The End of Free Money for the US Government

The End of Free Money for the US Government

Wednesday, 14 February, 2018 - 11:30
For most of the past decade, fixed-income investors have effectively been telling the US government: Borrow more money! Please!

A simple quantitative measure of this sentiment has been the yield on inflation-indexed five-year Treasury bonds (aka Treasury Inflation-Protected Securities, or TIPS), which has been below 1 percent since September 2009 and spent much of the time since then in negative territory. Yes, investors have been paying the US government to take their money.

My use of the word "investors" is perhaps a bit misleading, given that the biggest buyer of Treasuries from 2010 through 2014 was another arm of the US government, the Federal Reserve, as it engaged in the massive stimulative effort known as quantitative easing. Five-year TIPS yields did keep flirting with zero even after the Fed stopped adding to its holdings in October 2014, though, and in any case, the combination of Fed and market buying has allowed the government to borrow tons of money at quite a low cost. Gross federal debt rose from $9 trillion, or 61.8 percent of gross domestic product, at the end of the 2007 fiscal year to $20.2 trillion, or 105.5 percent of GDP, at the end of fiscal 2017, but interest payments on that debt actually fell as a percentage of GDP over that period.

Lately, of course, interest rates have been inching back up. The yield on five-year TIPS is still well below 1 percent, but it's higher than it's been at any time since 2011. And while the recent rise in bond yields and the accompanying stock market tizzy may turn out to be fleeting, there are at least two reasons to think this in fact represents a turning point. One is that, in October, the Fed shifted from not increasing its holdings of Treasuries to actually reducing them. The other is that, with the tax bill enacted in December and the budget deal agreed to last week together likely to increase the deficit -- 3.5 percent of GDP in 2017 -- by 2 percent of GDP or more, government borrowing is going to rise over the next few years.

That the timing of this renewed borrowing boom is perhaps not optimal has been widely commented upon. Increasing borrowing in 2011 or 2012, when the unemployment rate was above 8 percent and real interest rates below zero, would have made a lot more sense than doing it now. By pushing hard for deficit reductions then, congressional Republicans almost certainly harmed the economy. By legislating deficit increases now, they're showing themselves to be cynical hypocrites, although the jury's still out on whether they'll be harming or helping the economy. "Certainly there's a risk that interest rates will spike," White House budget director Mick Mulvaney acknowledged on Sunday. 

Whether interest rates "spike" or not, the combination of even modestly rising rates and increased government borrowing will make interest payments on government debt a bigger part of the fiscal picture. Overall government spending in fiscal 2017 was, at 20.8 percent of GDP, barely higher than the 20.6 percent average since 1980. When you look just at non-interest spending, though, the gap between 2017's 19.4 percent and the 18.4 percent average since 1980 was markedly bigger. Declining interest rates allowed spending on Social Security, Medicare and Medicaid to rise while not bumping up overall government outlays much. That's about to start changing.

The Congressional Budget Office projected last summer that net interest payments would more than double as a percentage of GDP over the next decade; I have to think the projected interest payments will be much higher when the CBO finishes factoring in the legislative changes of the past few months. Here's net interest expressed as a percentage of total federal spending, with the (outdated) CBO projections to 2027 included.

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