Interest Rate Explosion to Follow Debt Explosion?

In 2003, Thomas Laubach, an economist in the Federal Reserve’s Division of Research and Statistics, wrote a paper titled “New Evidence on the Interest Rate Effects of Budget Deficits and Debt.” At the time, federal debt here in the U.S. seemed to be under control, and I’m not sure how much notice the paper received. But its conclusion has obvious implications today, as we contemplate the unprecedented mountain of debt that the Obama administration intends to incur in the years to come:

This study has shown that statistically significant and economically plausible estimates of the effects of government deficits and debt on interest rates can be obtained by focusing on long-horizon forecasts of future deficits or debt, and future interest rates. The projections of deficits and debt published by the CBO and the OMB are arguably among the best publicly available forecasts for these variables. The effects of these projections manifest themselves at the longer end of the yield curve, as economic reasoning would predict. All else equal, the results of this study suggest that interest rates rise by about 25 basis points in response to a percentage point increase in the projected deficit-to-GDP ratio, and by about 4 basis points in response to a percentage point increase in the projected debt-to-GDP ratio.

If, like me, you’re not an economist, that may seem a little dry. The Telegraph supplies some context: “US lurching towards ‘debt explosion’ with long-term interest rates on course to double.”

Applying [Laubach’s] assumptions to the recent spike in the US fiscal deficit and national debt, long-term interests rates will double from their current 3.5pc. The impact would be devastating by making it punitively expensive to finance national borrowings….

The US deficit has blown out from 3pc to 13.5pc in the past year but long-term rates are largely unchanged. Assuming Mr Laubach’s “typical estimate”, long-term rates have to climb 2.5 percentage points. …

Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points. The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down.

Long-term interest rates have indeed begun to rise. The Fed appears to be more or less complicit in the Obama administration’s scheme to run up debt that, as a percentage of GDP, is unprecedented except for the last year or two of World War II. Maybe someone in Congress–it would have to be a Republican–should ask Ben Bernanke whether he has some reason to disagree with the Fed’s own economist’s projections.

The Obama administration, with the enthusiastic connivance of the Democratic leadership in Congress, has set the nation on an economic course that cannot possibly have a happy ending.


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