Traditionally, when the US runs a budget deficit it sets off a cycle of rising interest rates. After all, sale of US treasuries goes a long way toward financing the operations of the US government – particularly when tax revenues don’t meet expenses. And when the US has has to increase the sale of treasuries to fund the deficit, investors can demand a higher yield in return. These higher interest rates on US treasuries force private lenders to raise rates to entice investors – and the cycle of higher interest rates begins.
Well, that’s how it usually works.
But this time, things are different. The collapse of markets and currencies around the globe has encouraged weary investors to run to the safety of US treasuries. As a result, the US dollar is actually stronger than ever. And the Obama Administration has plenty of money over the near term to fund both its stimulus and its more long-term “investments” in health care and energy. Concerns about China no longer funding our debt are unfounded – in the short term at least. Moreover, the lower interest rates here will help homeowners re-finance (if they aren’t underwater), and will help strong businesses obtain relatively cheap credit.
There are three problems with this scenario, however.
1) The rest of the world is screwed right now. Eastern Europe is about to implode, having pegged its investments to the Euro and the Swiss franc (and bringing down Western European banks with it). Poorer countries will have a very tough time attracting investment.
2) Exports go down in the US when the dollar goes up. For now, that is not such a pressing matter because, well, nobody is really buying much of anything right now anyway. But if we want to develop an exportable green energy economy, where we sell solar panel and wind power technology, we want the dollar to drop a bit. Also, if we want more investors to jump into the US stock market, we want the dollar to drop as well.
3) While the sale of treasuries is an attractive way to fund the deficit right now, there is no telling how long that will last. When investors finally start selling their US government bonds again and jump into more lucrative investments, the US government is going to have to find a better source of funding. And printing more dollars – another fund source – could result in hyperinflation. I don’t believe this scenario is imminent by any stretch. But, to quote Obama, we need to be as careful getting out of this downturn as we were careless getting in.