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Even 0% Financing Doesn’t Mean It’s Free

December 17th, 2008 . by economistmom

Hey!  Looks like it’s no-money-down, 0% financing for everyone these days!  First we hear that rates paid on Treasury debt have fallen to essentially zero, and then that the Fed has followed suit with their key rate (slashing their target for the federal funds rate to a record low of between 0 and 0.25 percent).  From the Bloomberg story on Treasuries (by Matthew Benjamin and Liz Capo McCormick):

Dec. 15 (Bloomberg) — Bill Clinton was forced to abandon spending initiatives to boost the economy at the start of his presidency when advisers warned him that the borrowing needed to fund the programs would push interest rates higher. President- elect Barack Obama may not have the same problem.

While the total amount of U.S. government debt outstanding rose to $10.7 trillion in November from $9.15 trillion a year earlier, the amount of interest paid in the last two months fell by $10 billion, according to the Treasury Department.

Instead of shunning the U.S., where losses on subprime mortgages in 2007 triggered a global seizure in credit markets that led to the downfall of securities firms Bear Stearns Cos. and Lehman Brothers Holdings Inc., investors can’t get enough Treasuries. Even as estimates of Obama’s stimulus package and the budget deficit rise to a record $1 trillion, demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal…

“This is not about return and yield and value; investors are functioning out of raw fear,” said Barr Segal, a managing director at Los Angeles-based TCW Group Inc., which oversees $90 billion in fixed-income assets. At the same time, “this is fabulous for the Treasury because they are borrowing at virtually nothing,” he said…

“It’s good news,” said James Horney, director of federal fiscal policy at the Center on Budget and Policy Priorities in Washington. “Even though we’re borrowing larger amounts of money, the total amount we’re going to pay in interest is going to be somewhat lower.”…

But really, it’s not as good news as some might want to think, because even 0% financing on our private and public borrowing doesn’t mean that borrowed money is “free.”  The unfortunate reality beyond the next few months to a year is:

  1. We still have to pay it back; and
  2. Interest rates will eventually (and inevitably) come up.

I worry that the downside of currently very-low interest rates is the same kind of downside that led to the subprime mortgage crisis.  Rates near zero give individuals, businesses, and government the false sense that borrowing is costless, and that they can afford to take on more debt than they really can.  Interest rates cannot stay near zero for very long, as there are ultimate limits on the worldwide supply of capital that prevent it from keeping up with our insatiable demands.  The interest rate paid on Treasury debt is near zero now, not because investors are not worried about the government’s ability to pay down the debt in the future, but because they’re more worried about the current riskiness of other investments.  That dynamic will change over the next few months.  And if consumers and businesses begin to see the zero percent Fed rate passed through to much lower interest rates on their own borrowing, they will be encouraged to borrow and consume again–which is what we want to happen with the monetary stimulus–but will they be encouraged to borrow and consume too much, such that when interest rates start to rise again as the economy recovers, they will find themselves (yet again) overextended?  Are the now near-zero interest rates like “teaser” rates–the kind of only-temporarily-low rates that encouraged unsustainable debt burdens that got us into this mess in the first place?

My “bottom-line worry” is that the news of these near-zero interest rates will make politicians and the American public believe (falsely) that deficit spending is free.  Today’s Washington Post reports on a new poll showing that public support for a massive increase in government spending is strong, but only when people don’t think about the costs:

The poll found that nearly two-thirds of Americans support new federal spending to stimulate the economy, and majorities of both Democrats and Republicans back the idea. Concern about deficit spending, however, mutes enthusiasm for the stimulus plan. When respondents were asked whether they would back the plan if it increased the deficit, support dropped to 47 percent. Overall, nearly nine in 10 said they are worried about the size of the federal budget deficit, including nearly half who are “very concerned.”

So the danger is that in a world of no-money-down, 0% financing, people will start to over-discount the costs of borrowing, start to think (falsely) that money is free, start to think (falsely) that anything with any potentially positive marginal benefit is worth pursuing–regardless of the marginal costs.  In other words, people (and the government) will start behaving as if there are no budget constraints and no need to scrutinize and prioritize, when exactly the opposite attitude is needed going forward.

As Alice Rivlin is quoted at the end of the Bloomberg article on Treasury rates:  “We can’t press our luck”… “Eventually, we’ve got to show the world that we are fiscally responsible.”

But we Americans are not good at self-discipline.  That’s why I worry about the “good news” of near-zero interest rates. 

3 Responses to “Even 0% Financing Doesn’t Mean It’s Free”

  1. comment number 1 by: John Lounsbury

    I left a comment on this article on Seeking Alpha’s comment stream. It consisted of very simple Econ 101 concepts. I wanted to be sure that you did not misinterpret: you were not my intended audience.

  2. comment number 2 by: B Davis

    John Lounsbury wrote:

    I left a comment on this article on Seeking Alpha’s comment stream. It consisted of very simple Econ 101 concepts. I wanted to be sure that you did not misinterpret: you were not my intended audience.

    It would probably be a good idea to provide a link to the comment stream and include the article here. I’ll include it below in italics followed by my comments:

    The cost of zero interest financing is not free except when it is paid for in the term of the loan in an economy that is stable or inflating.

    I detect a sense of the above statement in the article but it deserves to be clearly stated. Elaborating:

    The cost is not free if the debt must be rolled over later and interest rates are then higher than zero.

    The cost is not free if the economy is deflating because the repayment dollars are worth more than the borrowed dollars.

    I don’t think my statements are necessary to improve the understanding of many of the commenters (or the author), but making them may help some readers who have confusion about the subject.

    I follow what you’re saying. If we borrow X dollars at 0% financing and then repay the X real dollars (the original amount that we borrowed, adjusted for inflation), the loan has had no real cost. However, the first reason that Diane gives that the borrowed money is not “free” is that “We still have to pay it back”. Hence, if we borrow money and fritter it away on an unproductive project, we will end up losing when we have to pay it back with dollars that we could have spent on something useful. One might call this the “opportunity cost”. That’s why I’ve long felt that the only really valid reasons to borrow money is for emergencies and investments that will likely pay for themselves. An individual with bright prospects might feel that they can borrow from their future prosperity. However, this can be dangerous if those prospects are less than assured.

    The only really free debts are those for which the principle and any interest can be rolled over indefinitely. I suspect that many of us have made such loans before. They’re known as “bad loans” or “gifts”, depending on how you want to look at them. To the borrower, of course, they are known as “free loans” or “gifts”. I don’t think that anyone is suggesting that the money being borrowed by the U.S. government will or should become such a loan. Hence, I think we should be looking to borrow money just for emergencies and investments that are likely to pay for themselves. Of course, there will be disagreements as to what constitutes an emergency or an investment. However, that is much better than falsely thinking that we are getting a free loan.

  3. comment number 3 by: economistmom

    John and B Davis: I’m with you both. John: yes, you’re right that deflation literally turns 0% financing into some positive (real) interest rate on the term loan (even if debt is not rolled over). But B Davis actually interpreted my simplistic arguments correctly, as I wasn’t just referring to the cost of financing (the interest), but the borrowed money itself (the principal). I think people often take a no-money-down, 0% financing deal as “free money” or a “windfall” of sorts (wealth created from thin air), not just a “free loan.” That’s because people are short-sighted and impatient and have insatiable wants. When people take a loan now, it’s because they don’t have the money now. Often they don’t take the time to think about whether they’ll have the money later–and by “the money” I mean the principal, as well as any interest. If you borrow “free” money and therefore squander it (rather than invest in things that are likely to increase your capacity to pay it back later), it makes it all the more likely that when someone reminds you it’s time to pay it back, you won’t be able to.