January 16, 2014

Interest Rate Increase Will Swamp Local Governments

By: Ken Silva

Debt-ridden local governments across the country are mistakenly hoping that the Federal Reserve will raise interest rates, under the mistaken belief that collecting more interest on dwindling budget reserves will solve their financial problems.

Officials in the cash-strapped college town of Oberlin, Ohio, for instance, argue that things will get better in the long run, pointing out that the city used to collect $1 million annually (the size of its current general fund deficit) on reserves as recently as 2007. Accept a tax hike now, they tell voters, and perhaps it can be repealed in five to 10 years — once interest income from reserves picks back up.

But while interest rates will undoubtedly have to rise eventually, this will not be good for municipal governments. That’s because rising interest rates will do so much damage to the federal budget, the notorious “sequester” from last year will seem like a pillow fight.

Right now, with interest rates near historic lows, the U.S federal government is spending a whopping $400 billion annually, just on the interest on its debt. If interest rates rise a mere one percent, the figure would jump up another $150 billion — more than the combined annual cost of the wars in Iraq and Afghanistan, and almost twice as much as the vaunted sequester cuts from a few months ago. If rates rise to just six percent — the level they were at just a decade ago — debt payments double to more than $800 billion, according to University of Duquesne economist Antony Davies. And six percent interest rates aren’t simply a possibility; they’re inevitable if historical norms are any sort of indicator.

What does this mean for cities? Drastic reductions in revenue.

The inevitable rise in interest rates will burden an already strained federal budget (U.S. public debt-to-GDP ratio exceeds 100 percent) to the brink of disaster. Massive cuts will have to be made — not just to federal programs, but also, and perhaps predominately, to state and local programs, such as community development and law enforcement grants. Less federal funding to the states will also mean less state funding to municipal governments. The golden years of 2009, when localities were swimming in federal stimulus money, will be a distant memory. And when all is said and done, cities will lose much more in funding from state and federal sources than they will gain through a bump in interest income.

A rising interest rate is not a tide that will lift all boats; it’s a tidal wave that will submerge the federal government and anyone foolish enough to hitch their hopes to it.

Ken Silva is a writer from Ohio. Image courtesy of Big Stock Photo.

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