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16%
Interest rate (10-year T-Bond)




14%
12%
10%
8%
6%
4%
2%
0%
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999




04*
2000
2001
2002
2003




* part of year


FIGURE 7.1 20+ Years of Declining Interest Rates and Rising Bond Prices
Source: Federal Reserve
144 Applying Science and Art to Bonds, Stocks, and Real Estate



Over the last 20 years”since the time that bonds were hated”bond
investors have had the best of all imaginable investment worlds. They
have enjoyed high returns and low risk. Fantastic. Is this trend likely to
continue?



The Mother of All Deficits: Eating Up
the World™s Savings?

In an episode of The Simpsons our hero Homer Simpson is sent to hell.
His somewhat innovative torture is to be forced to eat donuts until it
becomes excruciating. Accordingly, the devil™s workers collect all the
donuts in the world, which they stuff one after another into Homer™s
mouth. Far from being unhappy, however, Homer eats every donut in the
world and still wants more.
There is a similar specter haunting the bond market; it is the vora-
cious U.S. federal budget deficit. If, like Homer Simpson, the U.S. gov-
ernment eats up all the available credit, what will be left for
homeowners and businesses? If there is not enough money to be bor-
rowed at low interest rates, then large budget deficits might cause inter-
est rates to rise.
There are indeed reasons to be afraid of the U.S. budget deficit as it is
forcing the U.S. government to borrow an additional billion and half dol-
lars a day. Former U.S. Senator Dirksen (who died in 1969) is reported to
have said: “A billion here, a billion there, and pretty soon you™re talking
real money.” While there is no written evidence that the senator actually
made this statement, $1.5 billion a day (including weekends) is definitely
real money.
The problem with large deficits is that they eat up the supply of
credit or “crowd out” private investments. Here™s how James Tobin,
Yale professor and winner of the Nobel Prize in Economics, described
the problem:
Bonds 145



The key issue is “crowding out.” Funding the Federal debt and pay-
ing interest on it absorbs private saving that otherwise could be
channeled to investments that will benefit Americans in the future”
homes; new plants and modern equipment; education and research;
schools, sewers, roads provided by state and local governments;
and income-earning properties in foreign nations.3

How much will budget deficits crowd out private investments? Figure
7.2 shows budget projections as calculated by the congressional budget
office (CBO). We are so accustomed to deficits that most economists
chart the size of the overspending. Thus the “deficit” that is a negative
number is usually shown as a positive.
I think the CBO assumptions are somewhat optimistic, particularly with
regard to future spending. Nevertheless, the CBO picture of the future is
about as accurate as is available. It estimates that the U.S. federal govern-
ment deficit will be large and will not shrink for many years to come.


$600
$537 $523
$519
$509
Projected "on-budget" Deficit




$482
$466
$500

$400

$300

$200

$100

$0
2005 2006 2007 2008 2009 2010


FIGURE 7.2 $500 Billion Deficits for as Far as the Eye Can See
Source: Congressional Budget Office
146 Applying Science and Art to Bonds, Stocks, and Real Estate



Whenever you read deficit projections, you should ask, “how do these
projections account for social security?” During the 2000 presidential
campaign, Vice President Al Gore talked about putting the social security
savings into a “lockbox.”4 This was such a theme of his campaign that he
was mocked for his lockbox on Saturday Night Live. While the lockbox
comedy skit was funny, the topic is deadly serious. When President Bush
predicts that the deficit will be cut in half by 2008, he is using social
security surpluses to cover other expenses.
Because social security currently has a surplus, combining it with
other accounts makes the deficit look smaller. Since the social security
funds will be spent in future years, I prefer to work with the “on-budget”
figures. In other words, Figure 7.2 shows the deficit as if the social secu-
rity funds were in a lockbox.
Given that the federal government is likely to be running large deficits
indefinitely, these large deficits will put upward pressure on interest
rates. To understand how much, we need to put these figures into the
proper perspective.



The U.S. Annual Budget Deficit and Cumulative
Debt in Historical Perspective

While the U.S. budget deficit seems likely to be large for the foreseeable
future, the situation doesn™t look particularly grim in comparison with
other times in U.S. history.
There is a story of a snail who was walking through New York™s Cen-
tral Park. A tortoise attacked the poor snail and stole his money. When the
police asked the victim what had happened, he said, “I don™t know, offi-
cer, it all happened so fast.”
Like the speed of slow-moving creatures, most things are relative.
Accordingly, the U.S. financial position should be compared with the size
of the overall economy (GDP). Using this comparison, the current fiscal
position is not as bad as at previous extremes in U.S. history. Figure 7.3
Bonds 147



shows total U.S. federal government debt as a percentage of the overall
size of the economy for a few selected years.
The three years shown in Figure 7.3 are the extreme points of their
eras. During World War II, the United States ran up enormous debts. By
1946, just after the end of World War II, the U.S. federal debt had risen to
122% of the overall economy. Using the current projections, the most
extreme figure over the next decade will occur in 2011 when the U.S.
federal debt is projected to reach 74% of the size of the overall economy.
Not only is this figure far below World War II levels, it is not substantially
different from where we stood in 1996.
When we move from the cumulative federal debt to the annual budget
deficit, the current projections look even better. While $600 billion is an
enormous sum, when scaled against the size of the economy, our current
deficits are tiny compared with those during World War II. Figure 7.4
shows the annual deficit as a percentage of the overall size of the econ-
omy for a few selected years.
In 1943, the government™s one-year deficit exceeded 30% of the


140%
122%
120%
U.S. Debt as a % of GDP




100%
74%
80% 67%

60%

40%

20%

0%
1946 1996 2011


FIGURE 7.3 The U.S.™s Cumulative Debt Is Below Historical Highs
Sources: Office of Management and Budget, Congressional Budget Office
148 Applying Science and Art to Bonds, Stocks, and Real Estate




35%
30.3%
Annual Deficit as a % of GDP



30%

25%

20%

15%

10%
6.0% 5.6%
5%

0%
1943 1983 2004


FIGURE 7.4 The U.S. Annual Deficit Is below Historical Highs
Sources: Office of Management and Budget, Congressional Budget Office



overall economy! The CBO projects that over the next decade, 2004 will
have the largest deficit when measured against the size of the economy.
The projected 2004 figure of 5.6% of GDP is smaller than the 6.0% of
GDP figure that occurred in 1983 (the largest of the Reagan era deficits).
Is it possible to have $500 billion deficits as far as the eye can see
without harming the economy? The answer appears to be a resounding
yes. In fact, throughout the early 1980s, the United States ran large
deficits every year while the economy prospered. Specifically, in spite of
large deficits, interest rates fell during the 1980s. While we can™t know
what would have happened in the 1980s with smaller deficits, the U.S.
economy seems able to handle deficits in the range of 5% of the size of
its economy.
So what is the likely effect of deficits on interest rates? With current
projections, the deficits look to provide some upward pressure on inter-
est rates but with no cause for panic. The projected U.S. federal deficits
and debt are well within historic ranges. The key will be to watch as the

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