Saturday, June 13, 2009

What Happens to US Federal Budget Deficits When Interest Rates Go Back Up?

Here is something you hardly ever hear the Mensas bring up on the cable shows or talk radio:

"What will happen to the budget deficit projections when interest rates go back up?"

You know they will; they always do. It has only been in the recent past that we have seen interest rates touch the incredibly low levels of next to zero. For much of the time since 1970, interest rates have been much higher. In 1981, the federal funds rate hit an amazingly high level of 16.39%, believe it or not, for those of you who were just kids or not even born at the time.

We have been through difficult economic times before so this current deflating recession (deflession?) is nothing new. It is just particularly hard and deep because of all of the excesses in spending and consumption we have done over the past couple of decades.

One thing you won't hear most politicians tell you is just how bad of a hole we are really digging ourselves into with all of this deficit-spending they are authorizing. President Obama and Speaker Nancy Pelosi came out this week to say they wanted to reinstate the PAYGO spending requirements that says any dollar spent on health care has to be saved from some other program or paid for by a new tax.

That is a little like giving birth control pills to a young lady who finds herself unfortunately 6 months pregnant, isn't it? A much larger national debt baby is on its way whether we like it or not and no amount of wishing and hoping and rubbing on the magic lamp will put that genie back in the bottle at this point.

Sometimes economic statistics can be interesting and exciting, believe it or not. Sir Winston Churchill took the opposite view when he said: "Statistics are like a drunk with a lamp post: used more for support than illumination."

But when you get a chance, take a look at the 2009 Statistical Abstract for the United States at "Bond Yields" and see what you think. We have been able to pay historically very low rates of interest for the humongous amounts of debt we have had to issue for the past 8 years, and almost inconsequential levels of interest rates in 2008.

Interest rates on all bonds are sensitive to inflation expectations. When the expectations of inflation fell from 1992-1998 or so, and it looked like the federal government was finally getting its fiscal house in order, interest rates plummeted. This reduction in interest costs, plus the "peace dividend" from lower defense costs post-Iraq War I, contributed to the reduction of overall spending costs and led to the balanced budgets that ensued after the Balanced Budget Act of 1997.

But what will happen in 2010, '11, '12 when inflation expectations rears its ugly head and we are still running $1 trillion annual deficits after the Obama Health Care plan is enacted? We have injected so much monetary stimulus into the economy by the Federal Reserve 'expanding its balance sheet' that it is almost inconceivable to believe we will avoid rampant inflation in coming years.

If we are paying 4.25% today in interest rates to the Chinese government to take this debt load off of our hands, what will we be paying when inflation goes back up to say 5% per year? Some experts believe 'rampant inflation' won't happen in the modern globalized financial world. I hope they are right. But what if they are not?

Will the Federal Reserve ever be able to 'de-leverage' its balance sheet as easily as it "expanded its balance sheet" to buy the auto companies and extend TARP payments to all the banks? What exactly would that mean and how will the process occur precisely? Burn up all the excess currency we have been printing up over this past year?

Our current gross interest costs for the government now runs close to $500 billion per year. What if interest rates go back up to 7%, 9%, 16%? Will federal budget interest costs ramp up to $1 trillion per year? The President’s FY2007 Budget contained a sensitivity analysis that estimated the 5-year additional cost of only a 1% increase in interest rates over that period of time to be $203 billion. What happens if it is a 3% increase in interest rates? 5%?

We really don't know. The extraordinarily high interest rates and inflation caught everyone by surprise in the late 1970's, including virtually all of the economists and expert forecasters . The implosive downturn in the economy recently caught virtually the same group of experts and econometricians by shock and awe as well. We just do not know for sure what the future holds.

The only thing we can absolutely control is how much we allow our congressional representatives and senators to spend. And we are not doing a good enough job yet since Congress is still pumping out more spending than ever before.

Use the links on the right side of this column to contact your representative and senator and tell them to stop. You are our only hope.

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