"Debt, Interest Rates, Price Fixing & Fear"

                  Sydney M. Williams

Thought of the Day

“Debt, Interest Rates, Price Fixing & Fear”

April 13, 2015

In a speech to business executives, shortly before he resigned as Chairman of the Joint Chiefs of Staff in September 2011, Admiral Michael Mullen was quoted: “I’ve said many times before that I believe the greatest threat to our national security is our debt…”

In his most recent “Grant’s Interest Rate Observer,” Jim Grant noted that for nine years, 1942 to 1951, the Federal Reserve kept the Treasury Bill yield at 0.375% and the Long Bond yield at 2.5%. “The object,” as he wrote, “was not to stimulate the economy, but to cheapen the cost of wartime…government borrowing.”

Excessive debt, as Admiral Mullen suggested, places a burden on future generations and limits our abilities to be proactive, whether it is fighting terrorists, educating our youth, feeding the poor or retrofitting bridges. Normalized interest rates would considerably burden an over-burdened federal budget. Projected borrowing costs on public debt are projected to be $250 billion in 2015, or 6% of the federal budget. Should rates return to their average of the last two decades, interest costs would more than double, putting pressure on such non-mandatory spending categories as defense and education.  For the five years through 2008 Fed Funds averaged just under 3.0%. Today they are one twelfth that number. A conundrum facing the Fed: Will they ever be able to release the controls they now have over the cost of money?

Since the end of 2008, the Federal Reserve has kept Fed Funds at 0.25%. During that time, the Three-Month Treasury Bill has never risen above 0.25%, and has spent most of the time under 0.10%. On Friday, it closed at 0.02%. By the end of 2009, the Ten-Year Treasury was yielding 3.8%, up from 2.2% at the end of 2008. In the midst of the credit crisis, in November 2008, the Federal Reserve began buying mortgage backed securities, easing the burden of homeowners. By June of 2010, with $2.1 trillion having been purchased and the economy looking a little better, the program was halted. In August, however, with the economy once again stumbling and deficits exploding, the Fed began its first round of quantitative easing, with a program to purchase $30 billion of Two-to-Ten Year Treasuries every month. Since then, the yield on the Ten-Year has averaged 2.5%. It closed Friday at just under 2.0%. The Fed’s balance sheet, which went into the crisis with about $900 billion in assets, now stands at $4.4 trillion.

Mr. Grant’s explanation for war-time price controls on interest rates has a familiar ring. We have, of course, been involved in a war against Islamic terrorism for almost fifteen years. While that has caused spending to increase, this war – unlike World War II – has not been the main cause of our ballooning debt. That explanation has to do with our welfare state, its growth and the costs it entails. The real reason for extraordinarily low interest rates, as it was seventy years ago, is more about easing annual federal deficits than helping the economy. Despite low interest rates, GDP growth, since the economy began its recovery in June 2009, has been the slowest in post-War history.

The price of any commodity has a number of components, the most important of which is supply and demand. Money is no different. Typically (and classically) when borrowing demand increases, prices (interest rates) rise. “Price fixing” can mediate those swings, which accounts for one of the Fed’s mandates – maintaining stable pricing. The price of money, however, is also subject to other factors, like fear. The fear of a credit collapse, for example, will send investors into the safest of all assets – very short term government bills. Borrowing costs for the U.S. government are low, while in places like Japan and Switzerland they are negative. Just imagine, lenders to the Swiss government will be receiving an annual negative return of 0.055% for ten-year paper! One has to ask, with returns so low, why are sophisticated investors willing to accept little or negative returns? The obvious answer seems fear – perhaps of the debt to which Admiral Mullen alluded; perhaps because banks too big to fail have become even bigger; perhaps, as Jamie Dimon recently suggested, new bank regulations encourage banks to rush to cover at the first sign of trouble; and perhaps because governments have allowed monetary responses to substitute for fiscal ones, suggesting administrative and legislative bodies have abandoned their responsibilities.

The obvious, but unsung victims of central banks’ easing policies have been savers – generally low and moderate-income seniors living on fixed annuities and the like, who cannot afford to speculate, and who have seen substantial declines in income.

The Fed, along with the Administration and Congress use the excuse that the economy needs stimulating and therefore rates need to remain low. They claim that the risk of current deflation out-weighs that of future inflation. Perhaps that is true, but the price of education and healthcare continue to rise. In Connecticut, we were hit with a 26% increase in electric rates at the beginning of the year. And, as mentioned above, low rates have done little to boost economic growth. One reason for anemic growth has been that demographically we are an aging population, with fewer people working relative to those that are retired. Another reason has to do with the deleveraging of the consumer from mortgage debt incurred in the run-up to the 2008 credit and housing collapse. But perhaps most important is the fact that both Congress and the Administration have largely stayed on the sidelines, in the sense that neither has addressed the complexities in our tax codes, nor the burdens in a regulatory process that is good for lawyers, but not for many others.

It is true that deficits have been declining, but they are doing so from high levels. The last seven years have seen the seven highest deficits in our history. The deficit for 2015 will likely rank as the eighth. In the meantime, total federal debt is approaching $19 trillion.

The real problem facing Americans has been a loss of confidence in the future. People see the country moving in the “wrong direction,” with neither Party providing an upbeat message for economic growth. In my opinion, the time in which we are living is reminiscent of the late 1970s, when we sensed the United States was on a downward trajectory. It took the sunny outlook of Ronald Reagan to shake the nation free of despondency – to bring “morning to America” again. In 2016, we must seek the candidate that can best restore faith in America – that the future is bright if we honestly face the debt problem that confronts us.