David R. Henderson  

U.S. Government as ARM Borrower

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From my most-recent Mercatus study, "Canada's Reversed Fiscal Crisis," Working Paper No. 11-15, May 2011, co-authored with Jerrod Anderson:

The average annual decrease in government expenditures on interest payments due to falling interest rates ranged from about 0.46 percent to 1.46 percent of GDP between 1996 and 2009, and averaged approximately 1 percent of GDP each year over this period. Therefore, Canada's cuts in spending on government programs took place during a period of falling interest rates, which further decreased government spending by lowering its interest expense on outstanding government debt.
By contrast, the U.S. government unfortunately cannot count on large savings from falling interest rates in future years. The reason is that interest rates are currently at historic lows--the current rate on three-year U.S. Treasury notes is now only 1.28 percent, for example. Interest rates cannot go much lower and are likely to go higher in the future. In fact, although predicting interest rates is always risky, the Congressional Budget Office predicts that interest rates will rise through 2017, with the ten-year Treasury yield rising to 5.4 percent from its current level of about 3.5 percent. Indeed, if anything, the government should go the other way, rolling over expired short-run debt into longer-term debt before interest rates rise further. The government could, for example, convert one- , two-, and three-year debt at 0.23, 0.80, and 1.28 percent, respectively, to seven-year debt at a still-low rate of 2.89 percent. Doing so would cost the government more money in the short run but save it potentially huge amounts in the long run.

I thought of this while reading John Cochrane's "Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic," October 18, 2010. On page 24, John writes:
Last, and perhaps most important, the fiscal analysis suggests that this is an ideal time for the exact opposite policy, to substantially lengthen the maturity structure of US debt. Long-term debt smooths surplus shocks. When a surplus (or discount rate) shock hits, the market value of long-term debt can fall to reestablish fiscal balance, rather than requiring the price level to rise. If the government is rolling over short-term debt, fiscal shocks have to be expressed immediately, as Greece recently discovered. Governments are usually reluctant to fund themselves with long-term debt, on the view (common to hedge funds) that rolling over short-term financing is cheaper. But two percent long-term rates represent an outstanding opportunity for the US to adopt what is, in the fiscal analysis, a much more stabilizing maturity structure.

Of course, the whole Washington establishment seems to be rejecting this idea, which is why I titled my post as I did: the federal government is trying to do what people have done with adjustable rate mortgages, arguing, in effect, "So far, so good."

Co-blogger Arnold commented on John's paper at the time.

HT to Jeff Hummel.


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CATEGORIES: Fiscal Policy



COMMENTS (4 to date)
Scott Sumner writes:

You make a good argument, but I think people might be surprised at how low rates stay for the next decade. There are two previous cases of countries hitting the zero bound--the US in 1932 and Japan in the 1990s. In both cases rates stayed near zero for several decades. (Actually I can't quite say that yet for Japan, but I am confident rates will stay low in Japan for a few more years.)

I don't expect US rates to stay near zero until 2028, but I have a hunch that they will stay relatively low for longer than people expect.

Over the next few decades I'd expect roughly zero real interest rates to be the norm on short term government debt. This is based on the expectation that there will be huge growth in the number of high-saving middle class people in Asia, combined with a dramatic slowdown in Asian population growth, and then a sharp decline. Asia will begin to look like Japan.

David R. Henderson writes:

@Scott Sumner,
Good point. But what if you're wrong? Notice that I didn't advocate switching all debt over to long-term. I think the federal government should do what I do in my investments: diversify. Have, say, 60% of the debt as short-term and 40% as long-term.

Scott Sumner writes:

David, Yeah, you're probably right. I suppose my point was slightly unrelated, but it's something I've been thinking about recently. Maybe I'll do a post when I return.

Justin Rietz writes:

Will shorter or longer term debt be easier for the U.S. to restructure? ;-)

Scott, to your point, the question that lingers in my mind is how effective will the Fed be at managing the massive growth in bank reserves? React too slow to an outflow, and it risks significant inflation, too fast, another economic downturn. Thoughts?

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