The unpleasant arithmetic of compound interest
For the last decade or so, most of the English speaking countries have been running large and generally increasing trade deficits, and therefore running up increasing foreign debt. At the same time, until recently, both real and nominal world interest rates have been falling, which has made debt more affordable. This has produced a sense of security which is about to be reality-checked.
Short-term interest rates have been rising for the last couple of years, and now long-term rates are rising as well. The US 10-year bond rate is now 5.1 per cent, and has been rising fairly fast in recent weeks. The effect is to add a rising interest bill to a large and growing trade deficit. Brad Setser does the math for the US and it isn’t pretty.
If the average rate [on private and government debt] should rise to 6% — roughly the interest rate the US paid back in 2000 — the 2008 US interest bill would reach $420b. That is more than three times the 2005 interest bill.
Unless the trade deficit starts turning around fairly sharply, this would imply a current account deficit close to 10 per cent of GDP, which no country has ever sustained (please point out exceptions in comments).
The story for Australia is broadly similar, though the picture is complicated by the effects of commodity prices, which still seem to be generally rising. As long as that continues, our trade deficit should decline. But, high commodity prices have rarely been sustained for more than a few years at a stretch.