Investors Rebuke Feds: Get Ready For Higher Interest Rates

(AP Photo/Susan Walsh)

The plan dreamed up by the Obama administration and the Federal Reserve for an economic recovery included a big bet: that interest rates would remain extremely low. That would, they hoped, spur borrowing and lending, encourage mortgage refinancing, and even lend support to housing prices.

We're already seeing signs that this bet may not pay off. One came on Wednesday, when long-term interest rates hit a high for the year when investors forced the Treasury Department to offer higher interest rates. Another may come on Thursday afternoon if investors remain leery of the Treasury's attempt to auction 30-year bonds.

Fixed-rate mortgages are becoming more expensive. A 30-year fixed-rate mortgage is now 6.1 percent, according to financial data firm HSH Associates, up about a full percentage point from a few weeks ago. (This means far fewer people will refinance -- one estimate puts it at 50 percent fewer -- and housing prices in the most bubbly areas may fall even faster than before.)

The reason for the interest rate hikes? Increased fears that the U.S. government is borrowing so much it won't be able to pay it back without printing money. The greater the perceived political and currency risks, the higher the interest rates demanded by investors will be, and the more likely it is that any economic recovery will be stalled.

(Translated: Investors seem to be worrying that America runs the risk of becoming something of a spendthrift, debt-addicted deadbeat who can't stop running up bills she can't pay.)

The primary reason the world's wealthiest nation arrived at this state is deficit spending. The federal budget deficit leaped under presidents Reagan, Clinton, Bush and now Obama; with the exception of a few years under Clinton that coincided with high returns from capital gains during the dot-com bubble, the United States has run a budget deficit since 1970 and significant ones since 1982.

At the dawn of Bill Clinton's presidency, government debt was $4.3 trillion, and increased by only $1.4 trillion in eight years. By the end of George W. Bush's administration, government debt had increased by another $4.9 trillion. After the GM and Wall Street bailouts and the stimulus package, our current president can hardly be accused of fiscal prudence.

This leaves the U.S. Treasury in a precarious position. It needs to borrow nearly $2 trillion a year to finance its budget deficit, and is dependent on the willingness of foreigners (primarily China, Japan, and other central banks) to lend it the necessary cash.

Our creditors are, reasonably, worried that we won't be able or willing to pay back these handsome sums in full -- will congressional Democrats really be willing to slash entitlement spending or increase income taxes by, say, 50 percent? -- and fear the Federal Reserve will simply print money instead. Russia's central bank said this week that it will diversify away from U.S. Treasury bonds, and Brazil and China may follow suit; a Chinese audience recently laughed when Treasury Secretary Tim Geithner assured them their country's holdings of U.S. debt were "very safe."

No wonder that Nassim Nicholas Taleb, author of the 2007 bestseller "The Black Swan," is now betting on inflation. No wonder that Arthur Laffer, the chairman of Laffer Associates, wrote an opinion article this week saying: "We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s." No wonder that the dollar index has fallen in the last few months while gold is up for the year.

It's possible, of course, that the Federal Reserve and the Obama administration can extricate themselves from this situation without any more negative consequences. But as this week's market turmoil shows, it's becoming hard to imagine how their gamble will pay off.

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    Declan McCullagh is the chief political correspondent for CNET. You can e-mail him or follow him on Twitter as declanm. Declan previously was a reporter for Time and the Washington bureau chief for Wired and wrote the Taking Liberties section and Other People's Money column for CBS News' Web site.