How does government borrowing drive up interest rates, and why does it impact things like my car loan or mortgage?

Classroom Scenario: Economics 101 Discussion on U.S. Government Debt and Credit Downgrade

Key question to discuss:

1. How does government borrowing increase interest rates for private borrowers, and why does it affect things like my car loan? 
2. Why does the recent Moody’s downgrade of the credit rating to Aa1 signal higher risk?
3. Why would my taxes go up in the future because of what the government is spending now?
4. Why does a weaker dollar cause inflation, and how does that impact someone like a student and other people who are just trying to pay for groceries?
5. Are there other economists’ perspectives that tackle the issues with different strategies?

Setting: 

A university lecture hall, Economics 101 class, with Professors Sanchez and Carter co-teaching. 

The class has just finished discussing the article by Thomas Savidge on the U.S. government’s credit downgrade by Moody’s and its economic implications. Three students raised their hands to ask questions about the article’s content.

Student: Maria

Question: “Professor Sanchez, the article mentions that government borrowing increases interest rates for private borrowers. Can you explain how exactly this happens and why it affects things like my car loan?”

Professor Sanchez: 

Maria. The article references the yield curve, which shows the cost of borrowing for the U.S. Treasury over different periods. When the government borrows heavily, it competes with private borrowers, like businesses or individuals, for available funds in the loanable funds market. This increased demand drives up interest rates, as lenders can charge more due to the competition. 

For example, if the government’s borrowing pushes up Treasury yields, banks use those as a benchmark for setting rates on things like car loans or mortgages. The article notes that the recent Moody’s downgrade to Aa1 signals higher risk, which further pushes up these benchmark rates. So, your car loan becomes more expensive because lenders raise rates to offset the risk and competition from government borrowing.”

Student: Jamal

Question: “Professor Carter, the article says that government debt shifts tax burdens to future generations. I don’t really understand how that works. Why would my taxes go up in the future because of what the government is spending now?”

Professor Carter: 

Jamal. The article cites economist James Buchanan, who explained that when the government funds spending through debt, it’s essentially borrowing against future tax revenues. Currently, the government issues bonds to cover deficits, and investors buy them expecting to be repaid with interest. Those repayments, including the growing net interest payments—14 cents of every dollar this fiscal year, as the article mentions—will need to be funded eventually. That funding often comes from future taxes. 

So, down the line, you or your kids might face higher taxes to cover today’s deficit spending, especially if entitlement programs like Medicaid or Social Security aren’t reformed, as they’re a major driver of this debt.”

Student 3: Priya

Question: “Professor Sanchez, the article talks about the declining dollar and how it could lead to higher inflation. Can you explain why a weaker dollar causes inflation, and how that affects someone like me who’s just trying to pay for groceries?”

Professor Sanchez: 

Good question, Priya. The article points out that the U.S. Dollar Index (DXY) fell after the Moody’s downgrade, signaling a weaker dollar. When the dollar’s value drops, it takes more dollars to buy the same goods and services, mainly imported ones like oil or electronics. This increases the cost of those goods, which pushes up prices across the economy—hence, inflation. 

For you, this means that the price of groceries, which are largely imported foods or products tied to global supply chains, goes up. The article also mentions that a sell-off of dollar assets could further weaken the dollar, amplifying this effect. So, your grocery bill rises because the dollar buys less than it used to.”

Follow-Up Discussion:

Professor Carter wraps up by tying the questions together:

“Notice how all these effects—higher interest rates, future tax burdens, and a weaker dollar—are interconnected. The article suggests that without serious spending reforms, like those proposed but not fully implemented by the Department of Government Efficiency, these issues could worsen. What do you all think about the feasibility of the spending reforms mentioned, like tackling entitlement programs?”

The class then shifts to a group discussion, with students debating the political and economic challenges of reducing government spending, referencing the article’s point about the need for “political courage and coordination.”

Professor Sanchez and Carter emphasize that the scenario discussed in the article by Thomas Savidge incorporates the article’s key points. There are other economists’ perspectives that you, as an assignment, are asked to bring to the next class session. For example: 

Alternative perspectives that address the article's key points by highlighting:

• Yield Curve Dynamics: Global demand, Fed policy, and low term premiums can limit yield increases, while the economy’s resilience suggests a crowding-in effect.

• Borrowing Costs: Low rate sensitivity and credit risk dynamics may dampen the impact on private borrowers.

• Tax Burdens: Ricardian equivalence and growth-driven revenues could lessen future tax burdens.

• Dollar and Inflation: The dollar’s strength and anchored inflation expectations contradict claims of immediate depreciation and inflation spikes.

• Policy Alternatives: Revenue increases and adjustments to monetary policy offer pathways to fiscal stability beyond spending cuts.