The role of the adjustable-rate mortgage in the housing bubble is the subject of some dispute, a question that has launched a thousand headlines reading “ARMed and Dangerous.” Our prescient friend Paul Krugman saw it coming back in 2003, when he wrote: “With war looming, it’s time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits. . . . I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that ‘a fiscal crisis threatens our future standard of living’ — investors still can’t believe that the leaders of the United States are acting like the rulers of a banana republic. But I’ve done the math, and reached my own conclusions — and I’ve locked in my rate.”
I would offer a hearty “bravo” to Professor Krugman except that he now identifies that panicky column as one of his major professional mistakes of the past several years. But he is being too hard on himself. He was correct in the short-term particulars: By January 1 of 2004, Treasury interest rates had indeed risen, to 4.15 percent. They would rise further in each of the following years until reversing themselves in 2008, plunging to 1.86 percent as of Tuesday of this week. And he was correct about the underlying economics. But timelines are everything in economic forecasting, and the ruinous drain on the Treasury predicted by Professor Krugman in 2003 did not come to pass.
Professor Krugman now heaps scorn on those who today predict that our national fiscal incontinence will produce higher interest rates in the future. But as a broad question, his 2003 analysis is valid today, as it was then: Large, sustained deficits would at some point undermine the financial credibility of the United States government and bring higher interest rates. The argument is about the length of the rope, not about whether the rope has an end. While I find Professor Krugman’s rhetorical viciousness off-putting, he is correct that we deficit hawks should be more circumspect. But that does not change the underlying economic reality.
Just as the resets on those adjustable-rate mortgages caught a great many borrowers with their pants down, a substantial increase in federal borrowing costs would turn the budget upside down, with consequences that have been explored at some length. But there is an aspect of our deficit mania that is underappreciated: its regressive nature. Deficit spending causes a wealth transfer from taxpayers and government beneficiaries to investors and financial institutions. Even at our current low interest rates, every $1 in federal benefits costs $1.20 if financed on a ten-year note. Which is to say, for every $1 in benefits they fund, taxpayers pay 20 cents to a bank, a mutual fund, an insurance company, Caribbean offshore havens (the 14th-largest holder of Treasury debt), the oil-exporting nations, or our dear friends in Beijing.
Treasury interest rates approached 8 percent as recently as the Clinton years. Our national debt is headed toward $17 trillion. The portion of the debt held by the public (by banks, mutual funds, and other investors) is about $12 trillion. Financing that at 8 percent would cost just under $1 trillion a year, or nearly as much as Americans paid in personal income taxes in 2012. That means all of your 1040 money going to bond investors. Treasury interest rates have within my lifetime exceeded 15 percent — old ladies of my acquaintance still speak wistfully of the return on their T-bills during the Reagan years. But if interest rates should rise to that level again — and there is no reason to believe that such a thing is impossible — then interest on the publicly held portion of the debt would far exceed both personal and corporate income taxes, and in fact would take up 80 percent of all federal revenue. And the debt is growing every day.
The politics of that sort of development would be worrisome, to say the least. One of the least attractive features of life in the Obama era is that class-warfare politics is well and truly off the leash, and economic resentment has been harnessed as a political force to an extent not seen since the days of Huey Long. If the regressive nature of deficit spending should be unveiled in some particularly dramatic way — if 80 cents out of every $1 paid in taxes represented a direct wealth transfer from struggling taxpayers to relatively well-off investors — default would move from an unthinkable outcome to a politically viable option.
As it stands, 7 cents of every $1 Washington spends is a wealth transfer to bond investors. Even those who believe with Professor Krugman that current deficits are necessary to counteract economic weakness must appreciate that they are also ensuring that more money is transferred from taxpayers to investors, and that while President Obama may have succeeded in making the tax code more progressive, he is making spending more regressive. And if that adjustable-rate deal with which we have mortgaged our nation sees a serious reset, the pointy end of that stick will be plainly visible.