Ask a Scholar: Interest Rates on Government Debt

King Banaian

Dear Ask a Scholar,

I believe there is a consensus that the U.S. debt is too high, but interest rates on government debt are really low.  This, to me, indicates that the market's opinion of the U.S. government's likelihood of default, monetizing, or other options is really low. How do you reconcile?

- Richard Bauman, Ripon College’61, University of Wisconsin ‘67

Answered by King Banaian, professor and chairman of the Economics Department of St. Cloud State University. He holds a Ph.D. in economics from the Claremont Graduate School.  He has consulted at the central banks of Ukraine, Egypt and Macedonia and the ministries of finance of Indonesia, Macedonia and Armenia.  He is author of The Ukrainian Economy Since Independence (Edward Elgar, 1998), co-editor of The Design and Use of Political Economy Indicators (Palgrave, 2008) and more than thirty-five articles and book chapters discussing monetary policy and political economy. He directs the Center for Economic Education at SCSU. He has just been elected to the Minnesota House of Representatives.

Interest rates reflect both fundamentals and current economic conditions. Default risk is part of the price we pay in interest on issuing debt, as is inflation risk. However, at the present time money seeks a safe haven, particularly when European markets seem rather shaky. Thus some money will come to buy US debt as a ‘safe haven’ for liquidity. That money may flow back out quickly as inflation figures begin to show the types of increases we see in commodity prices. But prices for services and consumer goods still show little sign of inflation.

I would also note that there are two relatively recent demands for U.S. government securities that raise their price and thus lower their interest rates. One of them is the U.S. banking system. It has the option of buying U.S. securities as an alternative to making loans, and in a marketplace with mortgages and commercial loans with higher default risk, U.S. securities can look attractive. The second source of demand is the Federal Reserve itself, purchasing securities through quantitative easing. The liquidity effect of that purchase is to lower rates even though we know that, with some lag, the increased money creation will raise inflation.

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