The Battle of Wits Has Begun

What's the impact to me if investors and others stop buying U.S. debt? I've heard lots of columnists say that as the U.S. debt increases, it's less likely that we can borrow money or at least we'll have to pay a higher interest rate. Is this something I'd notice in service cuts, government layoffs, etc., or would nothing seem to change?
-Matt K. Tacoma, WA

If or when investors lost their appetite for U.S. Treasury debt, you would notice the change.

If investors gradually decided they didn’t like our debt, the Treasury would simply increase the amount of interest paid on newly issued debt. This is how long term interest rates are determined. (The Federal Reserve sets only very short-term interest rates that apply to banks lending to each other. Banks also peg their so-called prime rate to the Fed’s short-term rate.)

Every time the Treasury auctions debt, it takes bids from investors who want to buy it. Whoever bids to accept the lowest interest rate wins the bid. That helps the Treasury keep borrowing costs low. Demand for Treasury debt has its ups and downs. When the dollar is falling, for example, investors usually want a higher rate to make up for the impact of that falling dollar on their investment. Those higher rates push up the cost of other long-term loans like mortgages.

Credit has become much harder to get — but not because of a lack of investor interest in Treasuries. The problem is that banks are afraid to lend because the system is still riddled with private debt — mostly backed by mortgages — that may go bad. Most mortgages will be fine, but they’ve been so scrambled up in complex pools of securities that no one knows exactly who’s holding the bad ones. It’s kind of like someone offering you 10 glasses of water and then telling you one of them is poison — but they can’t tell you which one.

That makes it pretty risky to take a drink.

The good news is that, despite the current financial turmoil, a rapidly slowing economy and huge the levels of U.S. debt, investors around the world are still snap-ping up Treasuries as fast as they’re printed. For the time being, the U.S. Treasury is still seen as the safest place to put your money. That strong demand has helped give the dollar a big boost in value against other foreign currencies. It’s impossible to predict how long that will last. These days, it’s impossible to predict just about anything related to the economy or financial markets.
--John W. Schoen, Senior Producer, msnbc.com