Hamish McRae: The cost of the US government's borrowing could be the recovery

Economic Life

Maybe it isn't such a great idea for the US government to be borrowing so much money. We see the shift in perception of US financial probity in the dollar/sterling exchange rate but there is something more troubling going on: longer-term US interest rates are on the rise.

Let's step back a moment. Three months ago, financial markets were in a blue funk; share prices were collapsing worldwide. Any currency deemed to be at all risky, such as sterling, was plunging. Everyone sought a safe haven for their savings and the general perception was that the safest haven of all was US government debt.

That has all changed. Share prices have made a solid recovery from their early March lows though, to put that in perspective, they have merely regained the ground lost in the previous three months and they still look twitchy now. Sterling has recovered strongly, despite the possibility of the government losing its prized AAA status. And, to take a more arcane indicator of market confidence, the spread between interbank rates on the money markets and official interest rates has narrowed significantly. Things are not yet back to normal, for the weaker banks are still struggling to persuade the stronger ones to lend them money, but the collective heart attack suffered by the money markets a few months ago is past and the markets are in recovery mode.

Now, many market commentators write of this as a return of risk appetite: investors are prepared to accept the risks involved in, for example, holding banking shares and don't demand the ultra-safety on US Treasury securities. I think that is wrong, or at least only partly true in the sense that some assets, bank shares being a good example, had become so cheap that the risk was more than compensated for by the potential returns.

Another, more helpful way of looking at what is happening is to see it as a change in perception of where risk lies. Of course, there is risk in equities – how could there not be with the prospect of the once-mighty General Motors filing for bankruptcy? But there is also risk in bonds, including dollar bonds issued by AAA governments. So, as you can see in the graphs, the dollar/sterling rate has come sharply back, reflecting a change in the relative perception of risk between the two countries. More significant still has been the rise in the interest rate on 10-year bonds issued by the US, the UK and eurozone governments. As you can see, the interest rate on 10-year US bonds spun down from about 4 per cent in the middle of last year, to close to 2 per cent at the turn of the year. Now it is heading back to 4 per cent again. Those are astounding swings. If you have bought at the right moment last summer, and then sold at the right moment, you could just about have doubled your money. December buyers would now be facing a large loss.

Now look ahead. What will happen over the next decade, particularly in the US? Tax revenues have collapsed, while spending has soared, as the third graph shows. The US federal government is raising only about 55 cents in taxation for every dollar it spends. The rest has to be borrowed, either from foreign countries such as China and Japan, or by artificially creating the stuff by borrowing from the US Federal Reserve system. In the latter case the debt is being "monetised", the practice that normally happens only in wartime or in Latin America and which threatens massive inflation (the US mechanism for monetising debt is slightly different from our own "quantitative easing", but the effect is pretty much the same).

This cannot go on, as President Barack Obama acknowledges. "We are," as he puts it, "out of money." So what will happen?

It is very hard to know because there are no obvious precedents. Will there be a long period of cold turkey, as debts are gradually paid off, albeit at the cost of sub-par growth in living standards for perhaps a decade, or will governments try to inflate away the debt, as occurred after the Second World War? I have been looking at some work by Chris Watling of Longview Economics, who has looked at what happened in a variety of situation, including the Latin American extreme inflations and the rather less extreme inflation that cut US indebtedness after the Civil War. His conclusion is that the outcome will probably be somewhere between paying off the debt in real terms, with all the pain that this will bring, and inflating it away. If so, you have then to ask about the risks of holding government debt that yields only a nominal 4 per cent. At least equities give some protection against inflation as well as a similar running yield from dividends.

There is a further issue. If governments borrow so much and long-term rates rise as a consequence, they will crowd out other borrowers and push up the cost of finance for everyone else. So people wanting mortgages, or companies seeking to replace scare bank loans with bond issues will have to pay more for their money. The result will be that far from boosting the economy, high levels of government borrowing might start to hinder the recovery. The economy gets a Keynesian boost from the extra spending but that is offset by a monetary squeeze from higher long-term interest rates.

I don't think we face this sort of dilemma yet, either here or in the US, or indeed on the Continent. The point worth making, though, is that central banks control only short-term rates; they influence longer-term ones but that influence is conditioned by other factors, including trust in governments not to inflate away the real value of their debts. At the margin, the recent rise in long-term rates will put a curb on recovery and, if it continues, this could become serious.

What has to happen is very clear. Governments, all governments including our own, have to set out a convincing plan both for unwinding the monetisation of debt that has taken place and for correcting the fiscal imbalances that have been made much worse by the downturn. It cannot be right to spend nearly double your income, can it? Yet that is what the US federal government is doing.

Confidence is a funny thing. Look at the way it suddenly evaporated during the sub-prime collapse. In the space of a few weeks loans that were deemed impeccable suddenly were dud. I don't think we are facing that sort of catastrophic breakdown now and the US has just had its AAA rating confirmed. But the global perception of the US government's ability to service its debts has dropped a couple of notches and may well drop further in the months ahead.

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Guru Careers: Stockbroker

£Basic (OTE) + Uncapped Commission: Guru Careers: A Stockbroker (qualified / p...

Recruitment Genius: Financial Adviser

£20000 - £60000 per annum: Recruitment Genius: Are you recently QCA Level 4 qu...

SThree: Graduate Recruitment Resourcer

£20000 - £22500 per annum + OTE £30K: SThree: SThree Group have been well esta...

Guru Careers: Application Support Analyst / 1st Line Support

£25 - 30k: Guru Careers: We are seeking an Application Support Analyst / 1st L...

Day In a Page

Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

How a costume drama became a Sunday night staple
Miliband promises no stamp duty for first-time buyers as he pushes Tories on housing

Miliband promises no stamp duty for first-time buyers

Labour leader pushes Tories on housing
Aviation history is littered with grand failures - from the the Bristol Brabazon to Concorde - but what went wrong with the SuperJumbo?

Aviation history is littered with grand failures

But what went wrong with the SuperJumbo?
Fear of Putin, Islamists and immigration is giving rise to a new generation of Soviet-style 'iron curtains' right across Europe

Fortress Europe?

Fear of Putin, Islamists and immigration is giving rise to a new generation of 'iron curtains'
Never mind what you're wearing, it's what you're reclining on

Never mind what you're wearing

It's what you're reclining on that matters
General Election 2015: Chuka Umunna on the benefits of immigration, humility – and his leader Ed Miliband

Chuka Umunna: A virus of racism runs through Ukip

The shadow business secretary on the benefits of immigration, humility – and his leader Ed Miliband
Yemen crisis: This exotic war will soon become Europe's problem

Yemen's exotic war will soon affect Europe

Terrorism and boatloads of desperate migrants will be the outcome of the Saudi air campaign, says Patrick Cockburn
Marginal Streets project aims to document voters in the run-up to the General Election

Marginal Streets project documents voters

Independent photographers Joseph Fox and Orlando Gili are uploading two portraits of constituents to their website for each day of the campaign
Game of Thrones: Visit the real-life kingdom of Westeros to see where violent history ends and telly tourism begins

The real-life kingdom of Westeros

Is there something a little uncomfortable about Game of Thrones shooting in Northern Ireland?
How to survive a social-media mauling, by the tough women of Twitter

How to survive a Twitter mauling

Mary Beard, Caroline Criado-Perez, Louise Mensch, Bunny La Roche and Courtney Barrasford reveal how to trounce the trolls
Gallipoli centenary: At dawn, the young remember the young who perished in one of the First World War's bloodiest battles

At dawn, the young remember the young

A century ago, soldiers of the Empire – many no more than boys – spilt on to Gallipoli’s beaches. On this 100th Anzac Day, there are personal, poetic tributes to their sacrifice
Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves

Follow the money as never before

Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves, reports Rupert Cornwell
Samuel West interview: The actor and director on austerity, unionisation, and not mentioning his famous parents

Samuel West interview

The actor and director on austerity, unionisation, and not mentioning his famous parents
General Election 2015: Imagine if the leading political parties were fashion labels

Imagine if the leading political parties were fashion labels

Fashion editor, Alexander Fury, on what the leaders' appearances tell us about them
Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

The architect of the HeForShe movement and head of UN Women on the world's failure to combat domestic violence