Low Interest Rates Today Don't Mean We're Safe From a Fiscal Crisis Tomorrow
The administration is arguing that we shouldn't worry about a debt crisis because investors are demanding low interest rates in exchange for loaning money to America. The argument is that if investors were actually worried about the long-term U.S. fiscal outlook, they would be expressing that concern by demanding a higher rate of return. Essentially, the administration is arguing that we can safely use interest rates as a warning system.
That's not very reassuring. As Catherine Rampell points out at the New York Times' Economix blog, when it comes to debt crises, research suggests that interest rates are poor predictors
Treasury Secretary Timothy F. Geithner tried to soothe foreign investors who might be concerned about the security of United States debt.
Mr. Geithner offered the following words of comfort: "Look at the price at which we borrow." In other words, don't worry, because interest rates are still joyously low.
But run this observation by economic historians, and you will find that it also provides little assurance.
In other research Professor [Carmen] Reinhart has found that that interest rates are surprisingly bad at predicting debt crises in the near future. The painful rise in the cost of borrowing that is typical in a sovereign debt crisis often comes on extremely suddenly, Professor Reinhart says. (After all, the assumption that just because things have been trending a certain way for a long while means they will stay that way forever is exactly the kind of logic that led to the housing bubble.)
When I got in touch with Arnold Kling about what a debt crisis might look like, he told me much the same thing. In the runup to a crisis, the rise in interest rates is likely to be swift and unexpected. Indeed, the loss of investor confidence is what triggers the resulting crisis. By the time rates rise, then, it will be too late; we'll be pushed into panic mode, and in need of giant-sized tax hikes or spending cuts very, very quickly. The administration is relying on a fiscal alarm system that offers little or no chance for course correction. Interest rates won't warn you that the crisis is coming eventually; they'll let you know it's arrived.