarantee convertibility. This affects many dynamics, including the imperatives of government securities, the nature of unfunded liabilities, and the determination of interest rates. With floating currencies, taxes create a notional demand for the currency. Without taxes, and without convertibility, there would ultimately be no reason to hold the currency.

Ms Shlaes overlooks historian John Steele Gordon's description of the last US debt pay-off. Andrew Jackson, who viewed debt as a "national curse", completely eliminated the national debt in 1835. He deposited federal surplus funds in his state-chartered "pet banks", causing money supply to grow rapidly as banks increased notes in circulation. This led to enormous land speculation. Horrified by the bubble, Jackson insisted the Land Office accept payment only in gold or silver.

Such a deflationary move brought the speculation to a grinding halt but was also the catalyst for the 1837 Wall Street crash. What followed was a 72-month depression that Gordon called "the most protracted period of continuous economic contraction in US history".

Warren B. Mosler, Chairman, AVM Associates, 250 S Australian Avenue, W Palm Beach, FL 33401, US Eileen M. Debold, Vice-president, The Bank of New York, 32 Old Slip, New York, NY 10286, US

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