Rising Interest Rates & Bank Balance Sheets

Aug 15, 2017 No Comments by

As the Fed unloads its bonds, changes in government regulation will encourage financial institutions to absorb them.

The Fiscal Crunch

Before diving into the more esoteric analysis, let’s run some simple numbers. As of this writing, the federal government “Debt Held By the Public” (which does include Treasury bonds owned by the Fed, but not bonds in the so-called Social Security trust fund) was $14.4 trillion. Of that amount, $1.7 trillion consisted in Treasury bills (which mature in one year or less), while another $8.8 trillion consisted in Treasury notes (which mature in two to ten years). Therefore, several trillions of dollars of debt will mature in the next few years.

CBOprojections

At the same time, short-term rates are extremely low. The nominal yield on one-month Treasuries is 1 percent while the yield on three-year Treasuries is just shy of 1.5 percent. Over the next couple of years, a shift upward in short-term rates of just 1 to 2 percentage points could therefore imply a doubling of the interest cost associated with this portion of the outstanding debt.

This is huge: It would mean another $50 billion in annual financing costs, just on the short-term debt alone, in the next few years. (In Fiscal Year 2016 the gross total interest on the federal debt was some $433 billion, though the net interest on the federal debt was $241 billion.) And of course, as more time passes and more of the bonds are refinanced at higher rates, the interest cost would grow even more staggering.

Indeed, in its baseline scenario the CBO projects that federal government net interest costs will rise from $241 billion in 2016 to $768 billion by 2027. As a share of the economy, those figures translate into 1.3 percent in 2016 to 2.7 percent in 2027. Yes that’s right: In a mere decade, almost three percent of the entire economic output of the country will be absorbed just by interest on the federal debt.

Part of the story of how we got here is that the Obama Administration ran enormous budget deficits at the same time that interest rates plummeted. (To be sure, a Republican administration would have done the same thing.) Just as a household can get by with racking up huge credit card debt so long as those “balance transfer” offers keep coming in the mail, so too have Americans not really felt the sting of the fiscal profligacy of the last decade. But with interest rates rising to more normal levels, the vise will tighten.

CBOprojections2

Don’t We Owe it to Ourselves?

Some Keynesian commentators, such as Paul Krugman, argue that to the extent the Treasury debt is held by Americans, then it doesn’t really represent a burden on Americans per se. After all—so Krugman argues— in the year 2027, the IRS will take $768 billion from American taxpayers, in order to give most of it right back to Americans who hold Treasury securities. So how does that hurt Americans?

There are several things wrong with this glib analysis. For a full explanation, see my recent lecture at Mises University as well as an earlier article for EconLib.

But for our purposes in this article, let me make two points. First, to the extent that massive increases in government debt make it politically possible for the government to spend more than it otherwise would, then the growing debt does indeed impoverish future generations because resources are channeled into political outlets. Our grandchildren inherit a smaller assortment of factories, tractors, and offshore oil rigs because fewer resources were directed into private investment.

Second, the burden of government debt can indeed fall more heavily on future generations. It is a subtle mechanism, but here’s the gist of it: If the government spends (say) $500 billion today through taxation, then the people alive today feel the pain; they are coerced against their will into handing over the money, which then might be spent in a way they enjoy.

However, if the government finances $500 billion in spending through a budget deficit (i.e. borrowing the money), then nobody alive today has to complain. Nobody is being taxed extra for that money, and even the people handing it over are doing so voluntarily. They look at the safety and yield on Treasury securities, and decide that lending Uncle Sam that money is a good investment.

CBOprojections3Since there’s no such thing as a free lunch, it must be the case that deficit finance therefore shunts the burden of the deficit-financed spending onto future taxpayers, including those not yet born.

Down the road, when today’s lenders decide to retire, they can sell their Treasury securities to young workers who aren’t yet born today. So it’s true, those young workers (once they grow older) may end up receiving the interest and principal from the Treasury, but that “transfer” among Americans down the road doesn’t represent a pure wash. It’s because the Americans (in the year 2060, say) who are receiving the large tax payments to retire their bonds had to (in the year 2030, say) pay retired folks for the predecessors of those bonds. That is the very real sense in which all the Americans in the year 2060 (say) can be collectively poorer due to government deficits run decades beforehand.

To repeat, this is a subtle mechanism, and I got into heated arguments with professional economists about it. The key fact to remind ourselves is that if government spending today is financed by deficits, then nobody feels the pain. Since there’s no such thing as a free lunch, it must be the case that deficit finance therefore shunts the burden of the deficit-financed spending onto future taxpayers, including those not yet born.

Coaxing the Banks to Absorb Fed Assets

As Carlos explains in his article this issue, we are alarmed at what appears to be an “exit strategy” for the Fed in which changes in financial regulation will encourage large institutions to add more Treasury securities and even mortgage-backed securities to their balance sheets. Presumably, the purpose of this strategy (assuming we’re right) is to limit the sharp spike in Treasury yields and mortgage rates that would otherwise occur, if the Fed begins selling down its assets as Yellen & Co. keep promising they intend to do.

This is a complex topic and warrants further analysis in future articles. But for now, let me make two points.

First, to the extent that this strategy works, it is yet another example of the government placing its own needs (and that of Wall Street) above that of the average person. Remember during the bailouts in the fall of 2008 how people like Treasury Secretary Hank Paulson assured us that all of these measures were taken to keep credit flowing to Main Street? Well, in October 2008 the Fed instituted a new policy, in which it paid commercial banks to not make loans to their clients. They called the new policy “interest on excess reserves,” but what it did in practice was pay banks to keep their loanable funds parked at the Fed.

Similarly, if banks and other financial institutions are given (through carrots and sticks) incentives to absorb more Treasury securities and MBS, then, other things equal, they will be less willing to grant credit to small businesses, credit card users, etc. By keeping it artificially cheap for the government to carry its debt, more of the “pool of savings” will be devoted to politically-approved channels.

Second, if Carlos and I are right that the Fed’s policies have blown up another asset bubble—including a bubble in Treasuries— then artificially encouraging U.S. financial institutions to load up on these assets is a bad idea. If Treasury yields spike and/or the housing market crashes again, the banking system will be that much more vulnerable, because they’ve artificially expanded the amount of Treasuries and MBS on their balance sheets.

The dark comedy in all of this is that, should these events come to pass as I’ve described, we can be sure people like Elizabeth Warren and Bernie Sanders will lament that Dodd-Frank “wasn’t enough,” and that “raw capitalism” had once again wrecked the financial system.

Conclusion

Even if things go according to plan, we should expect rising interest rates over the next few years. This will put incredible pressure on the federal government’s finances, since its debt burden (relative to the economy) is now at levels only seen during World War II.

Carlos’ research suggests that the government has a plan to coax financial institutions into accepting the Treasury securities and mortgage-backed securities that the Fed will begin selling in the next few months. Although this might contain a crash in these sectors, it will simply concentrate the pain of tightening onto other sectors.

Furthermore, the measure in reality will only postpone a crash. When the crash occurs, the banking system will be that much weaker for having been induced to load up on government debt and housing derivatives.

Julie Ann Hepburn, National Private Client Group – Lara-Murphy Report

Knowledge is Power

About the author

Julie Ann Hepburn, is a Private Banking Expert and Financial Coach. She is the founder and principal of National Private Client Group, LLC , a Chicago based financial consulting group. Ms. Hepburn is a licensed finance professional, and serves as an agent and consultant for several major mutual insurance carriers. For full bio, please see: http://nationalprivate.com/bio.html
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