Winston Churchill's quip that "you can always count on Americans to do the right thing -- after they've tried everything else," seems especially relevant this week.
The congressional supercommittee tasked with cutting the budget deficit by $1.2 trillion over 10 years has failed. "After months of hard work and intense deliberations, we have come to the conclusion today that it will not be possible to make any bipartisan agreement," the committee announced yesterday.
Is this surprising? I don't think so. And not because of partisan quarrels -- although those certainly played a role -- but because of what Churchill hinted at: When it comes to fixing the budget, we haven't exhausted all of our options. It's still easy to keep doing the wrong things.
The reason any country needs to keep its deficits in check is that interest rates can rise if lenders question your ability to repay -- sometimes quickly and sharply, stifling the economy.
But that's not happening in the slightest today. While total debt and annual deficits are at all-time highs, interest rates are at all-time lows, and demand at weekly bond auctions has never been higher. The day after America lost its AAA credit rating this summer was one of the best days for Treasuries in history. The bond market is sending an unmistakable message to Washington: Keep the deficits coming; we have an insatiable appetite for every dollar of debt you can issue.
As long as that's the case, Congress will kick the can down the road and put off fixing the deficit. Why wouldn't they? It's analogous to asking people to stop guzzling gas when it costs only $1 a gallon -- rather than change, they'll laugh at you and buy another Hummer. You need urgency to drive change, and right now the bond market is anything but urgent. "Despite the overheated rhetoric in Washington, the markets are giving us plenty of space," Washington Post columnist Ezra Klein wrote yesterday. "So though deficits will eventually prove a problem, they're not our most pressing concern."
It hasn't always worked this way. Consider this 1992 quote from the Los Angeles Times: "There will be serious constraints on the policy options of the President of the United States in 1993 -- and it doesn't matter what his name is." Another news account summed up why after President Clinton won the election:
Bill Clinton's economic stimulus plan may have won a good reception from voters, but it faces a more difficult -- perhaps fatal -- test at the hands of a powerful counterforce: the bond market. If the president-elect moves to jump-start the economy by sharply increasing government spending, the bond market is likely to react negatively by jacking up yields and raising the cost of government borrowing.
Which is exactly what happened. In 1993, 10-year Treasury bonds yielded 5.3%. By 1994, the yield had surged to over 8%, in part likely due to worries that a continuation of the huge deficits of the previous decade would spark inflation. As Clinton advisor James Carville famously said, "I used to think if there was reincarnation, I wanted to come back as the president or the pope. But now I want to come back as the bond market. You can intimidate everybody."
He wasn't kidding. It was widely accepted at the time that the bond market dictated the direction of the economy. "More than any other group, the bond market's members determine how many Americans will have jobs, whether the jobholders will earn enough to afford a house or a car, or whether a factory might have to lay off workers," wrote The New York Times in 1994.
But the same bond investors who seemingly held the keys to the economy helped move public policy to a safer, more sustainable path. The basis of all economic policy in the mid- to late 1990s was that the economy would only boom once long-term interest rates came down, and the best way to bring them down was to balance the budget. It wasn't complicated: Spending had to be restrained, taxes had to be raised -- both parties compromised -- the bond market would be appeased, and economic growth would take off.
By most measures, it worked. By 1999, government spending as a percentage of GDP was at a 35-year low, taxes as a percentage of GDP were at a 50-year high, the budget was in surplus, long-term interest rates had declined, and the economy was booming. You can never chalk up the state of an economy to one specific thing, but the fiscal policies of the mid- to late 1990s -- dubbed Rubinomics after then Treasury Secretary Robert Rubin -- are by and large thought to have helped fuel that period's economic boom. And they may have never happened unless the bond market forced Washington to act through higher interest rates in the early 1990s.
Today, there's no heavy hand forcing, or even encouraging, Congress to act. In part because deleveraging has sparked fears of deflation, and in part because other parts of the world are in far worse shape than America, our interest rates have never been lower. The impact this has on the economy is massive. The interest cost on the national debt was lower in 2009 than it was in 1991, even though the amount of debt was more than twice as high. The percentage of small businesses claiming interest rates are their largest problem was recently 4%, near the lowest it's ever been, according to the National Federation of Independent Businesses. A 30-year mortgage now carries an interest rate of 4.07%, down from 6.5% in 2008. America has plenty of problems, but high interest rates aren't one of them. Yet.
Once interest rates do rise, the amount of debt accumulated during these years of generous bond markets comes home to roost. The average yield on Treasury debt this year is around 2%. With $10.3 trillion in public debt outstanding, every 1% rise in interest rates adds $103 billion a year to federal spending -- or about what we spend annually on education.
Moving to an average cost of debt closer to 6% (where it was in the early 1990s) would balloon federal spending by nearly half a trillion dollars a year, or roughly what we spend annually on Medicare. Deficit spending is almost certainly necessary to help the economy recover from recession, but the easier it is to accumulate cheap debt today, the more dangerous it becomes tomorrow. It's the classic giving-us-enough-rope-to-hang-ourselves-with situation.
What's the solution? I asked former U.S. Comptroller General David Walker. "Low interest rates provide a false sense of security and interest rates could change quickly in the future," he said. A heave in the bond market might inspire Washington to act, but why wait? Providing Congress with the right incentives is up to you, he says. "If 'We the People' put pressure on Congress to act and make the political price of doing nothing greater than the political price of making some tough choices today, [we can] help create a better tomorrow."
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
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