In macroeconomics 101, a student learns that excessive government borrowing will lead to increased interest rates and will ‘crowd out’ businesses from being able to obtain lending. This sort of basic economics has been largely ignored by the government, due to its belief that the Fed can keep interests rates low forever and that this somehow won’t result in inflation.

It is true that there is more to it than just government borrowing. The risk appetite among lenders matters a lot too. In October and November, when the whole world was in a state of panic, thirty year bonds fell below 3% due to everyone buying US government bonds as a safe haven. That ‘treasury bubble’ has now burst, and interest rates have climbed. The 10 year rate is now around 4%, while the 30 year is around 4.64%

These rates are still low, but the trend is clear: rates are climbing. More and more government debt is being poured onto society, due to the government’s growing deficits. There are less buyers of this debt now, as other countries themselves are going into debt for their stimulus programs as well.

Already, mortgage rates have gone up. Just a few months ago, a thirty year mortgage could be had for 4.5%. Now it is 5.5%. Not bad by historical standards, but it is questionable how much more this economy can take.

The crowding out effect does not happen overnight; it is caused by years of government borrowing. But by 2012 or so, we will see the effects of the deficits kick in. Not only is the government spending record amounts on stimulus efforts and entitlement expansion, our existing entitlements, social security and medicare, are expected to balloon soon as baby boomers retire. Bond investors are taking note of this, and it should be interesting to see what happens. Before we know it, mortgage rates could be over 10%.