As Government Debt Increases, Interest Rates Will Rise, Dollar Will Fall

I've been paying very close attention to the 10 year treasury bond rate since the current economic meltdown started taking hold. As the Federal Reserve began massively printing money, essentially doubling the money supply in the last four months of 2008 alone, it occurred to me (and anyone else with a casual understanding of economics) that a couple of things must happen:

(1) bond yields will need to significantly increase in order to find buyers for the increased supply and risk of U.S. treasury bonds [ie: our government's borrowings].

(2) the value of the U.S. Dollar must fall relative to more stable currencies that are expanding at a slower rate [ie: Euro is bad comparison, I suggest evaluating dollar value against a basket of world currencies]

As with many things in economics, timing is always difficult to guess and even though you know the treasury rate must increase, other actions the government may take or human beings (and the markets) reaction to conditions and such is always difficult to guess ... but the long-term outcome is undeniable.

Instead of immediately rising, treasury rates (10 year) dropped to as low as 2.08%. Of course, this happened as I incredulously told people it was going the wrong way and HAD to go to 4 or 5 percent and then probably, and potentially much, higher.

The challenge here is that as people dumped their stock market investments and moved their holdings into what are historically considered "safe" government bonds, the demand drove up the price of the bonds. Understanding that bonds trade like stocks and can increase and decrease in price which affects the net percentage income you can derive from them, this made the bond's "effective interest rate" lower. So people may have been paying $1080 for a bond that pays 3% on $1,000. Thus, another asset bubble was created by the Federal Reserve intervening in the economy.

Now, the government is having trouble finding enough buyers for the massive amount of borrowing it is doing and that is driving the price of those $1,000 bonds DOWN. So, now anyone who bought those bonds at prices at $1,000 or higher, thinking they were "safe" is sitting on bonds worth $930. What this also means is that the interest rate our government is having to pay on 10 year debt (just to use this example) is now approaching 4% and is continuing to spike. In fact, it should rise past 4% pretty easily and quickly at this point.

At the same time, the government is planning to intentionally devalue our currency so as to "buy down" the value of its debts. Unfortunately, this also "buys down" the value of your savings, essentially creating a different kind of tax, and to the extent that it increases the dollar value of your home and other assets, you ultimately get taxed on the "inflation portion" should you sell assets and derive income from such. (ie: inflation rises over a period of time by 20%, your equity investments go up 40% ... you pay taxes on the 40% increase, not the 20% "REAL" increase - another reason the Income Tax is a terrible way to extract revenue from citizens).

The long and short of this is that our government is going to have to pay increasingly higher interest rates on ever increasing debt. Remember, "...trillion dollar deficits as far as the eye can see..." ? Without looking it up, I believe in 2007 the U.S. Government paid around $420 billion in interest on the debt. Imagine the interest rate on that doubling while the debt increases by ever more trillions of dollars. The personal income tax brought in around $1.1 trillion that year, which means we could very quickly see every penny of income tax revenue going to nothing but the Interest on our government's debt.

And you wonder why libertarians and other fiscal conservatives keep saying government is out of control, spending is out of control and we can't afford the programs we have now, much less new ones like national health care. Even if you raised the tax rate to 100% on EVERYBODY you wouldn't be able to collect enough money in a decade to pay our current and future obligations.