If you have trouble understanding or calculating exactly how interest rates affect things like bonds and installment loans you are in good company. Apparently, even some MBA’s don’t get it.
A recent article in the national media featured a recent Harvard masters of business administration graduate who found a way to pay off his $91,000 student loan balance in seven months.
What is difficult to believe about the story is not that he did it but that he was shocked — “blown away,” in his words — by the fact that after making two years of monthly payments on his $101,000 loan, only about half the total he paid went to reducing the loan balance, or principal. The rest was absorbed in interest charges, a good hunk of which accumulated while he was still in school.
Setting aside the educational quality issues raised by a newly minted MBA’s being shocked by the fundamental math of an installment loan, the story is still worthwhile because it illustrates the key role that interest rates play in our lives and our economy.
During the recession and our prolonged anemic recovery, for example, we haven’t seen the real burden of our national debt because interest rates have been so low.
We don’t have to be financial wizards to understand that lower interest rates make borrowing less expensive. We do have to know a little about how financial markets work, though, to understand how our accumulating national debt will create a problem for our economic future.
When the federal government spends more than it takes in, it borrows enough to make up the difference. The way it does this, generally, is to sell bonds in the financial market. When people buy the bonds, their payment goes into the U.S. Treasury, which then uses it to pay what the government owes for its commitments.
When the economy is growing lethargically like ours, our savings exceeds the total amount of attractive business investment opportunities. The result is a considerable amount of cash looking for a home.
That available cash was greatly expanded by the slowdowns in the global economy and especially by investors looking for safety from the European financial crisis.
The result for the U.S. has been a cascade of cash looking to be exchanged for Treasury bonds as the safest, actively traded investment available anywhere on earth. At present, the U.S. Treasury pays next to nothing to attract buyers for its bonds. Its 2-year debt pays less than a quarter of one percent and the 10-year bond has been recently paying just over 1.5 percent.
All that is great for our cost of borrowing, and it comes at a perfect time because we have been borrowing a lot. Since the recession, we have run deficits that now total over $5 trillion, and almost every dollar of that eventually ends up transformed into a Treasury bond held by individuals, funds and banks in the U.S. and around the globe.
Zero-cost borrowing sounds like a dream situation. What could possibly go wrong?
That’s where the fundamental math of bonds come in. Because bonds represent a debt payable at some future time, their price goes down when the interest rate goes up, because waiting for your money to be paid back is less appealing. Like the TV ads say, “you want it now,” and have to be enticed with more money to convince you to wait.
When interest rates are essentially as low as they can go, then, bond prices, or values, are also as high as they can go.
As long as the U.S. economy and the economies of Europe and the rest of the world are sleepwalking, the price of Treasury bonds probably does not matter much. However, we should not forget that we have already sold over $5 trillion worth of Treasury Bonds whose value will decline the instant the world’s economies begin to recover and interest rates begin to rise.
Anyone holding those bonds will immediately think of selling them to cut their losses. Dumping all those bonds on the market will increase the upward force on interest rates even further, of course, making the Federal Reserve’s job of controlling rates especially difficult, if not impossible.
In an election year, this kind of problem is easily dismissed as something that only economists would, or should, worry about, but it is an undisclosed, serious risk of deficit financing at our current levels. It is certainly one more reason to give a thought to the future when we consider the federal budget. Lastly, it is a reminder that interest rates are important to our economy and to us, personally, so especially if you are financing your tuition to get an MBA, remember to pay attention in class.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.
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