Tax Analysts Blog

Interest Rate Anesthesia About to Wear Off

Posted on May 22, 2009

London markets took a beating Thursday (stocks down 2.7%) when Standard & Poor's issued a warning that the U.K. government's AAA bond rating could be in jeopardy in the future. The reason for S&P's new outlook: the British government's spiraling debt. The country's net debt as a percentage of GDP is projected to increase from 49 percent in 2008 to 97 percent in 2013.

This sparked concerns that the United States could be next, and the Dow declined 1.5 percent. One market analyst said, "The market is right to ask whether a U.S. ratings outlook change could occur shortly." In the U.S., net debt as a percentage of GDP is projected to increase from 44 percent in 2008 to 77 percent in 2013.

Concerns about a government's financial soundness means that it will have to pay more to attract borrowers. As the Wall Street Journal points out, judgments about U.S. fiscal credibility will show up in the yields on Treasury debt.

The U.S. government has been enjoying incredibly low interest rates because investors around the world have sought the comparative safety of U.S. government guaranteed debt. (Temporarily low interest rates and low gas prices are the only good things about this recession.) That lucky break for the U.S. may be ending. The U.S. is losing its "haven appeal" as investors regain their appetite for more risky investments. "People are re-examining basic trades as part of the risk recovery story and it makes sense that money should flow towards higher-yielding assets and beyond the U.S.," explained one expert.

Yields on Treasury debt are, in fact, rising as shown in the adjacent chart.

Moreover, interest rates are moving to higher levels than the government predicted, with little prospect of them declining this year. As OMB Director Peter Orszag points out, "it is expected that as we come out of the downturn bond yields will go up." This means federal deficits will be larger than predicted.

And it's more than just government finances that are at risk from higher interest rates. The health of the whole economy could be in jeopardy. One unnamed administration official is paraphrased as saying, "the biggest threat to the economy [is] the risk that the bond market might lose confidence in U.S. public finances, pushing up bond yields and throttling growth."

It is almost inevitable that major tax increases are in our future. Columnist Martin Wolf said it more eloquently when he wrote, "the effort to consolidate public finances will dominate politics for years, perhaps decades."

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