Deficit, Debt, Interest Rates, and Inflation

Here is a post I've cobbled together from a wide variety of sources about the relationship between the federal deficit, debt, interest rates, and inflation...





Our deficit is a result of spending more money than we bring in.  (http://www.federalbudget.com has a pretty neat chart showing the breakdown of the budget.)  The difference becomes our debt.  The Federal Reserve (separate, nonelected) conducts open market operations to issue debt.  From Wikipedia: Gross debt has increased over $500 billion each year since fiscal year (FY) 2003, with increases of $1 trillion in FY2008, $1.9 trillion in FY2009, and $1.7 trillion in FY2010.^[7] Together with the budget deficit, this debt was one of the reasons given by Standard & Poor's to downgrade the United States' credit outlook to "negative" on April 18, 2011.^[8] (from Wikipedia)

The U.S. debt is over $14 trillion, and is the sum of all outstanding debt owed by the Federal Government. Nearly two-thirds is the public debt, which is owed to the people, businesses and foreign governments who bought Treasury bills, notes and bonds. The rest is owed by the government to itself, and is held as Government Account securities. Most of this is owed to Social Security and other trust funds, which were running surpluses. These securities are a promise to repay these funds when Baby Boomers retire over the next 20 years. (Source: U.S. Treasury, Debt to the Penny;Debt FAQ)

Interest on the debt was $414 billion in Fiscal Year 2010, higher than the $383 billion in FY 2009, but lower than its peak of $451 billion in FY 2008. That's because of lower interest rates. The interest on the debt is the fifth largest Federal budget item, after Defense and Security spending ($890 billion), Social Security ($730 billion) and Medicare ($490 billion). (Source: U.S. Treasury, Interest)

Since most debt is fixed in nominal terms, higher inflation erodes its real value. So we have to now explore interest rates and inflation.

Over time, diminished demand for U.S. Treasuries could increase interest rates, thus slowing the economy. Furthermore, anticipation of this lower demand puts downward pressure on the dollar. That's because dollars, and dollar-denominated Treasury Securities, may become less desirable, so their value declines. As the dollar declines, foreign holders get paid back in currency that is worth less, which further decreases demand. (I’ll talk about the dollar in another post)

The great thing about economics (or the horrible thing), is that it’s all model based and theory – you don’t know if something will happen until it happens.  A quick search for egghead research shows that while inflation is the biggest driver of interest rates, it’s tough to nail down the coorelation.  Some pullout quotes:

Does government debt affect interest rates? Despite a substantial body of empirical analysis, the answer based on the past two decades of research is mixed. While many studies suggest, at most, a single-digit rise in the interest rate when government debt increases by one percent of GDP, others estimate either much larger effects or find no effect. (Eric M. Engen, R. Glenn Hubbard, 2004)

“The estimated 30 basis point effect on interest rates of a percentage point increase in the projected deficit-to-GDP ratio is shown to be consistent with the 4-to-5 basis point effect of an increase in the projected debt-to-GDP ratio.” New Evidence on the Interest Rate Effects of Budget Deficits and Debt, Thomas Laubach, Board of Governors of the Federal Reserve System, April 2005

The Fed has been printing money like crazy [not literally, of course (the “printing” part)] through open market operations.

So inflation is a rise in prices that leads to a decline in the purchasing power of the dollar.  With a rise in inflation, interest rates would have to rise to provide a positive return on investments for lenders.  (If the dollar isn’t worth as much, you need to get more back for your investment.)  In the 2000’s, interest rates have been super low while inflation has actually outpaced lending rates.  So the government has paid off debt in cheapened dollars. 

Unfortunately, our debt continues to increase beyond what we are paying back.  So as our debt grows, interest rates have to be low so the government can keep running massive deficits.  Unfortunately, creditors won’t be willing to lend money to receive a negative return.  So, then why not raise interest rates to attract creditors?  

Here’s some bullet points about the risk of increased interest rates on the Government:

·         Rising interest rates will increase deficits.

·         Increased deficits increase the debt

·         Increased debt means higher interest payments (which then create higher deficits, which then creates more debt, and I guess higher interest rates)

·         Eventually, the government will need to borrow more than is available.

·         Oh, and all the trillions sitting in government debt held by pensioners would be evaporated

How do we get out of it?  Less spending or higher taxes.  That’s it.

Here’s some bullet points about the risk of increased interest rates on individuals and companies:

·         Increases the cost of borrowing (higher interest payments)

·         Increase in mortgage interest payments (a 0.5 increase in rates increases the cost of a $100,000 mortgage by $60 a month)

·         Decrease in spending (costs more, plus bigger incentive to save because you get a higher return on interest payments)

·         Increase the value of the dollar (exports less competitive – exports down, imports up, Aggregate demand reduced) 

OR 

Decrease in the value of the dollar if the government prints more money (QE3?) 

·         Decrease in consumption

·         Decrease in confidence

·         Decrease in business investing in their business (too expensive to pay back)

·         Decrease in production

·         Decrease in tax generation (which doesn’t help out the government section, above)

In the Budget and Economic Outlook from January, CBO estimated that 1 percent higher interest rates each year could increase deficits by $1.3 trillion over ten years. CBO also estimated a few other "rules of thumb" to show how changes in inflation and economic growth have significant impacts on budget forecasts. The projections show that lower economic growth of just 0.1 percentage point each year could increase deficits by $310 billion over ten years, while 1 percentage point higher inflation each year could add almost $900 billion to deficits.

The Debt Ceiling

One final comment about this whole Debt Ceiling debate going on.

Since March 1962, the debt ceiling has been raised 74 times, according to the Congressional Research Service. Ten of those times have occurred since 2001.  

If we don’t raise it, the government wouldn’t be able to pay off the debt it owes.  If we’re not seen as reliable, lenders probably wouldn’t want to take on our debt.  Interest rates would go through the roof if our credit rating dropped.  I don’t think S&P will downgrade us, but the fact that people are talking about it should make these Tea Partiers embarrassed by their massive ignorance.

Yes, increasing the debt ceiling will devalue the dollar, but that’s not the biggest issue right now. 

I’ll end with some larger pullouts to try to temper the hysteria that’s out there.

Our GDP is about $14 trillion.  Therefore, our debt – GDP ratio is 100%.  From elliotwave: Even though Japan's sovereign debt is at one of the highest levels in the developed world (200% of GDP), its bonds are held dear despite the tiny interest rates they pay. In contrast, the market requires Greece to pay much higher rates, even though it has a lower debt-to-GDP ratio. [115% as of July 2010; expected to be 150% by end of 2011.] Why? It's another display of non-rational, emotion-driven markets, since it's not the actual ability to repay that matters in the near term -- it's the perception of the ability to repay. 

Basically, if the U.S. gets in a position that we can’t repay our debts, then the world is H.O.S.E.D.

I love the Economist.  I’m going to let it finish this off with messages that allay and alarm:

http://www.economist.com/blogs/freeexchange/2011/04/american_government_debt_7:

Against this, one must set some offsetting pieces of information. American economic growth is generally quite hardy relative to that in other rich countries. The IMF projects that America will grow consistently faster than Europe over the next few years, and by 2016 America is forecast to grow at twice the German pace. This will make it easier to handle a given debt load. America's demographics are relatively better than those elsewhere, and if immigration picks up post-crisis, the fiscal situation could begin to look much better. America is the issuer of the world's dominant reserve currency and the world's most plentiful safe asset. Foreigners hold huge stocks of dollars and Treasuries and other dollar-denominated securities, and they therefore have an incentive to support the dollar and Treasury prices. And many of the other available safe assets aren't particularly attractive right now; as Gillian Tett put it in a conference last week, American yields are low not because American debt is winning a beauty contest but because it's losing an ugly contest.

http://www.economist.com/blogs/buttonwood/2011/06/escaping-debt-crisis:
On the primary deficit front, while higher inflation would boost tax revenues, it would also push up spending on state benefits and public sector wages. It is not clear that it would be beneficial; the UK recently blamed inflation for increasing its deficit.

On interest rates, investors would demand a higher interest rates to compensate for the inflation risk. While they might be surprised by inflation for a while, as they were in the 1970s, sending real rates negative (or even more negative than they are at present), they would eventually cotton on. Real rates in the 1980s were very high.

Governments would be cushioned from this process a bit since the value of existing debt would be eroded. But the US government, for example, has an average debt maturity of around four years. Britain has a much longer maturity at around 13 years but around a fifth of its debt is inflation-linked. And of course, to the extent that governments are running deficits, they have to fund themselves all the time.

…

Of course, governments could side-step the markets and get their central banks to buy all the debt; a sort of QE on steroids.  The risk of this outright monetisation is a very high inflation rate indeed.

And that brings us to the question of what would happen to GDP while inflation was increasing. A high inflation rate wouldn't just affect government bond yields. Remember that private sector debt is a much higher proportion of GDP than it was when inflation was let loose in the 1970s. In Britain, 66% of outstanding mortgage debt is variable rate; a significant rise in interest rates would devastate their finances. In the US, homeowners are mostly on fixed rates but more than a quarter of corporate debt is short-term and thus floating rate. New businesses would find it much more expensive to finance themselves, reducing job creation. Nor would consumers necessarily push up demand in the face of high inflation. Savings rates rose in the 1970s, apparently because savers have some "nest egg" figure in mind, and thus save more when the real value of their existing nest egg is eroded.

Even if growth was maintained in a brief inflationary period, central banks would then want to get it back down. As we have seen in the past, this usually involves generating a recession. If the debt burden had not been substantially reduced, policymakers would end up back where they started.

As Redwood and Bootle conclude:

The idea that inflation can be raised by a controlled amount for a fixed period then easily brought back down again is naive. When inflation has been used to reduce debt in the past, it has usually happened because a government has resorted to this out of desperation and weakness, rather than because it has judged that it is in the best interest of the economy in the long-term.