OPINION:
Since midsummer, interest rates have been surging. This will have painful implications for the sustainability of federal spending — particularly on entitlements and defense — and the vitality of the economy.
On July 27, the Federal Reserve last boosted the federal funds rate — the rate banks charge each other for overnight loans — a quarter point. From then until Hamas attacked Israel on Oct. 7, the 10-year Treasury rate jumped nearly a full percentage point to 4.8%.
This likely caught Chairman Jerome Powell, other Fed policymakers and the vast majority of economists by surprise. On Aug. 30, this column predicted the 10-year Treasury rate was headed for 5% when that benchmark was still only 4.1%.
For investors, when interest rates rise abruptly on newly issued debt, the market value of their bond holdings, which pay older, lower coupon rates, fall significantly. The July-August bond rout was likely the worst in 150 years, and bondholders’ losses rivaled those that stock investors took during the global financial crisis.
For too long, ordinary Americans and Washington policymakers have ignored the warning signs.
In 2011, the S&P downgraded U.S. federal debt, and that was easy to blow off. The world was still recovering from the global financial crisis, and the dollar was the essential currency for global trade. It’s the vehicle currency for 90% of foreign exchange transactions, and foreign central banks back up their currencies by holding interest-bearing U.S. Treasury securities.
Federal deficits have continued to grow, and what Washington spends is not adding enough to growth. Since President Ronald Reagan, Republican administrations have cut taxes, Democratic administrations have increased entitlements, and neither political party is much inclined to roll back tax cuts on working- and middle-class Americans.
We far outspend Russia and China combined on defense, but China has a larger navy, and we would be challenged to defend Taiwan or the critical lanes of commerce in the South China Sea.
Money lent to college students and then forgiven is not producing the skilled workers the economy needs. It’s hard to argue that the Biden administration is spending its infrastructure and industrial policy money as effectively as it could.
Much of the aid given to the automobile sector to reduce the cost of electric vehicles may be dissipated by the settlements the Detroit Three reach with the United Auto Workers. Those manufacturers, which in terms of sheer capacity represent the core of the U.S. auto sector, already suffer substantial cost disadvantages to Tesla.
U.S. foreign policy reliance on sanctions — in particular, access to the dollar payment system — has soured larger non-Western governments on the dollar. Central banks in Brazil, China, Japan, Saudi Arabia and elsewhere are halting dollar purchases, which reduces the overall demand for U.S. debt.
Hedge funds, mutual funds, insurers and pension funds will play a greater role in financing U.S. debt, and this will add to the volatility of Treasury security prices and rates.
At the same time, European nations are caught in a similar budget scissor.
They will have to spend more on defense with Russia, Iran and China behaving so aggressively, or face a grim future of democracy in permanent retreat and a less secure world for their businesses and citizens.
With aging populations, falling birthrates and the costs of replacing Russian natural gas and decarbonization, like ours, their governments are running much larger deficits post-COVID.
Not that the United States will default on its debt. But with the federal deficit at $1.7 trillion in fiscal 2023 and likely to grow without major cuts in entitlement spending, curtailing defense outlays, or lifestyle-reducing tax increases, the U.S. Treasury is pushing more debt on global markets than those are willing to finance at rates much lower than 5% on the 10-year note.
The Fed could become promiscuous. It’s selling off the Treasury securities it acquired during the pandemic, and it could start buying bonds again. But that would create a larger money supply and inflation.
Investors would demand even higher interest rates.
Near-term banks face defaults and corporate bankruptcies. Shaky small businesses and the landlords of half-vacant commercial buildings struck obsolete by remote work can no longer buy more time by borrowing cheaply.
Homeowners locked into cheaper mortgages won’t sell until they have no choice but to move or die.
In the long term, a lot of innovation in America has been driven by cheap capital. Consider all the startups that have been financed by angel investors that until now did not have a good place to park their money.
Funding for projects to create new apps or build out artificial intelligence — or to finance windmills to replace coal-fired power plants — will become scarcer.
In the end, a government that borrows too much and spends money poorly taxes its citizens through inflation and slower growth.
• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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