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Friday, May 6, 2011

It’s the Interest Rate, Stupid -- Squashing It Like a Bug

The U.S. has put itself on a slippery financial slope. The U.S. budget deficits and resulting debt-to-GDP ratio are headed down an "unsustainable path" if current trends continue. There is only one feasible way out of this mess according to a very concise and interesting analysis by James Gailbraith of the Levy Institute. It is for the Federal Reserve to squash interest rates, so that they yield a negative or extremely low real rate of return (after inflation) for a very long time.

In other words, the only way out of the budget mess is for the U.S. is to travel down the same low interest rate path that Japan has been following for the last fifteen years.

 Japanese Interest Rate: January 1990 to May 2011

This is why Bill Gross, head of the investment firm PIMCO, said he would not buy U.S. bonds for his giant bond fund. He did not want to get his "pocket picked" by the negative real returns the U.S. was offering. Gross said: "Policy rates basically pick the pockets of investors... It means investors aren't getting what they should from Treasuries."

Treasury Inflation-Protected Securities, or TIPs, are an example of a U.S. bond that will make you poorer. The MarketWatch article below highlights that point.

Also, pray that there is no serious inflation that upsets this low interest rate apple cart the Fed has started down.

So be warned, if you are a saver, or a retired person, or anyone living on a fixed income prepare yourself for possibly a generation of very low interest rates in this country.
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James K. Gailbraith /  LevyInstitute.org:
Is the Federal Debt Unsustainable? [pdf, 6 pages] --
By general agreement, the federal budget is on an “unsustainable path.” Try typing the phrase into Google News. When I did it, 19 of the first 20 hits referred to the federal debt...

[For example] Greece was (and is still) on an explosive path. Figure 1 shows the growth of the debt-to-GDP ratio for Greece...
Next, let’s apply the same analysis to the United States, using the long-term CBO [Congressional Budget Office] baseline projections, or something close (Figure 2). The CBO appears to call for a real interest rate on US public debt to rise from present negative values to around 3 percent—that is to say, the CBO expects average nominal interest rates on the US debt to run about 5 percent and for the inflation rate to run about 2 percent. A real growth rate of around 2.5 percent is also expected, though I’ll modify that to 3 percent to match the long-term average from 1962 through 2010. The starting point is a debt-to-GDP ratio of .74; let’s assume the primary surplus is about -5 percent of GDP (and that it stays at that high level, indefinitely).

The path shown is, by our definition, plainly unsustainable, though (by a factor of 100!) not so dire as that of Greece. The projected debt-to-GDP ratio rises steadily, reaching about 300 percent at midcentury, which is about what the CBO’s own model would project. It continues rising thereafter...
So long as interest rates exceed growth rates, any primary deficit* is “unsustainable.” ...

There is no reason why a 100 percent–safe borrower [like the U.S. government] should pay a positive real rate of return on a liquid borrowing! The federal government doesn’t need to compensate for risk. It isn’t trying to kill off a high and intractable inflation. It also doesn’t need to lock in borrowing over time; it pays the higher rate on long bonds mainly as a gift to banks. Moreover, it controls both the short-term rate and the maturity structure of the public debt, and so can issue as much short debt at a near-zero rate as it needs to...

Conclusion: It’s the Interest Rate, Stupid

The significant conclusion is that there is a devil in the interest rate assumption. If the real interest rate on the public debt is assumed to be greater than the real growth rate, unstable debt dynamics are likely. The offsetting primary surplus that is required for stability is an onerous burden for most countries, and to achieve it in the United States would be practically impossible, since the required cuts would undermine GDP growth and tax revenues. This is why the various budget plans now in circulation will not work out, if they are ever implemented.

However, where the real interest rate is below the growth rate or even slightly negative, the fiscal balance required for stability is a primary deficit, and the sustainable deficit gets larger as the debt “burden” grows. This is why big countries with big public debts can run big deficits and get away with it, as the United States has done almost without interruption since the 1930s...

The prudent policy conclusion is: keep the projected interest rate down. Otherwise, stay cool...
*Primary deficit is the pure deficit which is derived after deducting the interest payments component from the total deficit of any budget. In other words the total of primary deficit and interest payments makes the fiscal deficit.
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related:
MarketWatch.com:
Holding TIPS will make you poorer -- Commentary: Millions hold an investment guaranteed to lose money ...
Ten-year TIPS are offering real yields below 1%. It’s pitiful. The short-term TIPS are even worse.

As you can see from our chart, the “real” or after-inflation yield on 5-year TIPS bonds has plunged into the red. It’s minus almost half a percentage point a year. That’s right: negative.

In other words, under almost any possible scenario, these bonds are guaranteed to lose you nearly half a percent of your purchasing power, each year, for the next five years — a total loss of 2.5%, guaranteed.
TIPs Suck: They are guaranteed to lose you money

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