Is the U.S. playing a risky game of politics with interest rates?

By David M. Smick
Sunday, March 28, 2010; A15

The Obama administration just experienced its first interest rate scare. Last week's tepid Treasury bond auctions caused long-term Treasury interest rates to jump. One speculation: America's largest creditor, Beijing, reduced its purchases as payback for congressional criticism of China's currency policy.

Yet the surprise is not that interest rates jumped. The real question is: What took them so long? Despite today's mind-boggling level of public debt and deficits, and extraordinary monetary expansion, interest rates have remained surprisingly low.

The 10-year Treasury interest rate, yielding 4 percent before the September 2008 collapse of Lehman Brothers, still remains below that level. Yet the economy is recovering, with corporate profits on fire.

The five-year Treasury interest rate is yielding roughly 2.5 percent. Analyst James Capra points out that from 1980 to 2010 that rate has yielded 2.5 percent or less only 4.6 percent of the time.

So what's going on? Aren't large budget deficits and debt a recipe for rising inflationary expectations and soaring long-term interest rates?

One argument is that it's simply a matter of time before the chickens come home to roost. In the 1970s, despite inflationary expectations building, the long-term Treasury interest rate was the same on July 1, 1977, as it was on July 1, 1970. It was only at the end of 1978 that interest rates skyrocketed.

Another view is that long-term rates remain low because the Fed continues to anchor short-term rates near zero. Once the Fed weighs anchor, watch out.

Still another theory is three-pronged: The sovereign debt crisis in Europe has been making U.S. debt look relatively safer. The world is experiencing huge -- and disinflationary -- excess supply capacity from China's relentless production. And retiring baby boomers are switching from stocks to bonds. All three factors may have encouraged greater investment in U.S. bonds, thus lowering interest rates.

But the most interesting explanation is that large U.S. banks, with the Federal Reserve's assistance, have helped put a lid on interest rates. How? In lieu of lending to the private sector, today's government-managed large U.S. banks have been borrowing heavily from the Fed (paying near zero percent for money) and buying risk-free U.S. government debt (Treasurys and agency securities), which has no capital requirement. To be sure, these purchases reflect rational behavior. Private demand for credit has evaporated, and tighter credit standards have frozen out small businesses.

Unwittingly or not, the Federal Reserve and the Obama administration are further encouraging these bond purchases through new capital rules, liquidity requirements and other regulatory changes that traditionally cause bankers to increase their holdings of government debt.

Last week, regulators including the Fed and the Federal Deposit Insurance Corp. upped the ante by jointly ordering the banks to maintain larger stocks of "unencumbered, highly liquid assets . . . readily available . . . during the time of most need." Topping the list of suggested holdings? U.S. Treasury securities.

Sounds fine, but are there negative long-term implications to these policies? Is the Fed drifting, de facto, toward the situation that existed during World War II and continued into the early 1950s? The central bank, in lieu of the market auction system, financed America's huge national war debt (125 percent of gross domestic product) by directly purchasing Treasury securities.

The danger today is not that Washington policymakers, using the banks as proxies, would crudely order the purchase of specific amounts of Treasury debt. It is that every participant in the process, including the Fed and the banks, would be made aware of the administration's goal of aggressively financing its debt regardless of size.

In a similar fashion, Bank of Japan officials, despite strong misgivings, finally agreed this month to double the institution's three-month lending facility. Why? The central bankers were made to feel uncomfortable not following the government's script.

Could the U.S. bond market be similarly politicized? That sounds farfetched, but Sen. Chris Dodd's financial reform proposal calls for the president of the New York Federal Reserve to become a political appointee. Translation: The official delegated authority to direct and supervise America's largest banks would become a political agent for the White House.

Japan is an object lesson for why politically manipulating bond purchases to try to control interest rates can backfire. For decades, Japanese banks were politically muscled into buying massive amounts of 10-year Treasury bonds (called JGBs) to finance a debt that now exceeds 230 percent of the country's GDP. The cost: two "lost decades" of prosperity as private investment was crowded out.

This policy forced Japan into a trap. With so much sovereign debt on bank balance sheets, a vigorous recovery may be impossible. High growth would collapse the value of those bonds, destroying bank balance sheets and risking a severe banking crisis.

As U.S. interest rates rise and our sovereign debt grows, Washington will be tempted to follow the same illusory path. But there are no cheap, easy solutions to today's fiscal mess without serious, unintended consequences.

David M. Smick, a global financial market strategist, is editor of the International Economy magazine and the author of "The World Is Curved."

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