Altering the Federal Debt Structure: Go Long
By David Henderson
One advantage the United States has that Canada didn’t is low interest rates. Interest rates today are much lower than when the Canadian government altered course. The yield on the ten-year Treasury bond in late June 2010, for example, was only about three percent. So, one thing the U.S. government could do quickly is to convert some of its shorter-term debt to ten-year debt, paying a higher interest rate in the short run but protecting itself against interest rates greater than three percent over the next ten years.
This is from my Mercatus study, “Canada’s Budget Triumph.”
I thought of this when I read the latest post of John Cochrane, aka “The Grumpy Economist.” I advocated a partial shift in the federal debt from short-term to long-term debt so that the feds could protect themselves from an increase in nominal interest rates. John Cochrane advocates the Full Monty:
As I think about the choice between long and short term debt, I feel like screaming “Go Long. Now!” Bond markets are offering the US an incredible deal. The 30 year Treasury rate as I write is 2.77%. The government can lock in a nominal rate of 2.77% for the next 30 years, and even that can be paid back in inflated dollars! (Comments at the conference suggested that term structure models impute a negative risk premium to these low rates: They are below expected future short rates, so markets are paying us for the privilege of writing interest-rate insurance!)
His reasoning is similar to mine, although more spelled out and nuanced:
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.
Moreover, the habit of rolling over debt every two years leaves us vulnerable to a rollover crisis. Each year our Treasury does not have to just borrow $1 trillion to fund that year’s deficits. It has to borrow about $4 trillion more to pay off maturing debt. If bond markets say no, we have a crisis on our hands.
Going long buys us insurance against all these events. And bond markets are begging us to do it! Most large companies are issuing as much long-term debt as they can.
Cochrane also uses his extensive understanding of financial markets to handle the various concerns that might occur to the cognosenti. The whole thing is worth reading.
He cautions, though:
Obviously, these moves need to be coordinated with the Fed. There is no point in lengthening if the Fed just twists it away. I notice a tendency of the two institutions to follow parochial concerns and to forget that there is a single budget constraint uniting them!
I add my own caution, and it relates to why I didn’t advocate shifting all of the debt from short-term to long-term: the shift is a signal. If the feds did so in one fell swoop, people in the market might fear that it’s a signal that the government plans to raise inflation substantially. That’s why I had in mind shifting about $2 trillion.
In case I haven’t mentioned it on this blog–I vaguely think I have–I informally mentored John and his friend Chris Ballinger when they, on leave from UC Berkeley’s Ph.D. program–were junior economists at Marty Feldstein’s Council of Economics Advisers–Greg Mankiw was another junior at the time–and I was a senior economist.