Permanently low interest rates for Uncle Sam?

November 22nd, 2009

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Imagine you owe a lot of credit card debt. And also imagine you have a prodigal son who blew lots of money away in gambling debts and asked you for a bailout. So, you borrow more from your credit card to help bail out your son. Also, your yearly expenditure is projected to keep on rising.

As you borrow more, more and more of your yearly income is spent on debt repayment. What if, in 5 to 10 years time, half of your annual income has to be set aside for the interest payments alone for your debt? In addition to that, what if you have already made promises to your aged parents that you will be responsible for their aged care expense in that time? Eventually, it will come a time when you have to borrow more and more money to pay the interests on your debt. When that day comes, your debt will explode exponentially.

Well, this is the situation of the United States government. In this story, the prodigal son is Wall Street. The aged parents is the coming unfunded social security and Medicare liability of the US government. As the graph from this news article showed,

Interests on US debt

Interests on US debt

Now, what if you can choose the interest rates of your debt repayment. Obviously, you will select the lowest possible rates in order to reduce your debt burden. This is what the Federal Reserve will have to do. As we quoted Marc Faber in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

The Fed controls the short-term interest rates. It has keep the rates low because by pursuing tight monetary policy now, the short-run cost of servicing the US government’s debt will be significantly increased. As this?news article reported,

A Treasury borrowing advisory committee reported in early November that “approximately 40 percent of the debt will need to be refinanced in less than one year.

If the US wants to pursue tight monetary policy soon, it will have to deal with the short-term government. One way to deal with it is to refinance the government debt with more expensive longer-term treasury bonds. But the further the term of the government debt, the less the Fed has control on the interest rates.

What if, the free market insists that the US government pay higher interest rates? In that case, the Fed will have to buy up the government debt (i.e. print money), which artificially pushes up the government bond prices (i.e. push down the yield on the government debt). This is highly price inflationary, which in turn will make the government debt even more undesirable by the free market. That will result in the Fed having to print even more!

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