Teaser Rate Suckers U.S. Government
"Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."
Few dispute that the federal government is currently failing by a wide margin to heed Mr. Micawber's admonition. Explanations vary for this radical departure from financial prudence. One view is that politicians are acknowledging the simple, if cynical, truth that people already of age will cast more votes in 2010 than the children who will be obliged to pay for it all. Some pundits actually defend the profligacy on grounds that these are not ordinary times, so the President and Congress must spend now and worry about revenues later.
Most likely, the intellectual basis for the mega-deficit contains several strands. Don Rismiller of Strategas Research Partners notes one that has not been highlighted previously. He argues that the Washington behemoth does not fully understand the price tag for its extravagance because prevailing interest rates are artificially low. The true cost of borrowing to support the massive outlays will become apparent only when the Consumer Price Index, currently restrained by a high level of idle manufacturing capacity, resumes its rise. That will likely boost the inflation premium embedded in interest rates. Another temporary factor underlying today's improbably low rates is quantitative easing, i.e., the purchase of vast quantities of bonds by the Federal Reserve.
The notion that our leaders are influenced by a borrowing cost illusion has a startling implication: The United States government is repeating the mistake of homebuyers who were sucked into bigger mortgages than they could afford by teaser rates. When those below-market rates expired, the mortgages became unsupportable, intensifying the downward pressure on housing prices, which triggered the financial crisis that begat the recession. There is an important difference, however, in the ways that that homebuyers and the government succumbed to the siren of teaser rates.
The family that used a teaser rate to buy more house than it could afford did not expect its income to rise sufficiently to cover the future step-up in monthly mortgage payments. Rather, the family's plan was to get bailed out by an increase in the value of its home. That would make it possible to refinance, using the ostensible increase in equity to reduce the size of the loan, rendering the monthly nut affordable even with a higher, non-teaser rate.
The government, by contrast, does expect a rise in its income to cover at least a portion of the gap between income and outlay. The Obama administration's budget, presented earlier this year, was far more optimistic than private economic forecasters in its assumptions about growth in Gross Domestic Product and, by extension, the taxes to be generated by economic activity. (It is normal for the President's GDP forecast to be above consensus, but this time around the disparity was unusually large.)
The economy may not grow at 4% or more in 2011-2012, as President Obama hopes, but it is a good bet that the Treasury's borrowing costs will rise too. To put the matter in perspective, the Merrill Lynch index of interest rates on Treasury obligations of all maturities currently stands at 2.15%. That compares with an average of 5.73% since the index's 1986 inception.
In statisticians' talk, present rates are two standard deviations below their historical mean. In plain English, we should expect the government's borrowing costs to be higher than they currently are in 39 out of the next 40 years.
Could the actual outcome differ? Certainly it could. My analysis might prove too optimistic, considering that I have calculated the probabilities on a period that excludes the years of astronomical interest rates prior to inflation being brought to heel under Fed chairman Paul Volcker. In 1981, for example, the Treasury issued a 20-year bond with a 15-3/4% coupon. If I had the data necessary to include those earlier years, current government bond rates would be even further below their historical-and probable future-average.
The Treasury could lessen the impact of tomorrow's higher interest rates by locking in today's exceptionally low rates through issuance of very long-dated bonds. Unfortunately, the Treasury is currently doing the opposite. By raising an unusually large percentage of its debt in the short-dated sector, it is maximizing taxpayers' vulnerability to a rise in rates in the next few years.
To be fair, the Obama administration is trying to extend its debt maturities, but faces obstacles. Rismiller points out that the Chinese, on whom the U.S. is heavily dependent for funding, are wary of lending for long periods and getting repaid in greatly depreciated dollars. Why are they worried about the greenback losing value? They see that with the United States government spending so much more than it is taking in, there may be no other way out than currency devaluation on a massive scale.
In perhaps the cruelest irony of all, the same government that is being suckered by a teaser rate of its own design presumes to instruct consumers on responsible use of credit. The U.S. Financial Literacy and Education Commission's website (www.mymoney.gov) urges aspiring homebuyers who contemplate entering into adjustable-rate mortgages to ask themselves the following question:
"Is my income enough-or likely to rise enough-to cover higher mortgage payments if interest rates go up?"
If this is supposed to be a serious question, then teaching by example is clearly not the government's preferred pedagogical method.
As I was write this article, Bloomberg's Quote of the Day is by the actor who portrayed Mr. Micawber in the 1935 film of David Copperfield. W.C. Fields reportedly said, "Start every day off with a smile and get it over with." Anyone in the electorate who is mollified by the present spend-and-borrow policy had better get the smiling done now, for this will surely end in tears.
