Interest rates are at historic lows. The current interest rate on 10 year US Treasury notes is 1.6%. This is 5 percentage points below the historical average rate of 6.6%. On the surface this seems like good news. Low interest rates stimulate spending and lead to an economic recovery. Low interest rates also significantly reduce the current cost of financing the federal government’s record deficits and burgeoning outstanding national debt. However, once a recovery fully kicks in, expect interest rates to increase to their historical averages. This increase will significantly increase the federal deficit, weaken the nation’s money and banking system, and contribute to inflation.
The impact of increased interest rates on government interest costs and the budget deficit would be devastating. At today’s historically low interest rates, the government pays an average interest rate of 2.2% on the national debt of $16 trillion, or $359 billion. In a recovery, expect rates to increase to the historical average in the range of 5% to 7%. If rates on government debt to increase to 6%, the interest cost of federal debt would increase to $960 billion. That would increase the 2012 deficit 50% from $1.2 trillion to $1.8 trillion. The government would have to make up this short fall by increasing taxes, cutting spending or borrowing more money.
The increase in rates also has an adverse impact on the nation’s banking and financial system because increasing market interest rates reduce the market value of debt. For example, the current interest rate on 10 year treasury notes is 1.6% compared to the historical average rate of 6.6%. If market interest rates on these notes increases to 6.6%, the note would have a market value of 65% of the original principal amount. This is a 35% reduction in the principal value of these notes. A 35% reduction in America’s $16 trillion debt will cause $5.6 trillion loss to the holders of the national debt. Since a significant amount of the national debt is held by the banking system and by American investors such insurance companies, pension funds and retired individuals, such a decline will have a major impact on their net worth and solvency.