Meltdown 101: Deficits raise financing worries
WASHINGTON The federal government is being forced to greatly expand its sales of Treasury bills, notes and bonds to cover a deficit that is projected to soar this year to eye-popping levels. So far all that new debt had been sold at low interest rates as investors have preferred the safety of Treasury securities in uncertain times.
But what would happen if that changed?
If China and other foreign investors suddenly stopped buying U.S. debt, the cost of borrowing for consumers and businesses could rise and the value of the dollar could fall, raising the threat of inflation.
At the moment, chances of that outcome are remote, but analysts are worried about what might happen if Congress and the Obama administration don't do a better job of curbing deficit spending.
Here are questions and answers examining the links between the government's borrowing needs and the economy.
Q: What is happening to the government's need to borrow money to finance its operations?
A: The government's borrowing needs are ballooning, a reflection of the billions of dollars being spent to lift the economy out of a deep recession and deal with the worst financial crisis in seven decades.
The Obama administration estimates that the deficit for the current budget year, which ends on Sept. 30, will total an all-time high of $1.84 trillion. That would be four times the size of the current record, last year's $454.8 billion deficit.
As a share of the overall economy, the deficit this year would be the highest since 1945, when the government was borrowing heavily to win World War II.
Q: How are the current deficits being financed?
A: The government is expanding the amounts of Treasury securities it is selling on everything from the three-month and six-month bills it auctions on a weekly basis, to 30-year bonds. The 30-year bonds are now being auctioned monthly, up from four times a year.
Treasury securities are investments in government debt, where an investor buys government bonds, notes and bills, and earns interest in return.
Q: How are bond investors reacting?
A: So far, the debt sales have gone smoothly, with interest rates remaining at historical lows. The government's surging borrowing needs are coming at a time when investors have flocked to the safety of U.S. Treasuries in response to severe turmoil in financial markets.
The rates on three-month and six-month Treasury bills have been trading well below 1 percent so far this year, including at the most recent auction on Tuesday.
At one point last fall, when the market panic was at its height, the yield on the four-week Treasury bill dropped to a record low of zero, meaning investors were willing to accept no return at all for loaning the government money, rather than risk losses by investing elsewhere.
Q: If these rates are remaining low, why is there concern?
A: While three-month and six-month bills are heavily influenced by the Federal Reserve, which has driven a key short-term rate to a record low in an effort to jump-start the economy, longer term rates are more influenced by market forces. Those rates have been rising recently.
Rates for 10-year Treasury securities last week rose to above 3.4 percent on Friday, the highest level since November, and headed even higher to 3.55 percent on Tuesday. Though that is still low by historical standards. A year ago, the 10-year note was above 4 percent.
The 10-year Treasury is the benchmark rate for many mortgage loans. The worry is that rising rates in this area could drive mortgage rates higher and also increase the cost of borrowing for businesses. That could short-circuit the nation's efforts to emerge from a deep recession and the worst housing crisis in decades.
Q: How likely is such an outcome?
A: Many economists believe that the Federal Reserve, which is already spending billions of dollars to drive mortgage rates lower and assist in a housing recovery, will simply step up its purchases of mortgage-backed securities – investments that are linked to the value of mortgages. However, there are other factors at play as well which could overwhelm the Fed's efforts.
Q: What are those factors?
A: Foreign investors hold a major chunk of the federal government's debt – close to half of the roughly $7 trillion that is held by the public. The rest of the $11.3 trillion total national debt is held in government trust funds such as the Social Security trust fund.
China last September surpassed Japan as the largest foreign holder of Treasury securities. The worry is that at some point China and other foreign investors might decide they want to hold less in Treasury securities, a switch that would mean falling demand at Treasury debt auctions and rising interest rates. It would also mean a weaker dollar if foreigners switch out of their dollar-denominated investments into investments in other currencies.
That could send the value of the dollar plunging at the same time U.S. interest rates are rising. That could spark higher inflation because a weaker dollar would mean it would cost American consumers more to buy products made overseas.
Q: Would rising interest rates slow and possibly derail any recovery?
A: Yes. And there's a concern that a plunging dollar, by making inflation worse, would tie the Fed's hands in responding to the problem. (The Fed often lowers interest rates to encourage economic growth, but that can also worsen inflation.) That could leave the country in a fix – caught between weak economic growth and rising inflation, a situation that was dubbed "stagflation" when it last occurred in the United States during the oil price shocks of the 1970s.
Q: How big a threat is the risk of rising interest rates and a falling dollar stemming from the government's huge financing needs?
A: Economists believe that the risk is low, at least in the short term, because the economy is so weak. The weak economy means that businesses do not have as great a need to borrow from the same investment pool as the federal government.
But problems could arise when the economy starts growing and business borrowing picks up. The federal government's huge borrowing needs could leave less for private companies to borrow and that could slow economic growth.
Q: Is that inevitable?
A: No. Economists believe that investors – both foreign and domestic – will continue to buy government and corporate debt as long as the government develops what they view as a credible plan to get control of the federal budget deficit once the current economic and financial crises have passed.
The Obama administration, mindful of the need to convince investors that the soaring deficits are a short-run problem, has been stressing that the president is intent on cutting the deficit in half by the end of his first term.