The United States is not like Spain, Italy, Ireland, Japan, Greece or even France, all of which have large debt burdens, long-term productivity and economic growth problems, expensive social welfare and entitlement programs, rigid labor markets, stifling regulation and much higher tax rates.

The U.S. economy is the most diverse, flexible and resilient in the world. There remains some tax room for deficit reduction. Capital markets are broad, deep, and very accessible, although perhaps not on the microcap level. There is entrepreneurial verve, dynamism, innovation, renewal and creativity, things that are limited or absent in many other nations, particularly in Western Europe.

There is a growing population, to provide future demand, future labor and future taxpayers to support programs and debt servicing. There is a huge new, cheap energy resource in the form of shale gas and oil that, along with abundant cheap labor, depressed real estate, and new manufacturing technology, is starting to make the U.S. a low-cost industrial location once again. However, there remain some troubling similarities, which have much bearing on the course of interest rates.

U.S. Federal Government Debt Near Worrisome Levels

The U.S. federal government’s debt, depending on what is netted against it, is at about 100% of GDP. That is considered a tipping point by some economists; after escalation beyond that ratio, it becomes difficult for a nation to right itself fiscally without radical restructuring, default or something equally traumatic.

The U.S. federal budget deficit is about $1.2 trillion this year, about 8% of GDP. Less than $300 billion of that, 2% of GDP, is interest costs, since interest rates are so low and the government, perhaps unwisely, has been borrowing at the short end of the yield curve, where interest rates are under 1%. So, the rest of the deficit, over $900 billion — 6% of GDP — is either cyclical, or worse: structural.

The cyclical part is that which is caused by tax revenues being depressed by slow economic growth, and outlays for unemployment insurance, aid to states, welfare, and other formerly temporary benefits.

The structural part is that part that is now built in by virtue of low tax rates, deductions, credits, exclusions and dysfunctional collection; and permanently higher expenses for programs. Much of this has been intentionally enacted since the financial crisis began in 2008, and is now difficult, politically, to change.

Turning Japanese? Or Not?

In the 1990’s, Japan experienced a real estate bust that strained government, personal and corporate finances for a long time. The government embarked on a stimulus program, and greatly enhanced and modernized infrastructure. Debt also exploded. Japan’s debt-to-GDP ratio is now approaching 200%.

The nation has the oldest average age in the world, and highest longevity in the world, and one of the lowest birthrates, and very low immigration. This rapidly shrinking and aging population is exacerbating the government’s finances. Fortunately for Japan, it retains a current account surplus and a high savings rate, allowing it to finance itself without being dependent on capital inflows from foreign investors.

However, that is reaching its limit. Despite active financial repression from the Bank of Japan, which has kept interest rates even lower than they are in the U.S., Japan will soon not be able to finance its deficits or service its debt internally. Foreign investors may show some reluctance to accept low yields from a borrower that shows no sign of slowing its growth of debt, let alone reducing the total.

While Japan’s situation is a more advanced case of what lies in store for the United States, the U.S., along with a larger and more dynamic economy and growing population, has the additional advantage of having the world’s reserve currency. It also has the biggest capital markets — bond and stock — in the world. It is in no immediate danger of default or a big spike in interest rates. Yet, it cannot be too complacent.

One Nation Which Does Have Some Resemblance to the U.S.

There is one nation which has some uncomfortable similarities to the U.S. It, too, had a privately financed real estate and construction bubble, with the bursting of that bubble having cause major asset damage to important banks, which have taken a bail-out.

It, too, has a large budget deficit, some of which is cyclical, and some of which has become structural, with not enough growth to shrink it. Finally, it has persistently high long-term unemployment, very high youth unemployment, and heavy social welfare and entitlement spending burdens that are growing and will continue to expand with an aging population.

That nation is Spain, which actually has a much lower debt to GDP ratio than does the United States, and a lower deficit as a percentage of GDP. However, it is suffering from the perception that it cannot grow out of its escalating debt servicing costs, hence the interest rates it must pay on the bonds it issues are much higher than that of comparable Treasuries, or even those of Germany, which, like Spain, uses the common Euro currency. Some regions in Spain are in effective default already, much like some municipalities in the U.S.

As part of the Euro zone, Spain cannot issue bonds in its own currency anymore, and allow that currency to devalue to the point where its exports become competitive and demand for imports plummets, thus giving a boost to its economy and allowing it to grow and finance its expenses again. The United States is still able to do that; for now.

Threats to Continuing Decline of U.S. Interest Rates

There are a number of threats to the continued trajectory of lower U.S. interest rates:

External Shocks

The first is external shocks: war of some kind, in the Middle East, South China Sea or Latin America; oil price escalation; and a sharp, severe credit event, such as one or more defaults or effective defaults in the European Union or elsewhere.

Just about all of those possible external shocks, which should cause U.S. rates to go up on anxiety, uncertainty, and in competition with higher rates elsewhere, could actually have the perverse effect of lowering U.S. rates further, for two reasons: 1) the safe haven or alternative that the U.S. offers, and 2) the increased probability of recession, or at least much lower economic growth, reducing credit demand.

Internal Shocks

The second threat is an internal shock: Another major credit downgrade of federal debt by a rating agency; a major liquidity or solvency crisis at a U.S. bank, other financial company, or a municipal or state government; year-end sequestration or other drastic or dysfunctional action that reduces the perceived or real solvency or debt-servicing capacity of Washington. A large tax increase would do it.

Investors Start to Lose Interest, While Demanding More of It (Sorry)

The third possible threat is a drying up of buying of U.S. debt by investors, which could have one or more causes: A jump in inflation, possible with all the money creation, making realized returns fully negative; speculators and traders willing to borrow short and buy long gradually becoming fewer and fewer and finally reversing strategy; issuance of federal debt becomes too large to be easily and quickly absorbed; the Federal Reserve ends its financial repression and is no longer a buyer of bonds; the economy picks up, making investors favor stocks over bonds, at the margin.

Debt Servicing Difficulty

The fourth possible threat is actual inability to easily finance or service debt, and, as the U.S. is a net borrower from abroad, also put downward pressure on the U.S. dollar. That is not a near-term possibility, but perceptions of it could increase, and become self-reinforcing as they cause interest rates to climb, and debt service costs to escalate, making the federal deficit balloon, as in Spain.

Federal and state employee retirees, and general population Social Security obligations and health care spending are set to dramatically rise in volume over the next several years, and well beyond, to occupy the bulk of government spending. Tax increases needed to pay for them would hobble the economy and reduce the ability to fund those programs. Without reform, the programs will cause a big increase in government outlays and increased borrowing.

Capital Account Flows Help Dollar, Current Account Outflows Hurt It

As the U.S. borrowing demands increase more and more, the increased funding will come from abroad. Capital account flows will temporarily buoy the U.S. dollar, and also make U.S. exporters less competitive, but the increases flows of interest payments abroad will eventually make the currency decline, as it did in the late 1980’s, after an earlier large round of deficit financing. This currency decline will make investing less attractive, and interest rates will rise further to induce buying of debt by foreigners. It is impossible to predict when this might start to happen.

An Exhortation to Policymakers, If Any Are Listening

I was wrong last November when I made the judgment that U.S. rates were unlikely to fall further. I am certainly not suggesting that, in the current dismal economic climate here and abroad, that they will. Certainly the U.S. is the best-looking major market by comparison. However, if it continues on its present course, those rates will almost certainly have to rise.

Although the U.S. very definitely is not Japan, it is starting to have more than just a passing resemblance to Spain. It does not have to end up that way, but any budgetary and tax measures thus far, if enacted this year or next, will tend to either lower growth or widen the deficit, with the latter putting upward pressure on rates in the near term, and the former (i.e., lower growth) doing so later on, in the longer term.

Serious budgetary and operational restructuring, major simplification of regulation, and tax reform including simplification are needed. The bond market can continue to flummox both observers and some participants for quite some time longer, and then take its revenge on everyone later on, when least expected, even when predicted beforehand not just by myself, but many others who now gaze in wonder. Ol?!

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