Monday, March 4, 2013

Low Interest Rates Won't Last Forever ... Our Heavily Indebted Government Needs to Take Advantage of These Rates While There's Still Time

Interest rates are at historic lows. It's a good time to 'rent' long term money whether it's an individual, a company or a government needing to do the borrowing. And that's especially true if it's a still creditworthy borrowing government like the U.S.

However, our government's short term focus is going to end up making us all cry someday if we don't take the necessary steps to get our country's fiscal house in order.

That said, we could borrow billions of dollars in 'debt rollover' money for 30 years now, and then give ourselves whatever part of the ensuing 30 years we will need to get our nation's current and historic financial mess straightened out.

So let's examine another wrongheaded set of financial policies emanating from Washington today and discover what we can do to make the best out of an admittedly bad situation.

And let's also consider this --- however bad the mess is, two wrongs don't make a right, and continuing to practice the two wrongs (deficits and short term borrowing) approach to financing our ongoing deficits is sheer idiocy.

And that government knows best short term focused idiocy has to stop someday. So why not now?

Treasury Needs a Better Long Game is subtitled 'Today's low interest rates are a rare opportunity to buy time for a fiscal housecleaning:'

"Sooner or later, the Federal Reserve will want to raise interest rates. Maybe next year. Maybe when unemployment declines below 6.5%. Maybe when inflation creeps up to 3%. But it will happen.

Can the Fed tighten without shedding much of the record $3 trillion of Treasury bonds and mortgage-backed securities on its balance sheet, and soaking up $2 trillion of excess reserves? Yes. The Fed can easily raise short-term interest rates by changing the rate it pays banks on reserves and the discount rate at which it lends.

But this comforting thought leaves out a vital consideration: Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest.

Will Congress and the public really agree to spend $900 billion a year for monetary tightening? Or will Congress simply command the Fed to keep down interest payments, as it did after World War II, reasoning that "Fed independence" isn't worth that huge sum of money?

This additional expenditure would double the deficit, which tempts a tipping point. . . . Higher rates mean higher deficits—leading to a fiscal death spiral.

Many economists think the tipping point starts when total government debt (federal, state and local) exceeds 90% of GDP. We are past that value, with large state and local debts, continuing sclerotic growth and a looming entitlements crisis to boot. . . .

The obvious answer is to fix the long-run deficit problem, with the reform of runaway spending, entitlement programs and a pro-growth tax policy. So far that is not happening.

Still, the Fed and the Treasury can buy a lot of time by lengthening the maturity of U.S. debt. Suppose all U.S. debt were converted to 30-year bonds. Then, if interest rates rose, Treasury would pay no more on its outstanding debt for 30 years. And if the country couldn't solve its fiscal problems by that time, it would deserve a Greek crisis.

Alas, . . . our government rolls over 40% of its debt every year, and 65% within three years. . . . Thus the fiscal impact of higher interest rates will come quickly.

Mr. and Mrs. Smith shopping for a mortgage understand this trade-off. Mr. Smith: "Let's get the adjustable rate, we only have to pay 1%." Mrs. Smith: "No, honey, that is just the teaser rate. If we get the 30-year fixed at 3%, then we won't get kicked out of the house if rates go up."

Amazingly, nobody in the federal government is thinking about this trade-off. . . .

What to do? . . . the Treasury should seize its once-in-a lifetime opportunity to go long. Thirty-year interest rates are at 2.8%, a 60-year low. Many corporations and homeowners are borrowing long to lock in low funding costs. So should the Treasury.

You may complain that if the Treasury borrows long, then long-term rates will rise. If so, it is better that everyone knows that now. It means that markets aren't really willing to buy long-term government debt, that the 2.8% yield is only a fiction of the Fed's current buying, and that it won't last long anyway. Better fix the fiscal hole, fast.

You also may argue that 2.8% long term-debt is more expensive than 0.16% one-year debt. There are two fallacies here. First, the 2.8% long-term yield reflects an expectation that short rates will rise in the future, so the expected cost over 30 years, as well as the true annual cost, are much closer to the same. Second, to the extent that long-term bonds really do pay more interest over their life span, this is the premium for insurance. Sure, running a restaurant is cheaper if you don't pay fire insurance. Until there is a fire.

A much longer maturity structure for government debt will buy a lot of insurance at a very low premium. It will buy the Fed control over monetary policy and preserve its independence. . . .

But we don't have long to act. All forecasts say long-term rates will rise soon. As the car dealer says, this is a great deal, but only for today."

Summing Up

The concept of reversion to the mean is real, meaning simply that at some point interest rates will rise.

Whether due to inflation risks, economic growth, government mismanagement or just plain scared creditors demanding higher interest rates, interest rates will increase from their current historic lows.

And if they were to revert to those 'normalized' rates anytime soon, our nation's fiscal deficits would double.

That's a scary thought. The situation is also entirely avoidable --- for now at least.

Thus, the ability to borrow long term money, while admittedly more expensive than rolling over today's short term debt, is just that --- long term money.

And going long will give our government knows best gang, if prodded enough by We the People, sufficient time to get our fiscal house in order and avoid a catastrophe in the form of a return to higher interest rates in the next several years.

So why wait and why take the unnecessary but all too real interest rate risk?

Why not buy some cheap insurance protection in the form of long term borrowings while there's still time?

This pervasive government short-term-itis has to stop.

It's time to consider a time-frame that lasts longer than the next election.

Our kids and grandkids deserve at least that much from our government and from the rest of us too.

That's my take.

Thanks. Bob.

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