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In a 2003 paper, Thomas Laubach, the US Federal Reserves senior economist, calculated the impact on long-term interest rates of rising fiscal deficits and soaring national debt. Applying his assumptions to the recent spike in the US fiscal deficit and national debt, long-term interests rates will double from their current 3.5pc.
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The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research, called a debt explosion. Mr Laubachs study has implications for the UK, too, as public debt is soaring. A US crisis would have implications for the rest of the world, in any case.
Using historical examples for his paper, New Evidence on the Interest Rate Effects of Budget Deficits and Debt, Mr Laubach came to the conclusion that a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points.
The US deficit has blown out from 3pc to 13.5pc in the past year but long-term rates are largely unchanged. Assuming Mr Laubachs typical estimate, long-term rates have to climb 2.5 percentage points.
July 7, 2009