Ok, so I understand that the federal reserve has lowered the discount rate in which banks can lend to eachother resulting in easy lending. When the federal reserve decides to raise this rate, what exactly will happen? I understand banks will then have to tighten up lending and inveitably raise interest rates on lending which will encourage saving, but what sort of disastrous outcomes will there be? I keep hearing that our government will declare bankruptcy and will not be able to pay interest on our national debt, but why? I can imagine people may begin defaulting on current loans and banks may fail, but how does this apply to our government? Why is it when interest rates go up our government will have to declare bankrupcy but they haven't already? Aren't we already bankrupt? Can anyone clear this up for me? Thanks!
Welcome to the forum! Be sure to check out The Ultimate Beginner meta-thread for a great list of resources on different topics and forum tips and how-tos.
So first of all, don't forget the Federal Reserve has also lowered the Federal Funds Rate. And remember they do this by basically increasing the money supply. Here's a good video...
Now, the whole issue is, generally when money is borrowed, there are terms on which the contract is made...terms which among other things lay out the payment schedule, which will dictate how the loan is repayed.
When a loan is repayed in periodic payments consisting of principle and interest (as most loans are), these periodic payments are referred to as "debt service". The borrower is said to be "servicing the debt" with these payments. The amount of each payment is usually a function of the amount borrowed, the length of the loan term, and the rate of interest on the borrowed sum.
The U.S. Federal Government finances a lot of its debt with short-term borrowing, through Treasury bills (or T-Bills) (which mature in one year or less) and Treasury notes (or T-Notes) (which mature in 2-10 years). This means that much of the government debt is rolled over every year. This is where the issue of interest rates comes in in this context.
If the government had more of its debt held in longer term securities, such as Treasury bonds (T-Bonds, or the long bond), which have the longest maturity, from twenty years to thirty years...then fluctuating interest rates would have much less impact of the governments' budget, as the payment schedule would be set for many years. This is what people mean when they say "lock in" a certain interest rate. It means to take out a long term loan at a fixed rate of interest, so that you know exactly what your debt service payments will be for many years into the future, regardless of how interest rates move.
However, if the government has to take out new loans every year, because so much of the debt is short-term, it means that they are subject to new contracts...with new terms based on the new going rates of interest. If the interest rate is higher this year than it was last year, your new debt service payments will be higher than they were in the past...meaning you'll have to find a way to cover a higher expense.
The issue that people are worried about is that the US government does not have the capacity to shoulder any more in debt service payments. The government is broke as it is. And the people are broke too. There simply isn't enough wealth to pay the bills even if it was all taxed away.
So the only way for the government to cover higher debt service payments would be to print the money (i.e. create it out of thin air). This is exactly what governments of the past have done, which led to virtually all the great hyperinflations of the past.
When you say "declare bankruptcy", what that refers to is basically one of the other two options, which is namely defaulting on the debt. (Essentially printing the money to pay is defaulting as well, because the money that is paid to the creditors becomes worthless anyway, so you are really defaulting there just the same. They get their "money", but they still don't have their purchasing power returned to them...and of course purchasing power is really the only thing that matters. I'll give you all the money you want, so long as I get to decide the purchasing power.) But the government could very well just say "we're not paying you." (It's unlikely for this to happen, as throughout history governments have virtually always elected for the hyperinflation route, but it's a possible course of action nonetheless.)
People say the government is already bankrupt because it is understood by many that it is economically/mathematically impossible for the government to legitimately pay off the debt it has incurred.
Here's a segment from a video which mentions the scenario of interest rates rising to the level they hit back in the 80s under Fed Chairman Volcker.
Thank you!!
Your response helped a ton, but I do have a follow-up question...
If the Federal Reserve raises interest rates to, let's say, 21.5%, will that interest rate affect all of the debt that the government owns? In the second video you linked me to, it mentions that our national debt's interest alone will reach 2.4 trillion annually (assuming that our debt is still 11.4 trillion), but isn't most of the debt on some sort of long-term fixed interest rate, 'locked in' as you mentioned in your reply? If so, wouldn't that 21.5% interest rate only apply to new loans that are taken out after the interest rate is set in place? Or is all of the government debt on a some sort of fluctuating interest rate
Awiz90:If the Federal Reserve raises interest rates to, let's say, 21.5%, will that interest rate affect all of the debt that the government owns? In the second video you linked me to, it mentions that our national debt's interest alone will reach 2.4 trillion annually (assuming that our debt is still 11.4 trillion), but isn't most of the debt on some sort of long-term fixed interest rate, 'locked in' as you mentioned in your reply? If so, wouldn't that 21.5% interest rate only apply to new loans that are taken out after the interest rate is set in place? Or is all of the government debt on a some sort of fluctuating interest rate
No, that's the point. As I said, most of the Federal Government's debt is not in long term Treasury bonds, but in shorter term T-Notes and T-Bills, so if rates were to rise, most of the US government debt would be subject to the higher rates.
Peter Schiff speaks on this all the time:
Apr 26 2010 Peter Schiff vs James Galbraith on CNBC
Jul 29, 2011 Peter Schiff: Problem is the debt, not the ceiling
May 24, 2012 Peter Schiff: "U.S. Bond Market Is a Ponzi Scheme"
And here's Ron Paul:
Ron Paul: "We Will Default Because The Debt Is Unsustainable"
When the Fed eventually raises interest rates, expect a sudden downpour of lemonade, through which you might be able to make out a flock of pigs on the horizon, if not distracted by the sound of hell freezing over beneath your feet.
...seriously though, I wouldn't expect the Fed to raise interest rates any time soon, as it would make the cost of servicing the national debt unbearable: not to mention bankrupt all the cartel banks for whose benefit the Fed exists, and basically crush the entire debt-fueled, centrally-planned American economy.
No, inflation is the order of the day: unless they make massive spending cuts, and soon.
Minarchist: When the Fed eventually raises interest rates, expect a sudden downpour of lemonade, through which you might be able to make out a flock of pigs on the horizon, if not distracted by the sound of hell freezing over beneath your feet. ...seriously though, I wouldn't expect the Fed to raise interest rates any time soon, as it would make the cost of servicing the national debt unbearable: not to mention bankrupt all the cartel banks for whose benefit the Fed exists, and basically crush the entire debt-fueled, centrally-planned American economy. No, inflation is the order of the day: unless they make massive spending cuts, and soon.
Read the title of the thread. The rise of interest rates is inevitable.
I'm not sure how any of that helps to add to the OP's understanding or answer his questions.
Read the title of the thread.
Ok....?
The rise of interest rates is inevitable.
No, it is not. If the Fed keeps flooding the credit market with low rate loans, rates will remain low. And that is exactly what they will do, for the reasons I cited.
His question was what happens when rates rise. I responded, they won't, and explained why.
...now, would you like to ask me the meaning of the word "because" or "the" or "low" or anything before we conclude this most productive of dialogues?
Minarchist:Read the title of the thread. Ok....?
That sentence was coupled with the one that followed it.
The rise of interest rates is inevitable. No, it is not. If the Fed keeps flooding the credit market with low rate loans, rates will remain low. And that is exactly what they will do, for the reasons I cited.
Yes. It is. I even provided a hyperlink to explain. You might do well to read it.
Oh. Well you're wrong. They will. Again, that's the definition of "inevitable."
I'm not sure why you would ask such a question, but I do suppose the guy who comes in to post nothing more than commentary that has already been stated, along with a flawed premise and a useless idiotic attempt at humor, would certainly know something about unproductive dialogue.
I'll speak to you as a saver and investor whose eyes were opened by Austrian and Classic Liberal (Say, Bastiat etc) economists.
Ultra-low interest rates right now are both a cause and a symptom of the huge underlying problem of the post-Bretton Woods world: debt.
Until the burst of the IT bubble it seemed central banks had found a precarous balance to keep the system going on as long as possible. When a bubble burst, interest rates were sharply raised overnight: this brought about a very sharp but brief recession with the inevitable corollary of high unemployment, bankruptcy etc. However this sharp recession also allowed malinvestments to be liquidated in a relatively short time, and when this happened, interest rates were usually brought back to pre-burst levels.
After the IT bubble, something changed at worldwide level. It would probably take Gary North or somebody as equally versed in analyzing central banks behavior but somewhere after this crisis, credit started to pour in at worldwide level in volumes never seen before. If previously we saw a single main bubble with various sectors bloating as a side effect, this time we had a multitude of bubbles arising at the same time. Housing bubble, commodities bubble, car industry bubble, govenment bonds bubble... in short the worldwide economy was supercharged in a variety of sectors, something never seen before. It was obvious that when the bubble burst, it would have been huge.
The derivative and housing crisis of 2007-8 signaled a momentous shift in central banks policies. Instead of raising interest rates to allow for a sharp but brief recession followed by a quick recovery, they kept on lowering interest rates. They also committed capital sin #1 in a capitalist economy: they didn't allow malinvestment to be liquidated. TARP was akin to slamming a door in face of the natural laws of economy: "This time we won't allow it". The same is going on in Europe right now with the various schemes aimed at purchasing bonds from Italy, Greece, Portugal etc.
This is more or less unprecedent. In the aftermath of the burst of 1988-9, the Bank of Japan perpetually fixed interest rates at ridiculously low rates. This allowed the property bubble to slowly deflate (housing prices in the main Japanese cities are still falling after over twenty years) but also froze the Japanese economy in a vicious circle of anemic growth if not downright stagnation. The original plan in 2007-8 was probably the same. But there were a few flies in the ointment: Japan was able to avoid the inevitable inflation in consumer's prices because most of the newly printed yens went directly abroad (through the yen carry trade) and Japanese industries were able to weather the storm because they are so geared towards exports. Also the Japanese government has embarked on a huge number of "make work" schemes to support industries at home, financing them through debt. Because the Japanese have relatively high wages (thanks to high per capita investments) and high saving rates, the Japanese government has the luxury of having a "captive market" for its bonds which will accept extra low interest rates.
This of course hasn't happened in 2007-8: there was meddling at every conceivable way to avoid liquidation, both to avoid many well deserved bankruptcies in the banking/financial sector and to keep prices from falling at levels the markets will be willing to liquidate them. Think of it as pigskin full of holes: instead of letting it deflate and then patch it up (or better yet, toss it away and buy a new one), central banks and governments are blowing air in it at frantic pace. If they are lucky they'll just hyperventilate, if not they'll pass out.
The air being blown into the pigskin is capital: as we all know government and its agencies cannot generate capital. They have to take it from the private sector in form of higher taxation, inflation and tighter regulation (the more you control an economy, the more money you can squeeze out of it). Like the air escaping from the ruptured pigskin, capital (which as all resources is scarce) is being wasted. In this conditions it all boils down to will either go into hyperventilation, have a panic attack and stop blowing or drop dead first.
So is the interest rates rise inevitable? In the medium to long run yes, absolutely. The witch doctors at the Fed, at the ECB, at the BoJ etc have spent all their ammo but serious inflation. While I don't believe we will see hyperinflation in the classic sense of the term, we are already experiencing the effects of the huge mass of pent-up liquidity build during QEI and the ancillary operations carried out by the Fed's allies. Politicians in Europe (especially in counties like Germany and The Netherlands) are very worried about inflation (CPI is officially over 3% but really between 5 and 7%): historically speaking the German and Dutch electors have punished those politicians seen as responsible of "inacceptable" price inflation. Nobody likes losing an election. In the US I believe President Obama had a few words with Ben Bernanke: if you want to do something, do it after the November election. If "Helicopter Ben" goes on printing spree rit now, the effects on commodities would be devastating and felt immediately. Yes, money velocity is slow these days, but the promise of more inflation would drive speculators into a veritable feeding frenzy. Oil could hit $120-130 in a couple of weeks if not less. US voters are very sensitive to price inflation during election years. We will probably see inflation hitting a real 10% in Europe and slightly lower values in the US before the winds start changing (and I really hope I am dead wrong on this because it will be nasty). This will happen when somebody somewhere will remember how Voelcker pulled the US from the late '70s-early '80s slump. A short and (very) sharp recession will be seen as preferable to a decade long inflationary depression (that's what we are in right now). It's very likely a number of European countries will partially default on their debt obligations, probably choosing to harm their own citizens rather than banks and foreign investors (for example by forcing people to buy worthless bonds in a "national solidarity" swap). Following this it is likely the political map of Europe (and possibly Asia) will be redrawn. Interesting times for sure...
Kakugo and John James, thank you for your replies they were VERY helpful.
@Minarchist: Yes, interest rates WILL rise. Either by the Fed raising them or from my understanding, when the lenders realize the dollar's decline in purchasing power is no longer sufficient to sustain low interest rates, even if Fed tries keeping them low. Market forces always push back.
I have heard similar sentiments that there might be a "fiscal limit" to U.S. interest rates, such that if the Fed would raise interest rates, then the U.S. govt. interest payments on the debt must also increase. Technically, this is true. But here is why from the U.S. govt.'s point of view, this is not a issue:
From my understanding, when interest rates eventually rise, it will create an immediate downpour of problems. I can imagine that anyone with an adjustable rate loan will default and banks will surely fail as a result. Are you saying that the interest rates will be driven back down so quickly that none of this will have enough time to occur? I'm confused.
Awiz90:From my understanding, when interest rates eventually rise, it will create an immediate downpour of problems.
Yes.
Awiz90:I can imagine that anyone with an adjustable rate loan will default and banks will surely fail as a result.
Awiz90:Are you saying that the interest rates will be driven back down so quickly that none of this will have enough time to occur? I'm confused.
So we increase rates for a few years, driving us into another recession, then lower interest rates back down and create another bubble? How many times can we repeat this until the creditors of the United States' debt decide that it is time for us to pay up? Will this happen all at once? Or is it only until China decides that they will no longer lend us anymore money? But even if they don't lend us more money, surely we can find another way to fund our expenses (i.e. printing money).
Sorry if these are amateur questions, I feel like I keep running in circles when talking about our countries debt in relation to interest rates.