Ireland is the latest cautionary tale for the US
November 15, 2010
Ireland went through some nervous moments last week as yields on its debt soared due to concerns over the country's financial solvency. Could this kind of thing happen to the U.S.?
Whether Ireland pulls out of its debt problem with the help of aid from other countries or austerity programs at home, there are some important lessons for the U.S.
The price of debt
A few other countries, most notably Greece, have been down this road already this year. A national dependence on debt escalates to the point where lenders start to doubt the debtor country's ability to repay. That doubt drives the cost of borrowing up -- and thereby tightens the financial squeeze. Foreign aid was able to avert an immediate collapse in Greece, and may be part of the short-term answer in Ireland. The long-term answer is steep government budget cuts to reduce the need for borrowing.
As for whether something similar could happen with U.S. debt, the government may have to come to terms with that possibility. Individual, institutions, and governments have traditionally invested confidently in U.S. bonds. Now though, it isn't just that mounting debt raises questions about the ability to repay. The Federal Reserve's recent quantitative easing program threatens the stability of the currency. If the dollar goes into a steep slide, there would be no logical reason for foreign investors to by dollar-denominated bonds at low yields. Interest rates could skyrocket as a result.
Impact on savings accounts, money market rates, and other deposit rates
If rising interest rates sounds like good news for savings accounts, money market rates, and other deposit rates, think again. If caused in part by a plunging dollar, higher interest rates would probably be accompanied by higher inflation. The result would be no net advantage for interest rates, and a stifled economy to cope with.
The bottom line is that actions of the Federal Reserve and the U.S. government will increasingly be driven by the fact that the U.S. is dependent on foreign lenders. In the end, this may force some unpopular, but necessary, choices.