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The Impact of Rising Interest Rates

Friday July 12th, 2013   •   Posted by Craig Eyermann at 6:55am PDT   •  

Believe it or not, humans have had problems with debt for thousands of years – it’s not just a recent phenomenon! That’s a big reason why Reason’s interview with Nassim Taleb is so fascinating:

Here is a very insightful excerpt from the interview:

reason: Paul Krugman, one of your great friends or nemeses, just recently wrote that these trillion-dollar deficits don’t matter.

Taleb: All these economists, let’s put it this way: Risk is not their thing.

Debt leads to fragility. We’ve discovered since the Babylonians that debt has systemic consequences whereas equity doesn’t. Let’s say that you have two brothers. One of them borrowed and they both had predictions about the future—forecasts. One brother borrows. The other issues equity. The one who borrows will go bust if he makes a mistake. The one who issues equity will fluctuate but will be able to survive a forecast error.

For the current situation in the United States, the risk of continuing to borrow so much to support the government’s spending is directly linked to the timing for when a sudden, permanent escalation in the interest rates it must pay might occur. In his budget proposal in April, President Obama bet that interest rates wouldn’t escalate for years. In reality, they began to steadily rise just a month later.

That kind of forecast error has consequences, as the increased interest that the U.S. government will have to pay to those who lent it money will consume an increasing share of all government spending, crowding out the kind of spending that U.S. politicians would rather do. That has the potential to put the U.S. over the fiscal tipping point and creating a national debt death spiral if the amount of borrowing is increased further to keep the spending train running down its track.

Meanwhile, the surge in interest rates has already negatively impacted a large number of Americans – young people who rely on obtaining student loans from the federal government to fund their educations. The real reason why the U.S. Senate declined to act to continue subsidizing student loan interest rates is because the U.S. government, in its role as the dominant originator of student loans, directly benefits from collecting higher interest payments from student loans. Those payments are now set to double.

What the Senate achieved then is basically a back-door tax increase on low and middle-income earners in all but name. Remember, unlike all other kinds of debt, student loans cannot be discharged in bankruptcy. If you owe the debt to the federal government, who can set the amount you have to pay based upon your actual income level, and can withhold your loan payments directly from your paycheck (and also your Social Security check), for all practical purposes, it’s really an income tax.

Don’t be surprised if the government becomes much more deeply involved in other kinds of “lending”.

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July 2013