The United States is caught in a circle of borrowing and spending funded by low interest rates. But that can only go on for so long. We have reached the floor for interest rates and without the political will to reduce spending back in line with tax revenues, we will not be able to grow the economy.

As an individual or private company, the more debt you borrow, the riskier you or your company becomes, and the more expensive it is to borrow more debt. There’s also a limit on how much you can borrow based on your ability to repay the borrowed funds.

But while private companies have these constraints, apparently the federal government does not.

There’s a recent Wall Street Journal editorial discussing the borrowing habits of the federal government. The main point of the article is that the federal government should begin issuing long-term debt (upwards of 50 years or more) to take advantage of incredibly low federal borrowing rates (1.45% on 10-year and 2.18% on 30-year).

But my take-away from the article is that while interest expense is actually less today than it was in 1995, it’s not a lasting situation as the level of debt has actually tripled during that time. But because interest rates have dropped so significantly during that time, the government has been able to borrow more and more without paying more. At least without paying more today.

The problem arises when interest rates move back up again.

“The Con­gres­sional Bud­get Of­fice re­ported in July that fed­eral debt held by the pub­lic has surged to 75% of GDP from 39.3% in 2008. In its new long-term fore­cast, CBO projects debt ris­ing to 86% of GDP in 2026 and to a whop­ping 110% in 2036, ex­ceed­ing the his­tor­ical peak of 106% af­ter World War II.”

 

Fed Funds Rate vs Treasury Rate

Previously, I discussed how much debt the United States currently has outstanding. Just including the amount owed by the federal government, it’s over $19 trillion. And while that’s a large number, by itself, the number is meaningless. Instead, I prefer asking what does it mean when to have this much debt owed?

I’ll preface this by saying, I am not an economist. And I may have some glaring errors in my analysis. If you spot something, feel free to bring it to my attention. My goal is to not only help readers gain a better understanding of this issue, but also to expand on my own knowledge.

Before we get started, I should clarify that there are two different interest rates that I’m discussing here. The first is the benchmark borrowing rate. In the US, this rate is referred to as the federal funds rate and it is the interest rate at which banks lend money to other banks overnight. Although the actual rate is set by agreement between the borrower and the lending bank, the target rate for these overnight borrowing transactions is set by the Federal Reserve.

The other is the interest rate at which the federal government borrows money. This rate is referred to as the treasury rate and depends on the term (10 year, 30 year). Treasury rates are set by the market and influenced by such factors as supply and demand as well as current and future expected conditions in the economy.

 

Interest Rates Impact Government Behavior

Over the years, the target fed funds rate has ranged from nearly 20% in the last 70’s and early 80’s to the near zero rate where it currently stands. There tends to be two factors at play in determining how the government sets the rate:

(1) The government uses fed funds rate management in an attempt to control economic growth. This is the traditional view of the government’s role. When the economy is growing, raise interest rates to slow the growth and minimize inflation. When the economy is flat, or slowing, lower interest rates to reduce the cost of funds and encourage spending and investment.

(2) But there is also a correlation between the fed funds rate and treasury rates. Recall that the treasury rate reflects the cost for the government to borrow money to spend on programs. So because the government sets the target fed funds rate which has an impact on the treasury rate, the government can somewhat set the rate it pays to borrow money.

 

Government Borrowing Differs from Private Borrowing

Everyone agrees that too much debt is a bad thing. The question is where is the line between an appropriate debt level and too much debt? Many readers would say any debt is too much. Wherever you fall on the spectrum, the amount you can borrow is dictated by the lending markets.

The government’s borrowing threshold isn’t dictated so much by the markets but through Congress.

But here’s the problem. As interest rates decline, it becomes more and more attractive for governments to issue more debt. Essentially, if the government originally borrowed at 8%, but can now borrow at 2%, it makes perfect sense to refinance. That’s exactly what you or I would do with out home mortgage.

But the funny thing is the government never pays that money back. Unlike when you or I borrow, government debt is repeatedly refinanced over and over again. Effectively, the government isn’t paying off the original principal, it only pays the interest incurred which it has control over.

And because it is much easier politically to borrow money than it is to cut services, governments tend to continue this cycle of borrowing and spending.

But also as interest rates decline, the ability to use interest rate management to control economic growth diminishes. Although that doesn’t stop governments from trying as evidenced by the recent announcement that the Bank of Eng­land cut its bench­mark in­ter­est rate to a new low and said it would buy gov­ern­ment and cor­po­rate bonds as part of a broad pack­age of mea­sures to stim­u­late the U.K. econ­omy in the wake of the Brexit vote.

 

In Summary

The federal government sets the target fed funds rate at which banks lend money to each other overnight.

The target fed funds rate is used to control economic growth based on the government’s assessment of current and future economic trends.

The fed funds rate also influences the treasury yield, the rate at which the federal government borrows to fund its operations and programs.

By lowering the fed funds rate, the government has been trying to stimulate the economy and at the same time provide a cheaper cost of funds for government spending thereby allowing spending to increase without paying more.

But just like anyone funding a growing level of spend using debt, at some point, the debt will need to be repaid.

And because the amount borrowed has increased so significantly, if rates do increase by much, the government will not be able to fund the debt service.

Even with rates as low as they are, and the government talking about wanting to increase the fed funds rate, I still think there isn’t much opportunity to increase rates.

We are caught in a vicious circle of borrowing, spending, and lower rates.

As such, I think it’s likely that interest rates will continue to stay low for a long time.

 

Readers, any thoughts on my logic? What impact would long-term low interest rates have on your retirement plans?

 

About Financial Slacker

After over 20 years in the corporate world, I realized that I was a Financial Slacker. I spent all my time making money for others rather than for myself.

So I decided to make a change.

The good news is that despite being a Financial Slacker, I had saved and invested enough that I didn't need to worry about retirement.

But I wasn't ready to retire so I decided to start working for myself applying everything I knew about business, finance, and investing.

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