Raise Taxes or Lower U.S. Lifestyles

While banks are paying only 4% on your savings deposit, the U.S. government must pay 7% on 10-year bonds and 8% on longer term bonds--the kind that dictate interest rates for business and mortgage loans.

What gives?

Unfortunately, it means deep-seated economic and political problems in the United States--problems that no presidential candidates are addressing, but for which your grandchildren may curse you.

It’s unusual, to begin with, to have such a gap between short-term interest--one-year Treasury bills pay only 4.6%--and long-term rates, which are historically high at the moment. When consumer inflation is less than 3% a year, as it is now, an 8% bond pays more than 5% in real terms--a very attractive rate for bond investors but a difficult hurdle for business people and home buyers.

Economists are confused, as usual. Some say rates are high because the Federal Reserve is trying too zealously to kill inflation--but that’s not true. The Fed, which has been pushing down short-term interest, has less control over long-term rates that are set by professional investors on the world’s money markets.

Other economists see the high rates as a good sign, an indication that the budding U.S. economic recovery will be powerful. Their reasoning is that a strong recovery will hike inflation, and thus today’s interest rates are a forecast of higher prices in a booming economy. But that’s not true either. If inflation were going to pick up, short-term rates would be rising now, as the economy shows signs of quickening.

The truth is that persistently high long-term interest rates reflect the current government budget deficit--which will total at least $360 billion in this fiscal year--and all the huge budget deficits to come.

“They reflect the fact that the White House and Congress have given up trying to balance the budget and now openly acknowledge that deficits of $250 billion a year will go on for the next 20 years,” said economist Barry Bosworth of the Brookings Institution.

The Washington consensus that although economic recovery will shrink the deficit, the gap between revenue and expenditures won’t be closed in the foreseeable future is one reason Sen. Warren Rudman (R.-N.H.)--co-author of the Gramm-Rudman-Hollings deficit reduction act--last week angrily denounced paralysis in government and said he would not seek reelection.

Professional money managers are less emotional about it. “Long-term rates are high because the U.S. government is borrowing $1 billion a day and planning to go on doing that,” said Patricia deBlank Klink, president of Discount Corp. of New York Advisers, a firm that manages more than $2 billion in bond investments for companies and universities.

Buyers of long-term bonds--domestic and foreign pension funds, banks and other institutional investors--”normally have a percentage in their portfolio for U.S. government securities,” she explained. “But when the government comes to market wanting to sell more bonds, the buyers are pained and demand a higher interest rate for their trouble.”

That’s a caution for the individual investor: The 7% bond you might buy today may temporarily decline in price as later, similar government bonds pay interest of 7.5% (although of course all bonds will pay face value at maturity).

Understand that high rates have little to do with highly publicized investment from Japan or anywhere else.

Japanese banks and insurance companies, which have their own troubles these days, last year invested $37 billion less in U.S. Treasuries than they did two years ago. But U.S. banks increased their holdings by that amount and more--and if they hadn’t, other investors would have emerged. The U.S. government will be able to borrow--it will simply have to pay a high rate.

It’s a gloomy outlook because deficits matter. To finance them the government already scoops up two-thirds of the funds available from private U.S. savings--reducing the funds available to finance economic growth. Interest on the federal debt, at $210 billion a year, is already a burden. As deficits go on and interest mounts, it will become increasingly difficult for the U.S. economy to grow 2% to 2.5% a year--the minimum required if current obligations are to be met and living standards maintained.

The problem is clear: Americans don’t tax themselves enough even as they demand more services from government. And right now, government is paralyzed--with one party shouting “no new taxes” as the other resists cuts in spending.

A balance needs to be found and deficits curbed because slow economic growth will make the United States a country of pinched options and reduced opportunities. It’s already happening.

One of the most ominous statistics in the latest Congressional budget study is a rise in welfare payments in all parts of the country--up 28% in the past three years to more than $22 billion.

But middle-class entitlements--tax breaks for home equity loans and the like--are mounting just as fast, as are government bills for medical care, environmental protection and all the other hallmarks of a decent living standard that Americans expect from goverment.

The problem is Americans are not paying for those expectations. “We’re like the Rockefellers,” said economist Bosworth, “living off wealth produced in previous generations but not creating new wealth. Sooner or later, like Britain, we’ll fall behind in a competitive world.”

We have been warned. Today’s long-term interest rates, like fever, are a symptom of illness. Cutting deficit spending can bring them down and restore the economy to health.