The United States is not like Spain, Italy, Ireland, Japan,
Greece or even France, all of which have large debt burdens,
long-term productivity and economic growth problems, expensive
social welfare and entitlement programs, rigid labor markets,
stifling regulation and much higher tax rates.
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The U.S. economy is the most diverse, flexible and resilient in the
world. There remains some tax room for deficit
reduction. Capital markets are broad, deep, and very
accessible, although perhaps not on the microcap level. There
is entrepreneurial verve, dynamism, innovation, renewal and
creativity, things that are limited or absent in many other
nations, particularly in Western Europe.
There is a growing population, to provide future demand, future
labor and future taxpayers to support programs and debt
servicing. There is a huge new, cheap energy resource in the
form of shale gas and oil that, along with abundant cheap labor,
depressed real estate, and new manufacturing technology, is
starting to make the U.S. a low-cost industrial location once
again. However, there remain some troubling similarities,
which have much bearing on the course of interest rates.
U.S. Federal Government Debt Near Worrisome Levels
The U.S. federal government's debt, depending on what is netted
against it, is at about 100% of GDP. That is considered a
tipping point by some economists; after escalation beyond that
ratio, it becomes difficult for a nation to right itself fiscally
without radical restructuring, default or something equally
The U.S. federal budget deficit is about $1.2 trillion this year,
about 8% of GDP. Less than $300 billion of that, 2% of GDP,
is interest costs, since interest rates are so low and the
government, perhaps unwisely, has been borrowing at the short end
of the yield curve, where interest rates are under 1%. So,
the rest of the deficit, over $900 billion -- 6% of GDP -- is
either cyclical, or worse: structural.
The cyclical part is that which is caused by tax revenues being
depressed by slow economic growth, and outlays for unemployment
insurance, aid to states, welfare, and other formerly temporary
The structural part is that part that is now built in by virtue of
low tax rates, deductions, credits, exclusions and dysfunctional
collection; and permanently higher expenses for programs.
Much of this has been intentionally enacted since the financial
crisis began in 2008, and is now difficult, politically, to change.
Turning Japanese? Or Not?
In the 1990's, Japan experienced a real estate bust that strained
government, personal and corporate finances for a long time.
The government embarked on a stimulus program, and greatly enhanced
and modernized infrastructure. Debt also exploded.
Japan's debt-to-GDP ratio is now approaching 200%.
The nation has the oldest average age in the world, and highest
longevity in the world, and one of the lowest birthrates, and very
low immigration. This rapidly shrinking and aging population
is exacerbating the government's finances. Fortunately for
Japan, it retains a current account surplus and a high savings
rate, allowing it to finance itself without being dependent on
capital inflows from foreign investors.
However, that is reaching its limit. Despite active financial
repression from the Bank of Japan, which has kept interest rates
even lower than they are in the U.S., Japan will soon not be able
to finance its deficits or service its debt internally.
Foreign investors may show some reluctance to accept low yields
from a borrower that shows no sign of slowing its growth of debt,
let alone reducing the total.
While Japan's situation is a more advanced case of what lies in
store for the United States, the U.S., along with a larger and more
dynamic economy and growing population, has the additional
advantage of having the world's reserve currency. It also has
the biggest capital markets -- bond and stock -- in the world. It
is in no immediate danger of default or a big spike in interest
rates. Yet, it cannot be too complacent.
One Nation Which Does Have Some Resemblance to the
There is one nation which has some uncomfortable similarities to
the U.S. It, too, had a privately financed real estate and
construction bubble, with the bursting of that bubble having cause
major asset damage to important banks, which have taken a bail-out.
It, too, has a large budget deficit, some of which is cyclical, and
some of which has become structural, with not enough growth to
shrink it. Finally, it has persistently high long-term
unemployment, very high youth unemployment, and heavy social
welfare and entitlement spending burdens that are growing and will
continue to expand with an aging population.
That nation is Spain, which actually has a much lower debt to GDP
ratio than does the United States, and a lower deficit as a
percentage of GDP. However, it is suffering from the
perception that it cannot grow out of its escalating debt servicing
costs, hence the interest rates it must pay on the bonds it issues
are much higher than that of comparable Treasuries, or even those
of Germany, which, like Spain, uses the common Euro currency.
Some regions in Spain are in effective default already, much like
some municipalities in the U.S.
As part of the Euro zone, Spain cannot issue bonds in its own
currency anymore, and allow that currency to devalue to the point
where its exports become competitive and demand for imports
plummets, thus giving a boost to its economy and allowing it to
grow and finance its expenses again. The United States is
still able to do that; for now.
Threats to Continuing Decline of U.S. Interest
There are a number of threats to the continued trajectory of lower
U.S. interest rates:
The first is external shocks: war of some kind, in the Middle
East, South China Sea or Latin America; oil price escalation; and a
sharp, severe credit event, such as one or more defaults or
effective defaults in the European Union or elsewhere.
Just about all of those possible external shocks, which should
cause U.S. rates to go up on anxiety, uncertainty, and in
competition with higher rates elsewhere, could actually have the
perverse effect of lowering U.S. rates further, for two
reasons: 1) the safe haven or alternative that the U.S.
offers, and 2) the increased probability of recession, or at least
much lower economic growth, reducing credit demand.
The second threat is an internal shock: Another major credit
downgrade of federal debt by a rating agency; a major liquidity or
solvency crisis at a U.S. bank, other financial company, or a
municipal or state government; year-end sequestration or other
drastic or dysfunctional action that reduces the perceived or real
solvency or debt-servicing capacity of Washington. A large
tax increase would do it.
Investors Start to Lose Interest, While Demanding More of
The third possible threat is a drying up of buying of U.S. debt by
investors, which could have one or more causes: A jump in
inflation, possible with all the money creation, making realized
returns fully negative; speculators and traders willing to borrow
short and buy long gradually becoming fewer and fewer and finally
reversing strategy; issuance of federal debt becomes too large to
be easily and quickly absorbed; the Federal Reserve ends its
financial repression and is no longer a buyer of bonds; the economy
picks up, making investors favor stocks over bonds, at the margin.
Debt Servicing Difficulty
The fourth possible threat is actual inability to easily finance or
service debt, and, as the U.S. is a net borrower from abroad, also
put downward pressure on the U.S. dollar. That is not a
near-term possibility, but perceptions of it could increase, and
become self-reinforcing as they cause interest rates to climb, and
debt service costs to escalate, making the federal deficit balloon,
as in Spain.
Federal and state employee retirees, and general population Social
Security obligations and health care spending are set to
dramatically rise in volume over the next several years, and well
beyond, to occupy the bulk of government spending. Tax
increases needed to pay for them would hobble the economy and
reduce the ability to fund those programs. Without reform,
the programs will cause a big increase in government outlays and
Capital Account Flows Help Dollar, Current Account Outflows
As the U.S. borrowing demands increase more and more, the increased
funding will come from abroad. Capital account flows will
temporarily buoy the U.S. dollar, and also make U.S. exporters less
competitive, but the increases flows of interest payments abroad
will eventually make the currency decline, as it did in the late
1980's, after an earlier large round of deficit financing.
This currency decline will make investing less attractive, and
interest rates will rise further to induce buying of debt by
foreigners. It is impossible to predict when this might start
An Exhortation to Policymakers, If Any Are
I was wrong last November when I made the judgment that U.S. rates
were unlikely to fall further. I am certainly not suggesting that,
in the current dismal economic climate here and abroad, that they
will. Certainly the U.S. is the best-looking major market by
comparison. However, if it continues on its present course,
those rates will almost certainly have to rise.
Although the U.S. very definitely is not Japan, it is starting to
have more than just a passing resemblance to Spain. It does
not have to end up that way, but any budgetary and tax measures
thus far, if enacted this year or next, will tend to either lower
growth or widen the deficit, with the latter putting upward
pressure on rates in the near term, and the former (i.e., lower
growth) doing so later on, in the longer term.
Serious budgetary and operational restructuring, major
simplification of regulation, and tax reform including
simplification are needed. The bond market can continue to
flummox both observers and some participants for quite some time
longer, and then take its revenge on everyone later on, when least
expected, even when predicted beforehand not just by myself, but
many others who now gaze in wonder. Olé!