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A public policy blog from AEI
The Drudge Report links to a CNBC.com piece entitled “The Fed’s ‘hidden agenda’ behind money-printing.” The article’s claim: Although the Fed justifies its bond buying program — also known as quantitative easing — as a way to boost economic growth, there’s more to the story. The Fed’s “hidden agenda,” apparently, is the suppression of interest rates so Uncle Sam can more easily finance and afford its growing national debt:
I believe that one of the most important reasons the Fed is determined to keep interest rates low is one that is rarely talked about, and which comprises a dark economic foreboding that should frighten us all. … Thanks to the Fed, the interest rate paid on our national debt is at an historic low of 2.4 percent, according to the Congressional Budget Office. Given the U.S.’s huge accumulated deficit, this low interest rate is important to keep debt servicing costs down.
The piece goes to explore a scenario where US interest rates return to their 20 year average of 5.7%. If the federal government were to pay an average interest rate of 5.7% on its debt versus the 2.4% we pay today, debt service cost in 2020 would be about $930 billion. Here is the kicker: 85% of all personal income taxes collected would go to servicing the debt. And who knows, maybe rates will go even higher “as a result of the massive QE exercise of printing money at an unprecedented rate. We just don’t know what the effect of all this will be but many economists warn that it can only result in inflation down the road.”
Sounds awful. But I find this analysis problematic. While the 20-year average for long rates might be 5.7%, the six-decade average is about 3.0%. But the most recent Congressional Budget Office forecast already assumes 10-year rates rise to 5.2% in 2017, close to the rates specified in the article. And CBO forecasts that in 2020, debt service will nearly triple to $644 billion. But guess what? Net interest only doubles as a share of GDP to 2.8% from 1.4%. Total debt as a share of GDP actually declines to 71.5% from 75.1%. And the annual budget deficit falls to 3.2% from 4.0%.
What explains bigger debt but a smaller debt burden? An economy growing faster than the debt. Slow or falling nominal GDP growth is what creates debt problems. As Scott Sumner wrote about the euro crisis:
Lots of news articles on the eurocrisis focus on the sky-high interest rates now being paid by the Spanish and Italian governments, roughly 6%. But I rarely see people pointing out that until a few years ago 6% interest rates on government bonds were completely normal. As was the 70% ratio of public debt to GDP that you see in Spain. So why is this interest rate now such a crushing burden? Simple, in the old days 6% interest rates were accompanied by much more robust NGDP growth rates. The problem today in the periphery is that NGDP growth has collapsed.
You can’t assume all else equal and just forecast debt and interest rates rise. Maybe rising rates reflect faster economic growth. Indeed, as as economist David Beckworth explains, “The proximate reason for today’s low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets.”
The article also makes the mistake of equating low interest rates with the Fed running an easy monetary policy. As Milton Friedman put it: “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead.”
There is also a scenario worth exploring where interest rates never “normalize.” Maybe the Great Recession and Financial crisis have created long-term risk aversion and a desire for AAA US government debt. Economist Brad DeLong:
We may well find ourselves in a situation in which the U.S; government can simply borrow and borrow and never have to pay it back because the economy grows faster than interest accrues. In which case the U.S. government looks much more like the Renaissance Medici Bank–an organization you are happy to pay to keep your money safe, rather than a debtor from whom you demand a healthy return.
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