2011 June 29 Wednesday
US Government Interest Rate Risk
For some types of debt the problem with having lots of it is that interest on the debt can go up. Currently the US government can manage to service its enormous and growing debts because interest rates are so low. But what if interest rates turn back up? Lawrence B. Lindsey, a former US Federal Reserve governor, says, if interest rates go back up to levels seen on average over the last couple of decades then the US federal deficit will swell by hundreds of billions per year.
First, a normalization of interest rates would upend any budgetary deal if and when one should occur. At present, the average cost of Treasury borrowing is 2.5%. The average over the last two decades was 5.7%. Should we ramp up to the higher number, annual interest expenses would be roughly $420 billion higher in 2014 and $700 billion higher in 2020.
By running up large deficits even before the bulk of the baby boomers retire Congress and Presidents Bush and Obama have put the US government in a tenuous financial condition. Interest payments are already set to soar. A spike in interest rates could cause a sovereign debt crisis.
Against a background of growing debt, large deficits as far as the eye can see, and a very weak economic recovery we are beginning to see serious proposals to cut entitlements programs. After decades of their unchallenged growth finally we are nearing limits. Representative Paul Ryan wants to turn Medicare into an insurance voucher program. As an alternative Senators Joseph Lieberman and Tom Coburn want to raise Medicare eligibility age to 67 years old. Jennifer Rubin argues only the left wing of the Democratic Party denies current entitlements are unsustainable.
Congress might still duck responsibility for years. But the interest rate risk described by Lindsey could materialize if we continue to see weak economic growth. Deficits will widen and the market will grow nervous about US government debt. I see continued weak economic growth due to peak oil, limited other natural resources, and demographic changes.
The problem is even bigger than the mainstream discussion recognizes because a return to business as usual economic growth rates is still assumed in mainstream models of future program costs and tax revenues. Therefore for your own personal life planning expect to need to work years longer than current retirees did. Raising retirement ages, means-based eligibility testing, cuts in benefits, and higher taxes will all be used as policies to fund entitlements. So even once you retire at a later date you'll be faced with higher out-of-pocket costs.
So what would be wrong with higher interest rates? Responsible people would do just fine. Savers would get a much deserved boost in income. People who bought cars and homes they couldn't afford would get hurt -- who cares?
Interest rates would already have soared if not for QEII, aka the Fed buying the bonds. It's just a question of whether they keep printing or let the interest rates go up. Seems to me like their interests are better served by continued monetization, no matter what Bernanke might be saying right now.
@Jeff: the problem would be that the government couldn't afford the higher rates. As for the people who bought cars and homes they couldn't afford, I don't see how they'd be affected unless they had an adjustable rate mortgage. I do agree that interest rates at an unmanipulated level would be preferable, since it would mean that you could actually save money in conventional fashion.
Charles Hugh Smith has written about "The Con of the Decade" being set up right now.
The financial elites/oligarchy will be able to make a huge killing and centralize assets even more with higher interest rates followed by austerity:
"Here's where we see the Con taking shape. The ideal setup for risk-free returns is to own Treasurys that pay a high yield. The way to get higher interest rates is to first make the Treasury market supremely dependent on a central bank or single buyer: Done. That buyer is the Federal Reserve.
Next, have that buyer stop buying. Suddenly, interest rates start moving up. If you don't believe this is possible, or part of a larger project, then please explain why PIMCO sold all its Treasuries. Duh--because interest rates are set to rise, and not by a little bit or for a brief span, but by a lot and for years.
That means holders of long-term Treasuries (and other debt) will be cremated as rates rise. (Holders of TIPS will do OK, unless the government fraudulently sets the rate of inflation well below reality. Hmm, isn't that exactly what's it's already doing?)
Once long-term rates have leaped up, then start accumulating the high-yield bonds. Why would rates jump? Supply and demand: as the demand for low-yield Treasuries dries up, the supply keeps rising: every month, the Treasury has to auction tens of billions of dollars of bonds, or even hundreds of billions of dollars. There is no Plan B, the bonds must be sold, and if there are no buyers, then the yield has to rise.
Once rates have been engineered much higher, the Financial Oligarchy accumulates the high yielding bonds.
Here's where "austerity" comes in. Once rates are so high that they're choking the real economy, then voices arise demanding the Federal government stop borrowing and spending so much. Austerity (forced or otherwise) soon reduces the supply of bonds hitting the market and so rates decline, boosting the value of the high-yield debt.
To service the cost of all this Federal borrowing, taxes are raised on what's left of the productive members of society.
To add insult to injury, it will become "patriotic" to "buy bonds.""
Charles Hugh Smith continues:
"OK, let's check the setup:
1. Treasury market now dependent on one buyer: check.
2. That buyer stops buying, pushing rates higher: no QE3. Check.
3. "Austerity" is now seen as inevitable--but not just yet: check.
What the true believers of hyperinflation and the destruction of the dollar cannot accept is that debt is an asset to the owner of that debt. In focusing solely on the advantages of inflation to borrowers, they ignore the critical fact that inflation quickly destroys the value of the asset that debt represents to the owner. And debt is a primary asset to pension funds, insurance companies, banks, and indeed the entire financial sector.
So in claiming high inflation is guaranteed, adherents are claiming that the entire financial sector will accept being wiped out, just so Mr. and Mrs. Taxpayer won't have to pay interest on the ballooning government debt.
That's exactly backward: the entire point is for Mr. and Mrs. Taxpayer to pay high yields on Treasury debt, owned by the Financial sector's Oligarchs. The Con is to stripmine the public coffers, then impose higher rates and "austerity", buy the debt with the cash plundered from the public, and then sit back and enjoy risk-free returns as taxes are raised on the remaining tax donkeys. Inexpensive Bread and Circuses (SNAP food stamps and the political theater of the two parties staging a partisan "fight to the death") will keep the peasantry entertained and complicit.
As I concluded in the first foray into the Con:
In essence, the financial Elites would own the revenue stream of the Federal government and its taxpayers. Neat con, and the marks will never understand how "saving our financial system" led to their servitude to the very interests they bailed out.
The circle is now complete: in "saving our financial system," the public borrowed trillions and transferred the money to private Power Elites, who then buy the public debt with the money swindled out of the taxpayer. Then the taxpayers transfer more wealth every year to the Power Elites/Plutocracy in the form of interest on the Treasury debt. The Power Elites will own the debt that was taken on to bail them out of bad private bets: this is the culmination of privatized gains, socialized risk.
In effect, it's a Third World/colonial scam on a gigantic scale: plunder the public treasury, then buy the debt which was borrowed and transferred to your pockets. You are buying the country with money you borrowed from its taxpayers. No despot could do better.
This is the ultimate endgame of the financialization of the U.S. economy and the concentration of wealth and thus political power in the hands of those who skimmed the immense gains from that financialization."
Inflation now is about 1%, it previously averaged around 2.5-3%. If we go back to 5.7% treasury rates, it will be because inflation picked up, which will increase the nominal size of the economy and nominal capital gains, thus increasing tax revenue.
Our debt to GDP ratio is fairly low and our tax rate to GDP ratio is near the bottom for developed economies.
Hereís the mechanism for low rates: 1) Congress raised the debt limit 2) Congress/Treasury types up and submits a Bill to the FED 3) The FED creates digital dollars from nothing and credits the Treasurie's account. 4) Treasury spends the new money into banks, paying Granny for her Social Security or any other Federal requirement. In the meantime, the FED rebates 85% of the debt back to the Treasury. Look up Wright Patterson, who made the FED do this. 5) When the new money hits the private banking system to pay for Grannyís Social Security, it is seen as money that exists outside of said private banking system. It is exogenous money, which came into being at the Treasury/Fed level, not the banking level. 6) If Granny doesnít spend her social security check right away, the private banks see this new money as excess reserves. They then put Grannyís money on the overnight market.
With me so far? 7) Now that Grannyís money is on the overnight market, the price of borrowing money is driven DOWN, due to supply and demand. There is an excess supply of money available to be borrowed.
8) The Fed and Treasury then suck up any excess money using open market operations (OPM). OPM is designed to keep interests rates within a window. The FED and Treasury work together to keep interest rates in a window. Their target is ALWAYS a window, and the only limit on their behavior is INFLATION of our money supply.
9) The Fed buys up Grannyís excess money from the private bankers by issuing more bonds or repos. In effect the private banker can get very low rates on the overnight market, or he can accept higher rates to give the money back to the FED. Which would you do? Free money and free interest from the government, itís great to be a banker.
10) So, what happens if Granny decides she wants her money? The FED and Treasury work together with reverse repos and other devices to funnel the former excess money back to the private bank.
In this complicated way, the Treasury and FED use DEBT to make money come into being and use more debt to control an interest rate window.
But, credit money which comes into being when you take out a loan at the bank, is actually even worse for us than the money from the Government. Remember, the FED rebates 85% of the debt back to the treasury, whereas a bank loan is much worse at sucking out your wealth.
Itís a wonderful system where all money comes into being as based on debt. Debt based money will always suck wealth toward those who have excess money (government/banks/plutocrats). It is a game where you pay a toll in order to trade your own output.
@Dave: it could work out that way. I might add that the oligarchs don't necessarily need to buy high-yielding bonds (timing such a purchase might be difficult unless you have inside information or actual control); investment in stocks or other real assets (Soros is buying farmland) might also serve the purpose. The obvious difficulty is in keeping the US government maximally indebted without actually precipitating some sort of collapse.
@ZZ: 1% may be the official figure, but it is likely understated. Further, it is entirely possible to get 5.7% treasury rates without any inflation: there is this thing called 'supply and demand', and if you try to sell $1.5 trillion in bonds in one year without someone creating artificial demand on the buyer side, you will find that rates can go plenty high regardless of inflation. Thirdly, while inflation does increase the revenue stream from capital gains taxes, back of the envelope calculations suggest that this is an insignificant effect in the face of the mountains of debt being contemplated. Fourth, the fact that other developed economies have mounds of debt does not mean that it's a wise policy - it may just mean that democracies tend to pile on debt in a somewhat irrational fashion, because the politicians have a four-year time horizon while the bankers have a thirty-year one. In short, you are confused on multiple fronts.
@Ross: interesting summary of mechanisms... but isn't it also the case that the Fed loans money to banks in order for them to buy Treasuries? cf. the $1 trillion or so loan to BoA?
The FED can buy a bond on the open market, and use it to funnel money into its banking system. The law makes them do it this way. This is called "base" money, as it is the base at the bottom of the 10:1 credit ratio for which private banks can loan. Private banks can create loans at 10X their reserves. Base money is also called government money, but that is misnomer. Government money comes into being as I explained previously.
The primary bank dealers work with the Open Market Committe to target an interest rate window. In this way they make bonds available to the Treasury and FED, or buy bonds to maintain the window. There is never a bond failure in the U.S. as the money is already spent by the Treasury (defict spend), and then the excess bond money is bought up. People still think bond actions work like they did in the old days when we were on gold.
But, to buy a bond on the open market, the FED can create digital dollars and simply credit the bond holders account. Since the FED is not audited, there is no way of knowing exactly what they are doing.
QE1 was an asset swap where bad paper was taken off of the books of banks and went to the FED. The FED gave them cash for bad paper (bad loans). It makes the banks look better. By the way, this is how the Chinese got rid of their bad communist debt. QE2 was an asset swap, where the FED bought banks excess bonds and gave them cash. In effect QE2 took banks money out of their savings accounts and put it into their cash accounts. The banks then earned less interest income, and had more reserves to loan. This caused a commodity bubble, which we are living today.
QE2 did not fix our underlying problem, which is that homeowners are under water. Whenever their is a giant credit bubble expansion, which then pops, the banks books look bad. The loans were made when houses were high, and now they are low. The bank then will not give out loan money to people who are underwater, which then makes the money supply collapse. 95% of our money supply is credit money that comes into being when you take out a loan.
The real issue is flows of unproductive capital verses productive capital.
Government can spend to consume wealth from the private sector. Government can spend money to build infrastructure and to provide money for private sector savings. Government can spend money to buy your votes. Government can not tax certain people, which in effect is targeted spending. When government taxes, they can drain the money they spent into the economy. If they tax too much they drain credit money out of the economy.
Remember, there are two types of money primarily. Government money which comes into being at the Treasury level, and Credit money which comes into being when you take out a loan. The Government wants to consume from the private sector, and private bankers want their credit money backed up by government power. The two types of money mix in the money supply. It is a recipe for Chicanery on the part of both parties.
So, government can spend so that people have enough cash to have savings. This would be appropriate today, as bank loans need to be paid down. Only the government should spend straight into labor, so said labor can then bring down their balance sheets. By spending into banks, it is effectively making more apples appear on the shelf, but not lowering the price of the apples. People don't want to take out a loan when they are underwater. People need cash in the form of wages, not loans.
A simple tax cut for homeowners would have undone our balance sheet recession. Even better, the banks should have been given a haircut. Simply audit their books an adjust their ledgers. They shouldn't be screaming for the government to issue government money to make their books look better. The banks then DON'T make as much future profit at the expense of today. To bad for the banks, they already own about half of the housing stock and most big buildings in the U.S.
The big problem is unlawful expansion and contraction of CREDIT money, which distorts everything. We need to scrap our system and go to 100% reserve, which is lawful money.
An open letter to economists: A lot of you are confused. It makes me want to give you a supersonic wedgie. Why do we listen to you?
As long as we are in a balance sheet recession, people will want to de-leverage. That means they want to save money and get out of debt. That is exactly what people are doing.
When you pay down your car loan what happens? The numbers fall off of the ledger. Any loan you pay off, the numbers end up disappearing, and you are left with a house or car or some asset. Extra money entering the supply tends to vector to bank balance sheets and then disappear. Please get it economists, because a lot of peopleís livelihoods depend on you.
As long as people are de-leveraging there will be no real inflation, there is deflation. Again, the excess money enters the economy (deficit spend), which allows savings, and said savings can also pay down loans; paying down loans allows numbers in a banking ledger fall to zero. You cannot understand economics if you don't know the mechanisms. The inflation that we do see is in SECTORS. It is commodity inflation and gold and oil things like that. It is often hot credit money seeking returns. The hot money is easy low interest credit, due to spending into the BANKS as I described earlier. But, even with low interest rates, the savers don't want to get loans. It is the speculators who are taking out the loans and driving up SECTORS and seeking safety. Speculators are even causing a carry trade and causing sector asset inflation overseas. Housing will likely double dip back down as asset deflation!!!
The real problem is flows of money are mal-invested. Carry trades (take a loan out in the U.S and spend it overseas) are mal-investment, and government improper spend is mal-investment. Once again, the government can spend in bad ways that cause harm. See my previous comments. It is not deficit spend that is the problem per se. It is how it is spent. The private banks are complicit in that they have co-opted some of our congress critters, and confused others. I suspect Geithner and Bernanke are not dumb, but instead are disingenuous and corrupt. Their paymasters are the private banking system.
Let me help you economists out since you seem confused: 1) We could go to 100% reserve and the economy would be out of debt and roaring within four years. See the Yamaguchi paper at www.monetary.org This is the ultimate solution, and Dr. Yamaguchiís software is available for you to test 2) Within our current Credit system these things could be done: 2A) Haircut the banks 2B) Fiscal spend deficit money directly into labor, this allows wages to pay down the bank balance 3B) Target homeowners with tax breaks.
OK? Very few of you have recommended NONE of these things. You and our government are doing us laboring Americanís a giant disservice. Thanks for nothing.
My question is:
Given all the esoteric machinations above what does one need to do, as an educated middle income DINK, to stay above water or possibly even thrive?
Ross N - you say that inflation is at 1% but that is not what I am seeing. It seems to be more like 10%. It's true that the money supply isn't increasing and there is no demand-pull inflation, but what about cost-push inflation?
CamelCase: There is inflation in some areas and deflation in others. This is the case when you have distorted economics. You have distortions because we have financialized everthing, and our money no longer serves the function of fair valuing of goods and services. It is the money itself, e.g. credit money, that is the problem. That is why we are at a point in history, and inflection point if you will, where we have to change our money system, or go down the path of Statism. See my earlier comment about how government spending into banks causes sector inflation. Look around you, Statism is on the march, and it gets its funding from somewhere. I maintain that its funding is via the credit money system.
An example, the carry trade has pushed up commodities. Goldman Sachs can create new financial vehicles and drive up wheat during bumper harvest years (this ia an actual case proving that supply and demand rules can be obviated). Oil can change hands many times before it gets to the end user, driving up the price artifically. Financiers can pop new credit money into being and bear raid other economies. Derivitive players essentially add layers of insurance onto our money, because our money itself is manipulated. The derivitive players in turn manipulate the credit money further and slice off a piece for themselves. All of this stolen and mal-invested credit money can end up influencing politics and gaining rent seeking favor for industry or individuals. Half of all lobby money comes from the Banking District in Manhatten, and that is just what we can see.
In the stock market they are doing electronic front loading and stealing millions from the producers. The Capitalism we knew has become Pariah Capitalism, or as some call it, Financial Capitalism.
So, the argument about cost push and demand pull is really a side street. (We have both types by the way.) Focus your attention on what money is, which economists will not define. Money is that thing that allows you to trade your output. It is an abstract notion, and it ultimately is controlled by and has its basis in LAW. Money is a man made concept, like mathematics, and it has laws that should be observed. Unfortunately, the history of money has lots of characters who are self serving and distort things for their own gain. These characters often end up in politics, or as head of the Fed, etc. They distort things to rent seek. Hamilton, J.P. Morgan, Rothschilds, etc., history is full.
The answers are not simple if we stay with credit money: We'll have to have more patchwork law to bring it under control, but it will still take lots of tape to keep the balloon from bulging in areas. Clever people will find ways to manipulate the system for their gain. Also, credit money steals quite a bit of usury, as all money in this system comes into being with Credit. In other words you have to pay a credit fee for the right to use this type of money, a form of wealth transfer. Forever, we will be arguing about what kind of inflation or deflation we have. Our children will transfer their output in the form of Usury service to debt holders.
HR6550 was an answer, even though it was promoted by a liberal (Kucinich). But, it is a conservative idea to want the people to keep their wealth and freedom. We don't need any stinking kings, and we don't need to fund our own destruction.