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. And 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 to owe this much debt?
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 late 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.
And 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 our home mortgage.
Funny thing though – the government never actually 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.
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.
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 spending 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 low interest rates.
As such, I think it’s likely that interest rates will continue to stay low for a long time.
Route To Retire says
I’ve heard that low rates will probably stick around for a while as well. Although this is a pretty bad predicament, I’m going to try to use that to my advantage and purchase a couple more rental units for the long term. That’s about the best I’ve got for my plans.
— JimView Comment
Vicki@Make Smarter Decisions says
I’m with Jim here and we may try to buy a few more rental units too. The rates are low enough that it makes it very tempting!!View Comment
Financial Slacker says
Makes sense to me.View Comment
Financial Slacker says
I agree. Just heard about someone who refinanced at 2.5% yesterday. As much as I dislike debt, with rates this low, you need to take advantage.View Comment
Two major problems with this approach.
1. The more money “created” by the Federal Reserve in its attempts to borrow its way out of the economy doldrums, the faster the money in my pocket loses its value.
2. By constantly refinancing, and only paying the interest, the government is in effect getting new credit cards and doing cash balance transfers to pay off the old credit cards. It’s obviously bad for you and me. Why doesn’t everyone else see how bad that is for the government, and by extension, our nation?
This is a sad state we find ourselves in, and it’s not going to end well.View Comment
Financial Slacker says
If you look back over time, the country tended to get into deficits during times of war. And during peace time, the country could repay the borrowed money and maybe even build a surplus.
Lately, we’ve just decided to lower rates to spend more.
It can’t end well.View Comment
I’m with everyone else. I agree the rates are going to remain dangerously low, and that I’ll take advantage by re-financing debt I have.View Comment
Financial Slacker says
The only challege I see with rental property is when you live in a market with flat or even declining population and a surplus of residential real estate.
But when rates are low, it’s best to figure out how to use a little leverage.View Comment
Finance Solver says
Huh, I majored in economics and had no idea that continuous debt borrowing could keep rates very low. Great analysis and thoughts, FS. One thing that scares me with interest rates being so low is the fact that I work for a bank. The mortgage rates have been phenomenally low and it’s impacting a lot of business but I guess it’s great for buyers right? I’m planning on buying a property in the next 5 years for rental income so hoping that interest rates remain so low. Thanks for the analysis and your input!View Comment
Financial Slacker says
Thanks, Finance Solver.
With interest rates so low, if you have a long time horizon and can absorb a decline in market value (if one occurs), real estate definitely makes sense.View Comment