Tuesday, February 15, 2011

Deficit Financing

The AP details:

Not since World War II has the federal budget deficit made up such a big chunk of the U.S. economy. And within two or three years, economists fear the result could be sharply higher interest rates that would slow economic growth.

The budget plan President Barack Obama sent Congress on Monday foresees a record deficit of $1.65 trillion this year. That would be just under 11 percent of the $14 trillion economy — the largest proportion since 1945, when wartime spending swelled the deficit to 21.5 percent of U.S. gross domestic product.

The good news (if you want to call it that) is that low borrowing costs via the Fed pushing rates (at the front-end of the yield curve) to zero has caused the borrowing cost (in the form of interest payments) to plummet as a percent of GDP, even in the face of record debt. Using interest expense figures from Treasury Direct, the chart below details the cost of debt financing (interest expense / total debt outstanding) and interest expense as a percent of GDP. Neither appears worrisome at first glance.

The concern is what happens when rates begin to rise, if there is not offsetting growth and/or inflation to keep costs low on a relative basis. Back to the AP:

"The moment when markets react negatively to our budget deficit cannot be known in advance, but we are absolutely in the danger zone," says Marvin Goodfriend, an economics professor at Carnegie Mellon University's Tepper School of Business.

Higher interest rates would also raise interest payments on the federal debt. It would be costlier for the government to finance its operations. The interest payments themselves could then make the deficit increase, creating a vicious cycle.

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