The World Is Watching and, Oops, There Go Our Interest Rates!

Here’s a piece of dry financial data that could herald big changes in our politics and economy:  Over the last five weeks, yields on 10-year U.S. Treasury bonds have risen nearly two-thirds of a point.   The interest rates the U.S. government pays are rising across the board, and quickly, and it’s not because the Federal Reserve is tightening credit – the economy is still too weak and vulnerable for that.  Rates are rising, because the world’s largest global investment funds are “limiting their exposure to the US economy,” as the Financial Times puts it.   These funds move trillions of dollars in and out of investments around the world, on behalf of governments like China and Saudi Arabia, financial and industrial giants like UBS and Gazprom, billionaires from scores of countries and, behind a veil of shell companies in tax havens, a few hugely wealthy and liquid dictators and criminal organizations.   These funds are sending the White House and Congress a clear message:  They think that Washington is taking on more debt than the American economy can handle.  More important, they believe that when global markets catch up with this view, they will drive up U.S. interest rates sharply, starting with Treasuries, and then moving on to loans to businesses, consumers, and, yes, homebuyers looking for mortgages. 

It’s hard to fault their logic:  In 2009, the Treasury borrowed about $1.4 trillion, or nearly 60 percent more than the $885 billion it had to borrow over Bill Clinton’s entire two terms.  It’s almost certainly true that all that borrowing last year, along with the Fed’s willingness to flood every financial institution with liquidity (free money), prevented the Great Recession from morphing into a Second Great Depression.  But these large and obvious benefits don’t nullify or negate the costs.  And what’s happening now with interest rates means that those costs may be coming home to roost sooner than anyone would have wished.  

This problem is not really a new one, and President Obama should start by reviewing how his predecessors handled it.  The combination of a deep recession, tax cuts and a new military buildup produced an explosion of new debt in the early 1980s; it happened again in the early 1990s from another bad recession and a ramp-up in military spending (remember the first Gulf War?).  The formula in both cases was essentially the same.  First, pass revenue increases that look out a few years.  It’s not part of the right-wing canon, but Reagan accepted tax increases enacted in 1982, 1983, 1984 and 1986.  Clinton did the same in 1993, building on what the first President Bush (the serious one) did in 1991.  And they all also had policies to slow down some spending – Reagan cut health care and slowed his own military buildup down the line; Clinton cut military spending and slowed health care several years out.  

Apart from a few chronically uninformed complainers, most analysts can agree that these changes helped produce pretty successful runs for the economy in the mid-1980s and latter-1990s.  And most economists agree that the strong growth of those years owed quite a bit to Reagan’s and Clinton’s success in reassuring the investment funds of their own day that the American economy could handle the government’s debt. 

However, just as we don’t have to accept the years of stagnation that would follow from doing nothing as world markets drive up our interest rates, it would be a terrible mistake to turn this into a deficit-cutting frenzy in 2010 and 2011.  That would almost certainly ensure another round of Great Recession.   So, President Obama’s challenge is to reassure global funds and the larger global markets that he, too, can put in place a new fiscal program that several years from now will get control of the spiraling debt.  The biggest difference is that these days, the verdict no longer comes mainly from U.S.-based funds and markets.  To the money men in China, Saudi Arabia, Singapore, and even Japan, Germany and France, America is no longer even a sentimental favorite.  So the new lesson that this President has to learn – and it will be a hard one, given the powerful pressures in Washington for an America-centric approach to everything -- is that this country’s prospects henceforth will usually depend, most critically, on what’s happening beyond our own borders.