Wednesday, October 10, 2012

All that Bunk About Deficits and Skyrocketing Interest Rates

It is astounding how long experts can keep repeating the conventional wisdom in the face of -what SHOULD be - overwhelming reality.  The way things work today, the Federal Reserve sets the interest rate.  Additionally, inflation is determined primarily by aggregate demand.  We have nearly 5 years of data backing this stuff up.  Yet, the conventional wisdom marches on.

The federal reserve very plainly sets the (short-term) interest rate.  That is what they do.  It's called an Open Market Operation. When they want interests to go down they buy U.S. bonds.  That puts cash in the system and lowers interest rates.  When the Fed wants interest rates to go up, they sell their stock of U.S. bonds and remove cash from the system.  In this way the federal reserve sets the interest rate on U.S. bonds which then in turn influence other interest rates(like mortgages and car loans).  This isn't a secret.  They explain it on their website.

Despite this, we have deficit terrorists running around telling us that we need to cut social security and gut medicare right now! This very instant!  Because if we don't, interest rates will spike.  We'll have to start paying 150 bazillian% (Note:  not a real number) on the federal debt and our mortgages.  Pete Peterson, the stereotypical deficit terrorist, states the conventional wisdom very plainly.

I see two potential crises in the future: a near-term financial crisis rooted in declining investor confidence that leads to sharp rises in interest rates and forces sudden, draconian changes in the federal budget; and a longer-term economic crisis that would result from diverting more and more of our national resources to servicing debt instead of investing in areas that are essential to long-term growth. These crises are made all the more likely by the fact that growing debts aren’t just an American problem. Projections show that, by 2035, the world’s advanced economies could face debts approaching 200% of their GDP. With countries competing for scarce capital, interest rates are almost sure to rise steeply.
(emphasis added)
We are now on fiscal year 5 of approx trillion-dollar budget deficits.  I'm still waiting on those mythical bond vigilantes to spike our interest rates.

With that in mind, I found two news stories that are oh-so interesting.  The first is that Mortgage rates hit a new record low last week.  So much for worrying about skyrocketing interest rates...  But what about U.S. bonds?   Maybe those are skyrocketing?  They are still insanely low.  On top of that, there was a bond auction this week where, for every 1$ in U.S. treasuries being sold, 3.16$ was bidding to buy them.  That is a record high amount of bids.  So despite low interest rates and high budget deficits, bond holders are not only sticking with U.S. bonds, but are flocking towards them in record numbers.

In both cases, it is because the federal reserve is purposely keeping the interest rates low.  They always keep it low when they want it low and always keep it high when they want it high.  At this point, I expect someone who is well-versed in the conventional wisdom to grab his or her hair and shout, "Fed keeping interest rates low?  zOMG!  Hyperinflation!  Weimer!  Printing Press!", and then their head explodes(Note:  I cannot be held liable for exploding heads).  All I have to say is that I am still waiting on that hyperinflation.

The small, but growing community of Modern Monetary Theory(MMT) economists can explain this phenomenon better than conventional economists.  They understand how Modern money works.  How Inflation an interest rates are really set.  Unfortunately, the conventional wisdom doesn't want to hear it.  Instead, we continue to have both presidential nominees talk about budget deficits without anyone asking to explain the supposed problem.
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