A great debate is breaking out over concerns for our growing debt, and it is centered around interest rates on Treasury securities.  A fear held by many, including CRFB, is that growing deficits will cause investors to demand a higher risk premium on Treasuries, causing interest rates to rise and hurting the overall economy as a result.  Commentators on both sides of the debate have used interest rates as proof of investors' level of concern regarding the fiscal outlook. 

Those who are less concerned say the proof is in the pudding: even with record deficits, both short-term and long-term rates have been relatively low, indicating that investors are not worried about default risk on U.S. debt or inflation risk.  However, as Steve Randy Waldman pointed out, these low rates have been largely due to the Federal Reserve's historically low rates.  

A better measure to use to gauge investor concerns is the yield curve.  Waldman explains that long term rates are determined by adding the short term rate to a "term premium", which accounts for future interest rate and inflation risk (presumably default risk as well).  The yield curve, which subtracts a short term Treasury rate from a longer term rate (normally 2 years/10 years and 3 months/30 years), shows this term premium and therefore accounts for investor concern for future inflation and possible default.  The results are clear:

"Since the financial crisis began, the market determined part of the Treasury's cost of borrowing has steadily risen, except for a brief, sharp flight to safety around the fall of 2008.  Investors have been demanding greater compensation for bearing interest rate and inflation risk, but that has been masked by the monetary-policy induced drop in short-term rates."

Richard Fisher, the President of the Federal Reserve Bank of Dallas, made a similar observation.  Fisher stated the U.S. can't ignore the effect that growing federal deficits will have on Treasury yields.  He noticed, similarly to Waldman, that "the markets...have bid up longer-term nominal rates, resulting in a yield curve that is historically steep." 

It seems clear that investors are already concerned about the risk of inflation or even flat-out default as a result of huge federal deficits.  The longer we wait to take action, the more interest rates will rise, which will further increase the cost of borrowing to the federal government.  We must get our fiscal house in order to avoid being entangled in this destructive cycle.

Here are the highlights from this weekend’s editorials on fiscal and budget policy:

The New York Times believed that the suits made by various state attorney generals would not be successful and criticized them as political posturing.  Specifically, they cited Congress' broad power to regulate interstate commerce, arguing that with the way the individual health insurance mandate was structured, it would pass for regulating interstate commerce. 

The Washington Post claimed that the Obama Administration's new (or modified) homeowner relief plan will do little to turn around the housing market.  They argued that improvements in the wider economic picture must take place first for any significant recovery in the housing market to occur.  Additionally, they pointed to the fact that the current mortgage relief plan is signficantly lagging behind foreclosures, so the new plan isn't likely to work much faster.

The Los Angeles Times believed that the Administration's new homeowner relief plan is somewhat unnecessary.  They pointed out how a few major banks are already starting to write down the amount owed on underwater loans, so using taxpayer money to encourage banks to do so might not be necessary.  With banks coming around on reducing the principal amount owed, The Times thinks that that aspect of the plan is unnecessary.

The Denver Post praised the student loan reform that passed in the reconciliation bill to health care reform.  They appreciated "end[ing] the sweet deal that private lenders have had", saving $61 billion over ten years, of which some will be used to increase the maximum Pell grant level.  They argued that with the significantly rising cost of higher education, expanding Pell grants is a much needed move.

For budget and market watchers, the month of March has been a little scary. It is not easy to come out of the deepest recession and financial crisis since the 1930s, particularly when the fiscal outlook and prospects for its successful management are so uncertain.

Sovereign risk jitters are on the rise as markets are being asked to digest massive amounts of government debt, at the same time the supply of private sector debt going to market is increasing and investors' appetite for risk is returning. The changes underway are complex and shifts could well be sudden.

In Europe, sovereign debt crises are unfolding in Greece and now Portugal (whose sovereign debt was just downgraded by Fitch, a leading credit ratings agency). If not managed well, the credibility of the euro and perhaps even the foundation of the European Union may be at risk. The United Kingdom has just produced its new budget. And, as noted economist Martin Wolff commented, when a deficit of nearly 12 percent of GDP expected this year is considered good news, we are indeed in trouble.

Here in the United States, we have started to see problems at our Treasury auctions, which may be harbingers of a shift in investor preferences and expectations:

- In February and more recently, markets reportedly demanded a greater risk premium for the purchase of Treasury debt than for comparable corporate debt. In February, the yield on two year Treasury notes was higher than the yield on comparable debt instruments for Warren Buffett's Berkshire Hathaway company and the debt securities of a few other blue chip companies. This may be the first time (at least in recent memory) that a private debt instrument was considered less risky than a government debt instrument.

- On March 23 and 24, U.S. interest rate swap spreads were the smallest in 20 years.  For for some maturities, spreads were even negative. In the ten year market, the change was referred to as the "historic inversion". (Considered an early warning sign of market risk, the spread is the difference between the rate to exchange floating for fixed interest rate-based payments and the yield on comparable Treasury instruments.)

- Moody's recently announced that while the U.S. would retain its Aaa rating now, it might be at risk at some point in the near future unless it adopted a credible medium-run fiscal consolidation plan. Moody's has also noted that, along with the U.K., the U.S. has the highest debt service as a share of revenue (considered a key measure of debt affordability) among the major industrial countries. 

We can also see sovereign jitters in recent statements by our major creditors. Chinese government leaders have expressed concerns over U.S. fiscal management and worry that we might attempt to manage our debt through an increase in inflation, which would hurt their holdings. Today, Bill Gross, head of the world's largest bond fund (PIMCO or the Pacific Investment Management Company, typically referred to as the leading "bond vigilante" group), advised investors to shift from high debtor countries like the U.S., U.K. and Japan to lower borrowing countries like Canada and Germany, increase investments in private debt, and go for shorter maturities. His worries reflect the view that real interest rates are heading up as the economy picks up and the Fed tightens to head off higher inflation. Many leading experts, in contrast, see the risk of inflation and Fed tightening to come later.

Sovereign risk worries were undoubtedly heightened by recent remarks made by International Monetary Fund Deputy Managing Director John Lipsky, who noted that most of the G-7 countries will have debt close to or above 100 percent by 2014. The exceptions he noted were Canada and Germany, both of which are in relatively stronger fiscal positions. (PIMCO's Bill Gross had also positively singled out these two countries. Click here for details on Canada's fiscal turnaround.)

For the U.S., all of this is likely a harbinger of things to come. As our economy continues to recover, investors may not seek dollar-denominated investments, including Treasury debt, as safe havens. Preferring yield in the absence of another crisis, our creditors will be less willing to accept low returns on US debt and will shift assets out of dollars. They may also show a greater preference for sovereign debt at the shorter end of the market, to minimize risk. Fears of inflation to manage our debt burden will also be increasingly reflected in investor pricing and purchase of our debt. Higher interest rates will crowd out investment, which will hurt underlying growth and ultimately our standards of living.

It is important that our policymakers understand that the rise in sovereign risk jitters significantly reflects a rise in political risk perceived by the markets. It is all too apparent that we do not have an exit strategy to unwind the massive debt accumulated to address the crisis. Added to the picture, the fiscal challenges posed by an aging population are expected to start kicking in within the next 5-10 years. It is no surprise that our creditors see debt rising as far as the eye can see - and with no end in sight.

In the United States, market perception of political gridlock is undermining the fiscal management credibility of the government. Going forward, we will not be able to manage creditor expectations unless we come up with a strategic view and plan of how to manage our challenges. Otherwise, we should look forward to persistent debt finance problems (perhaps even crises) in the years to come. We  should take heed from an important paper in which the authors (Robert Rubin, Peter Orszag and Allan Sinai in 2004) argued that because investors are forward-looking and adjust quickly, fundamental expectations may shift - and shift abruptly - when large budget deficits are projected well into the future.

Unless our political leaders eliminate the uncertainty of our fiscal future through the adoption of a fiscal recovery plan that can be implemented gradually but steadily, the full faith and credit of the United States may well be increasingly seen at risk.  Our policymakers are in a position to do something about it sooner rather than later, in the national interest.

The Senate passed the reconciliation bill on health care bill reform (that includes student loan provisions) this afternoon by a vote of 56 to 43.  Three Democrats joined Republicans in voting against the bill, Sens. Blanche Lincoln (Ark.), Mark Pryor (Ark.) and Ben Nelson (Neb.). The House of Representatives now has to vote on the reconicliation measure again after Republican senators succeeded at changing several provisions.   The House is expected to vote later today.

Signaling bipartisan support for much-needed spending restraint, more than 100 members of the House and Senate are sponsoring legislation that would impose spending caps on discretionary spending. Nine bills imposing spending caps have been introduced in the House during the 111th Congress, while one bill has been introduced in the Senate.

Now that PAYGO requirements have been imposed on mandatory spending and revenues, the Committee for a Responsible Federal Budget believes that spending caps, with an enforcement mechanism, should also govern the discretionary spending (the spending that is decided during the annual appropriations process). Apparently, many members of Congress agree and have offered a variety of ways to set the caps.

For instance, Rep. Gresham Barrett (R-S.C.), would set annual spending caps use increases in the Consumer Price Index to set annual spending caps. A proposal by the Blue Dog Democrats, endorsed by 55 of the coalition's moderate Democrats, would cut non-security discretionary spending levels by 2 percent each of the next three years and then freeze those levels for the next two after that. Some 25 members of the Republican Study Committee (RSC) support having the President sign the annual budget resolution and the RSC sets specific caps in its bill. Other proposals would set spending caps based on a Gross Domestic Product formula and one plan would require caps only in years in which there is a budget deficit.

While the method of determining exactly how to set the caps is open for debate, the important step is deciding to reimpose the spending restraint on discretionary spending. While much attention has been focused on mandatory programs, discretionary spending makes up 40 percent of the budget. It has grown tremendously during the past decade and in fact, has grown faster annually than mandatory spending. We recently reported that between 1999 and 2008, mandatory spending increased 6.4 percent annually, while discretionary spending increased 7.5 percent.