The Ultimate Catch-22: Guess What?

“Ahead of the Street” Column, by Mitchell Clark, B. Comm.

As we all know, there’s only one way interest rates are going to go and that’s up. Here is the single most problematic issue the economy’s facing from a central bankers’ perspective. If the Federal Reserve raises interest rates, it risks killing an already fragile housing market and a lackluster economy. But, if it doesn’t raise interest rates, how is the U.S. Treasury going to meet its tremendous debt obligations?

Just this week, a report from the Treasury said that foreign demand for Treasury securities fell by the largest amount on record in December. According to the report, quoted from the Associated Press, China reduced its December holdings of U.S. debt by about $34.0 billion to $755 billion. In total, the government reported that foreign holdings of U.S. Treasury securities dropped by a substantial $53.0 billion in the month of December, a record drop. China’s drop in U.S. debt obligations put Japan back up again as the largest foreign holder of U.S. Treasuries.

Part of this reduction is a withdrawal of “flight to safety” funds that occurred during the recent global financial crisis. But, it’s also a reflection of the fact that creditors are going to want to see more return on their investment to finance this year’s record $1.56-trillion budget deficit. For nations, investment risk is going up, and so must interest rates to compensate for the risk.

To be very frank, the fundamentals for sovereign financial difficulty continue to get worse and this is a situation that is going to hamper global economic growth this decade. It’s a catch-22 situation that’s made from excessive promises of the past and I think it is finally going to blow back on us, where, previously, investor sentiment moved on to other things.

If the economy doesn’t grow at a meaningful pace, the tax base can’t reduce the debt burden. Conversely, if the debt burden can’t be reduced by economic growth, then the tax base must be enlarged. It’s a fiscal catch-22 developing right along with the current monetary catch-22 on interest rates. We’re left then with the prospect of economic mediocrity at the very time when we need economic luster.

While the discussion so far represents geopolitical economics, there’s a lesson here for individuals and their personal finances. You can’t get ahead with too much leverage in a lackluster trading environment. Eventually, someone’s going to have to pay the piper.