from Follow the Money

Daniel Gross is right …

October 2, 2006

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The increase in the interest bill of the US government is an underreported story.   The CBO reports that FY 2006 interest payments will be about $40b more than FY 2005 payments.  And that trend is set to continue.  From 2001 through 2004, falling interest rates – and a strategic shortening of the maturity structure of the US debt stock (see p. 11 of this document) by then US Treasury Under Secretary Peter Fisher – reduced US interest payments even as the US debt stock rose.

The chart (link) in the Gross story tells the story. 

We in the US are now starting to pay the price for the run-up in our debts. In two senses. 

  • Rising rates and a rising debt stock are combining to increase the US government’s interest bill.
  • And, as Dan Gross notes in his article, a lot of those interest payments are going to the United States external creditors.  That is only fair. Massive purchases of US treasuries by foreign central banks from 2002-2004 helped keep long-term rates, not just shor-term rates, low.  As a result, foreign creditors now own a majority of marketable US treasuries. 

It is often argued that higher interest rates won’t have much of an impact on US households, at least in aggregate.   Sure, some folks will have to pay more on their ARM (especially once the low teaser rates expire), but others will get more interest on their bank deposits.   In aggregate, it is a wash – some are hurt, others gain.

It is kind of like the interest the US Treasury pays the Fed on the Fed’s holdings.  Most of it comes back to the Treasury, as the Fed gives its operating profits back. 

Not so with the rise in the interest rate on US debt held abroad.  That is just a net drain on the economy.

OK, that is a bit too simple.   China and Japan get more interest on their exceptionally large (roughly $700b for China, over $900b for Japan) holdings of US debt.    

They could use their higher interest income to buy more US goods and services.  But both China and Japan are already running trade surpluses.  And China’s surplus is growing.  So higher interest income on US debt just means more money to buy …. drum roll please … more US debt.

The deterioration of the income balance in the US external accounts has occurred a bit more slowly than I expected, for complicated reasons related to the different maturity structure of US external lending and US external borrowing.  But I would be surprised if the 2007 income deficit isn’t closer to $100b than to zero. 

The rise in US external interest payments will be bit faster than the rise in the US government’s interest payments because, well, the US has more (net) external debt outstanding that the US government has marketable treasuries outstanding, and US (net) external debt is increasing faster.   The current account deficit is far bigger than the fiscal deficit.   

US net external debt should top $5 trillion by the end of this year.  I am using debt here to mean real debt – I am leaving out the positive net equity position of the US.  

Increasingly, the world’s central banks will be buying new US debt to, in some sense, finance interest payments back to themselves.

That will make it harder for the world’s central banks to finance an expansion of their own countries exports by lending to the US.  They can still do this, of course.  But if the US trade deficit continues to grow even as the US starts making big interest payments on its external debt, the current account deficit will get big fast. 

I think this impending shift is another under-reported story.  Probably because it is a hard story to understand.  

But basic balance of payments math says that the Bretton Woods 2 system is going to have to change in a subtle but significant way.  Unless you think the US trade deficit can get bigger, it will be hard for say China to finance the continued growth of its export sector.     

Barring a big change in policy, China will still lend to the US, of course.   The US will still depend on a financial subsidy from China’s taxpayers.   But at some point, that lending will finance China’s current level of exports and growing interest payments on China’s rising holdings of US debt – not further growth in China’s exports.   China will still be financing a large US trade deficit – it just won’t be financing a growing deficit.

That is a necessary implication of any forecast that has the US current account deficit stabilizing.   To keep the current account deficit constant in the face of rising US interest payments, the trade deficit has to fall …

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