I've been puzzled for the past few years about why the long-term interest rates on US gubmnt bonds are as low as they are. Given the continuing size of the gubmnt deficit, given the massive entitlement commitments in the form of Social Security and Medicaid, and given the apparent unwillingness of US politicians to do much about these foreseeable budget problems, I see only two possibilities for the future:
- the US gubmnt has to borrow a bunch more money. But if/as they increase the demand for lendable funds, that will drive up the interest rate. Why are the markets not anticipating that increase now?
- The gubmnt, combined with Fed support, might try to keep interest rates low for awhile, but eventually won't these attempts eventually lead to gigantic increases in the money supply? If so, then eventually the rate of inflation will increase, leading to an increase in the expected rate of inflation. And, following the Fisher equation, an increase in the expected rate of inflation would lead to an increase in the nominal rate of interest.
I suppose there are other solutions, but those two seem most likely. Both lead to large increases in the interest rate over the next few (?) years.
If I'm right, why haven't interest rates begun to rise, especially for the long-term US debt? It turns out I'm not the only one to ponder this (of course). David Henderson has actually, inter alia, recommended that the US start borrowing more at those low long rates and borrow less using short-term debt. David quotes John Cochrane,
Of course Cochrane's and Henderson's advice "go long" is directed toward the US gubmnt. Offsetting advice to investors would be to stay short and liquid. I cannot imagine that it would be sensible to lock any money into 30-year US Treasuries which as I type this are paying only 2.76%.
Here's the nightmare scenario: Suppose that four years from now, interest rates rise 5 percent [he means "5 percentage points], i.e. back to normal, and the US has $20 trillion outstanding. Interest costs alone will rise $1 trillion (5% of $20 trillion) - doubling already unsustainable deficits! This is what happened to Italy, Spain, and Portugal. Don't think it can't happen to us. It's even more likely, because fear of inflation - which did not hit them, since they are on the Euro - can hit us.