Wednesday, March 27, 2013

Debt, Deficits and "Normal" Interest Rates

Interest rates are at historic lows, largely as a result of Federal Reserve policies which are attempting to help the nation's economy to recover and normalize over time.

But while the Fed's intentions are good, the consequences of their current actions, both short and longer term, may not end up being so good. We need to clean up our financial act in order for our nation's financial and economic growth story to have a happy ending.

In the here and now, one analyst believes that gasoline prices are dramatically higher today than they would be if normal interest rates prevailed. See Fed's Unintended Consequences Are Hitting Everyday Life which says the following about oil prices and current Fed policy:

"By (the analyst's) math, the cost of (Federal Reserve policy), at least as it pertains to crude oil, is pushing up the price by about 50%, instead of the $65 a barrel level where he thinks current supply and demand metrics imply that it really should be. But since the Fed is actively (and justifiably) putting more dollars into the economy, he says that has resulted in "more dollars chasing that fuel," which of course leads to higher prices."

That's bad enough, but we don't even have to guess about what will happen when interest rates eventually rise to 'normal' levels, which they undoubtedly will in the next few years. The government's Congressional Budget Office has already done the math for us.

If Interest Rates Rise, Larger Deficit Follows has the details for us:

"Big borrowers are very sensitive to interest rates. The federal government is a big borrower. Even at today’s super-low interest rates, Washington spends a lot of money on interest — more than 6% of all federal spending last year.

And it will spend more on interest as rates move back toward normal, as they surely will someday. The Congressional Budget Office expects rates on three-month Treasury bills (now close to zero) to be at 4% in 2023 and rates on 10-year Treasury notes (now around 1.9%) to at 5.2% in 2023. If current budget policies persist, more than 14% of federal spending will go to pay the interest tab.

What if rates go higher than that? In response to a query from a member of Congress, CBO has done some calculations.

If interest rates rise to the averages seen between 1991 and 2000 — that is, 4.9% on the 3-month Treasury bill and 6.7% on the 10-year Treasury note in 2023 — then the deficit would be $274 billion bigger in that year than it would otherwise be — and $1.44 trillion bigger over 10 years. . . .

Of course, interest rates depend on inflation and on the strength of the economy and on Federal Reserve policy, all of which would have big effects on the budget.

But the point is clear: A government that borrows a lot will spend a lot more on interest when rates return to normal. And because about half of all U.S. government debt is now held overseas, that means a lot of that interest would be paid for foreigners, particularly the Chinese and Japanese."

Summing Up

The world's current financial situation as well as its near term outlook for economic growth are indeed bleak.

Cyprus is broke. Spain and Italy aren't far behind. Greece and Iceland went broke earlier. France, England and many other European countries are heavily in debt as well.

In the U.S., we're living on more and more borrowed money, and the Federal Reserve is actively practicing 'financial repression' by keeping unusually low interest rates. That can't continue indefinitely, and depending on what we do about solving our nation's economic problems the next few years, it could end either happily or as a financial disaster.

While I don't expect the result to be financial disaster, as a nation we simply can't ignore reality much longer. Accordingly, it's absolutely essential that we take the necessary time and available opportunity to clean up our act NOW with respect to our budget deficits and growing national debt while we're still able to do so.

Because when (not if) interest rates do rise, that increased interest expense will apply to whatever debts we have at the time as well as the current debts.

And the interest costs that amount to 6% of federal spending this year could easily amount to 14% or higher ten years from now. That's something we can't afford.

That's my take.

Thanks. Bob.


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