Monday, December 07, 2009

Every bubble pops, eventually 

The federal deficit was $1.4 trillion in the fiscal year that ended in September, or 10% of GDP, the largest peacetime deficit on record. But net interest � the cost of servicing the national debt � was only 1.3% of GDP, the lowest in about 40 years. For comparison, net interest was absorbing about 3% of GDP in the 1980s and 1990s.

In other words, loose money has created a temporary mirage where a massive increase in government spending appears to be an easy burden to carry. In particular, the mirage of low rates colors the public�s view of legislative efforts to fully nationalize the US healthcare system, making it seem more affordable than it is in reality.

How is this any different than the housing market from a few years back? Homeowners thought they could afford a larger home as long as they assumed interest rates would stay low forever.

Just like homeowners who relied too much on short-term adjustable rate mortgages, the federal government�s average debt maturity remains less than 4.5 years, which means net interest costs will soar over the next several years as thegovernment rolls over its debt at higher interest rates.

But here�s what makes a government bubble even worse. When private sector bubbles burst, investors flee that sector. Home building went from 6.3% of GDP back in 2005 to a recent low of 2.4%. Does anyone think a government bubble is going to bring about smaller government anytime soon? Of course not�government will try to keep its bubble alive by taxing and borrowing even more. But it can�t last forever�every bubble pops�eventually.
From Brian Wesbury and Robert Stein this morning. Let me add one thing to this. CBO's August forecast puts net interest cost rising from 1.3-1.4% of GDP in 2010 (as Wesbury and Stein note) to 3% by 2015 and 3.4% by 2019. It doesn't come down. CBO's economic forecasts project interest rates to rise to 5.5% on the ten-year bond and 4.7% on the three-month bill on average for 2014-19. If one believes that the inflation rate will be above 3% in the next five years thanks to all the liquidity used to reflate this economy (and I understand some think this isn't so, see for example Mark Thoma) do we believe that forecast? CBO is projecting long-term inflation below 2%.