As much as we may wish for it, Wyoming is not an isolated island in a global sea of economic and political turmoil. We are affected, sometimes brutally, not only by what happens in the rest of the country, but overseas as well.
Sometimes it is obvious how the rest of the world affect us, such as when we witness fluctuations in demand for coal and other natural resources. But there are times when the influence from the rest of the world is not as clear and visible. A good example is the relation between the budget of the Wyoming state government and the European debt crisis.
Speaking of which, you may not have heard a lot about the crisis in Europe lately. But don’t let that lead you to the conclusion that that it is over. Just like our federal government, European governments are still struggling to balance their budgets. In fact, the similarity goes beyond just having deficits on both sides of the Atlantic Ocean. Many European Union member states share these character traits with the United States:
· The deficits have been persistent over a long period of time now;
· Government debt exceeds or is rapidly approaching GDP;
· Spending has stopped growing but the deficits persist.
No government can run a deficit forever. There comes a point, set by global investors, where the trust in a country’s ability to honor its debt payments withers away. The United States has not reached that point yet, and despite two credit downgrades since Obama took office we probably will not reach that point in the immediate future.
But only “probably.”
We may have the world’s largest economy, and there still may be global demand for our currency, but that does not mean we cannot run out of credit. In fact, if conditions in Europe had been just a smidge better than they are, and thus had the euro been a stronger currency, the dollar would have been a lot weaker today than it actually is. Thanks to the ongoing mismanagement of the euro and eurozone government finances, the U.S. government has been given more time to saturate the world with dollar-denominated treasury bonds.
Recently, the European Central Bank has managed to stabilize its debt crisis. Interest rates in the worst-hit countries are trending downward or at least standing still. While rates are going up in other eurozone countries, this is overall good news for investors in the eurozone. If the good trend continues, the euro could experience a new surge, leaving the dollar in the debt dust.
If that happened, the consequences for the United States, and especially for Wyoming, would be serious. A plunging dollar rapidly increases the cost of maintaining our enormous federal debt. This would be associated with notably higher Treasury bond rates than today.
Let us put some numbers on this scenario. As of July 2013, the U.S. Treasury was paying – on average – approximately 2.4 percent interest on its debt. The monthly cost was $37 billion per month, adding up to $444 billion in one year. But the slow downward trend in debt cost over the past year may be coming to an end:
· Currently the yield on a 30-year U.S. Treasury bond is a high 3.85 percent; and
· The 10-year yield at a disturbingly high 2.85 percent.
Notably, the yield on a 10-year U.S. Treasury bond is higher than on a 10-year bond issued in Germany (1.92 percent) or in France (2.52).
It is not beyond the realm of possibility that the U.S. Treasury will see its debt costs go up, on average, by a full half percent over the next six months to12 months. If that happened, American taxpayers would have to pay $46.4 billion per month for a $16 trillion debt (i.e. assuming generously that we add no more debt during the next fiscal year). That adds up to $557 billion per year.
How likely is this rate increase to happen? It depends in good part on what the Federal Reserve does, but if they stick to their plans to phase out Quantitative Easing (QE), there suddenly be a lot less demand for U.S. Treasury bonds. The combination of a tight monetary policy – the practical meaning of the Federal Reserve ending QE – and rising worries about the debt cost is in itself a recipe for big trouble.
When Spain, the fourth largest economy in the euro zone, found itself in a comparable situation in 2011, it took less than a year for the Spanish Treasury bond interest rate to rise from four percent to six percent. That is a 50-percent rise in the yield.
Since the United States is bigger and performs better at the macroeconomic level, it is fair to assume a smaller yield rise. The half-percent interest rate increase represents approximately a 20-percent yield rise.
Other countries in Europe have experienced similarly drastic interest-rate rises under comparable circumstances. Even though the French still pay less on their 10-year Treasury bonds than we do, they have seen a rise in that yield over the past six months from 2 percent to 2.5 percent. Germany has experienced a similar increase. While bond markets fluctuate, long-term trends are formidable conveyors of investor expectations. A climb in interest rates is a warning signal in Europe as well as in the United States.
What will Congress do if it has to pay another $113 billion on the federal debt over the next year? The next part of this blog will answer that question and explain its consequences for Wyoming.