Amid terrible events abroad and the takeover of the Republican Party by agents of chaos, the U.S. economy has been delivering lots of good news. All indications are that real G.D.P. is still growing fast; we’re adding jobs at an extraordinary pace, even as inflation continues to fall.
There is, however, one piece of the economic picture that’s worrisome: Long-term interest rates have gone up a lot since early 2002, especially over the past six months (I’ll talk about the breakeven rate in a minute):
This spike in long-term rates is problematic in a couple of ways. It’s not a crisis, at least not yet. But in a better world we’d be taking action to bring interest rates down in a sustainable way. In particular, now would be a good time to rein in budget deficits.
However, the chances of serious action on the deficit anytime soon are near zero. And it’s important to understand why.
First, why are high interest rates a problem? So far, there’s no indication that they’re about to cause a recession. In fact, the resilience of the economy in the face of higher rates is probably the main reason rates have gone up so much. That is, investors seem to be throwing in the towel, concluding that r-star — “the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable” — has risen sharply. If it has, the Federal Reserve will have to keep short-term interest rates, which it more or less controls, high for a long time to avoid a resurgence of inflation. And the prospect of high short-term rates as far as the eye can see is in turn causing investors to bid up longer-term rates.
There are other possible explanations for rising rates, ranging from simple supply and demand — the government is selling a lot of debt right now, and the Fed is no longer buying it — to investor psychology. But in any case, there’s no clear case that rising rates will hurt the economy in the short run.
There are, however, longer-run concerns. One is that higher borrowing costs may make federal debt less sustainable. I still don’t think we’re facing a fiscal crisis any time soon — and neither do the markets. If investors were really worried about U.S. solvency, they would probably expect higher inflation as the federal government turns to the printing press to pay some of its bills. But we can infer market expectations of inflation by looking at the breakeven rate, the spread between bonds that are protected against inflation and ordinary bonds; as the chart above showed, expected inflation has remained stable, and doesn’t account for any of the interest rate spike.
Also, if investors were worried about U.S. solvency, we’d expect the dollar to fall in value against other currencies; in reality, it has risen:
But even if there’s no immediate crisis, high interest rates will almost surely crowd out private investment, hurting our long-term prospects. I’m especially concerned about the effects of high rates on investments in renewable energy, which are of existential importance.
So it would really be nice to get interest rates down again. Unfortunately, the Federal Reserve can’t just reverse its policy of raising rates to limit inflation. While the inflation news has been extremely encouraging, the U.S. economy seems to be running quite hot, and cutting rates could still cause it to overheat, sending inflation higher again.
To make room for lower interest rates, then, we would need to take some heat out of the economy in another way — most obviously by reducing the budget deficit, which is very high for an economy close to full employment.
Now, some readers may be surprised to hear me saying that. After all, I spent a large part of the past 15 years inveighing against the deficit scolds who hijacked economic debate after the 2008 financial crisis, shifting it away from the need to restore full employment. The turn to fiscal austerity caused by this shift in focus did immense harm, leading to millions of person-years of lost employment and neglect of important public investments.
But there’s a big difference between obsessing over the budget deficit in, say, early 2013 and believing that we could use a lower deficit now. Back then, the interest rate on bonds protected against inflation risk was negative, so that investors were in effect paying the federal government to take their money. Now that rate is 2.4 percent. So it makes much more sense to be worried about borrowing now.
Also back then, unemployment was still high — close to 8 percent — so government spending wasn’t competing with private spending for scarce resources. Now unemployment is below 4 percent, so crowding out is a real concern.
So while we needn’t panic over budget deficits, a lower deficit would really help with economic management right now.
But it isn’t going to happen.
Why not? If you listen to Republican politicians, you might think that major deficit reduction is easy: Just cut out wasteful government spending (a category that MAGA types think includes aid to Ukraine in fighting Russia’s invasion). And a majority of voters say that the government spends too much in general.
But ask voters about specific spending, and there’s almost nothing they want to cut:
The fundamental point, as always, is that the federal government is essentially an insurance company with an army. Look at spending in fiscal 2023:
Social Security, health care and other safety net programs accounted for most government spending. Add military spending and interest payments, and what’s left — NDD, for “nondefense discretionary” spending — is a small slice of the total. Furthermore, NDD has been squeezed by past austerity. So there’s no possibility for major spending cuts unless we slash programs that are extremely popular.
And is that even desirable? The United States has a much weaker social safety net than other advanced economies, reflecting low government social spending:
Our weak social safety net is at least part of the reason we have so much poverty and Americans are, to put it bluntly, dying so much younger than their counterparts abroad. Why make it even weaker?
But what about the deficit? Well, there’s an obvious answer: Collect more taxes. America is in fact a very low-tax nation compared with Europe:
The problem is obvious. Conservatives always want to cut taxes, especially for the rich, even though polls suggest that most Americans believe that the rich pay too little. Republicans are even trying to deprive the I.R.S. of the resources it needs to go after wealthy tax cheats. And while Democrats are at least willing to tax the rich, that by itself won’t be enough (although it would help). And they aren’t willing to take the political heat for proposing tax hikes on the middle class.
The point is that the economics of deficit reduction are straightforward. It can be accomplished either by reducing social benefits or by raising taxes. Given that America has weak social spending compared with other countries, taxes are the most plausible route. But I don’t see any plausible political path to a tax increase that would make a large dent in the deficit.
So serious deficit reduction, a bad idea a decade ago, is a good idea now. But I see no way to make it happen.
Quick Hits
Federal borrowing and rising rates.
High interest versus net zero.
Bank of America bet wrong on interest rates.
Are higher rates actually good?
Facing the Music
Actually, the taxman is our friend.
