JUNE 28, 2011, 10:33 A.M. ET
The Deficit Is Worse Than We Think
Normal interest rates would raise debt-service costs by $4.9 trillion over 10 years, dwarfing the savings from any currently contemplated budget deal.
By LAWRENCE B. LINDSEY
wsj.com
Washington is struggling to make a deal that will couple an increase in the debt ceiling with a long-term reduction in spending. There is no reason for the players to make their task seem even more Herculean than it already is. But we should be prepared for upward revisions in official deficit projections in the years ahead—even if a deal is struck. There are at least three major reasons for concern.
First, a normalization of interest rates would upend any budgetary deal if and when one should occur. At present, the average cost of Treasury borrowing is 2.5%. The average over the last two decades was 5.7%. Should we ramp up to the higher number, annual interest expenses would be roughly $420 billion higher in 2014 and $700 billion higher in 2020.
The 10-year rise in interest expense would be $4.9 trillion higher under "normalized" rates than under the current cost of borrowing. Compare that to the $2 trillion estimate of what the current talks about long-term deficit reduction may produce, and it becomes obvious that the gains from the current deficit-reduction efforts could be wiped out by normalization in the bond market.
To some extent this is a controllable risk. The Federal Reserve could act aggressively by purchasing even more bonds, or targeting rates further out on the yield curve, to slow any rise in the cost of Treasury borrowing. Of course, this carries its own set of risks, not the least among them an adverse reaction by our lenders. Suffice it to say, though, that given all that is at stake, Fed interest-rate policy will increasingly have to factor in the effects of any rate hike on the fiscal position of the Treasury.
The second reason for concern is that official growth forecasts are much higher than what the academic consensus believes we should expect after a financial crisis. That consensus holds that economies tend to return to trend growth of about 2.5%, without ever recapturing what was lost in the downturn.
But the president's budget of February 2011 projects economic growth of 4% in 2012, 4.5% in 2013, and 4.2% in 2014. That budget also estimates that the 10-year budget cost of missing the growth estimate by just one point for one year is $750 billion.
Full story: http://online.wsj.com/article/SB10001424052702304657804576401883172498352.html?mod=googlenews_wsj
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