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The United States must immediately rein in its chronic deficits or the country will find itself mired in a fiscal trap, says Lawrence Lindsey, a former governor of the Federal Reserve and key economic advisor to President Bush, in an essay published by the Weekly Standard.

The piece critiques the Fed’s Quantitative Easing 2 policy, which aims to restore inflation rates to normal levels, somewhat higher than they are today. “Normal” inflation rates, Lindsey argues, also will mean “normal” interest rates, which also would be higher. The most important portion of the essay illuminates how sensitive deficits are to interest rates. Writes Lindsey:

Now suppose quantitative easing is “successful” in the way the Fed intends, taking inflation close to the average 2.4 percent rate of the last two decades and government borrowing costs back to their two-decade average of 5.7 percent. To get an idea of what happens to the budget, assume this transition happens over three years, so that by 2013 interest rates are back to “normal.” This “return to normal” will mean the government’s interest costs will rise to $847 billion by 2015 and $1.15 trillion by 2019.

The increase in annual interest costs in 2015 alone—$557 billion—is nearly six times the additional revenue that is supposed to be collected by letting the higher end of the Bush tax cuts expire, the centerpiece of the current fiscal policy debate in Washington.

There is nothing controversial about Lindsey’s numbers. The Obama administration’s own 10-year forecast assumes that interest rates will level out around 5.3% annually during the second half of the decade, and projects interest payments on the debt to increase from under $200 billion in fiscal 2010 to $800 billion by 2020.

Low interest rates have anesthetized the country to the danger of a recklessly escalating debt. Because rates have declined so far over the past three decades, we feel no pain. Because we feel no pain, we take no corrective action. Indeed, despite the run-up in the national debt, interest payments on the debt are smaller today, measured as a percentage of the economy, than they were 20 years ago. However, interest rates are unlikely to stay so low for long.

Consider the following:

  • Inflationary expectations. If Bernanke succeeds in goosing up inflation, domestic investors in long-term Treasuries will demand higher interest rates to offset eroding value. Similarly, if QE2 succeeds, the dollar likely will fall; a weaker dollar will reduce foreign demand for Treasury securities.
  • Business cycle. As the economy recovers, demand for credit will increase, pushing interest rates higher. That’s the basis for the Obama administration's forecast of rising interest rates. (If the recovery remains sub-par, private borrowing may have less impact than in previous business cycles — but that doesn’t get us off the deficit hook. Slower-than-projected growth in the economy implies slower-than-projected growth in tax revenue.)
  • Sovereign debt hysteria. If the European Union cannot soothe investors’ nerves over Greece and Ireland, then Portugal, Belgium, Spain, and Italy could be in trouble. Spain and Italy both rank among the 10 largest economies in the world. If they topple, investors would come to believe that any nation, no matter how large, could fail. The sovereign debt contagion could spread to other European nations, as well as to Japan and to the United States. At the very least, investors will demand a higher risk premium on U.S. debt.
  • End of the global capital glut. One reason interest rates are so low is that the populations of the world’s major economies are disproportionately middle-aged, when people are in the wealth-accumulating phase of their lives. Savings are high. As middle-aged populations grow older and retire, however, wealth-building mode will transition to a wealth draw-down mode. Global savings will decline and interest rates will trend upward. The effect could have a measurable effect by 2020.

When I was writing my book Boomergeddon earlier this year, I asked Chmura Economics & Analytics, a Richmond, Va.-based economic consulting firm, to replicate the budgetary and economic assumptions of the Obama administration’s 10-year forecast to see how sensitive it was to variations in the interest rate. I wanted to know what would happen if 10-year Treasuries returned to the 10% level that prevailed as recently as 1990.

For purposes of the exercise, we assumed that U.S. interest rates would stay low for three years as prolonged financial turmoil in the European Union encouraged a flight to safety in the U.S. dollar. Eventually, we assumed, interest rates would start to engage in a steady march higher through the end of the decade. We looked at three different scenarios: One at 8% and two at 10 percent. The following chart shows the 8% scenario and the more dire of the two 10% scenarios:

Annual deficits, currently projected by Obama to be less than $1 trillion by 2020, would reach $1.8 trillion under the 8% scenario and $2.8 trillion under the 10% scenario. The national debt under the 10% scenario would hit $36 trillion by the end of the decade. If interest rates and deficits get that high, it’s game over. The U.S. will enter a death spiral in which higher rates mean higher interest payments on the debt … leading to bigger deficits … which run up the debt even faster … which leads to even higher interest payments. Long before 2020, investors will start jacking up the risk premium they require from Treasury securities, accelerating the downward spiral.

Lindsey does not consider the long-term shift from capital glut to capital shortage. Accordingly, his analysis is not as pessimistic as it should be. If interest rates on 10-year Treasury bonds do reach 10% within 10 years, we are all toast. The system will have collapsed well before then. If they don’t reach 10% within the next 10 years, they will eventually. We are living on borrowed time.

Disclosure: No positions.

Source: What if Ex-Fed Governor Lawrence Lindsey's Pessimism Doesn't Go Far Enough?