INTERESTing Insights

When someone loans you money they expect it to be paid back.  They also expect to receive a return on the loan (interest) while the loan is outstanding.  Details, details, details.

Europe is staring straight into the reality of what occurs when potential lenders start to get concerned with getting their loans repaid.  First and foremost, it makes them unhappy to think that a loan will not be repaid.  Second, they tend to not want to extend another loan if they are uncertain about getting their first loan repaid.  Third, if they do provide funds they want to be paid a very large risk premium in the form of a much higher interest rate.

There are some $7 trillion sovereign loans that need to be repaid and refinanced this year by the G-7 countries (U.S, Japan, U.K., Germany, France, Canada and Italy) that appears in this article in Zero Hedge.    That is a sizeable sum of money.  Additional amounts are needed by Greece, Spain, Portugal and other countries that have been living beyond their means. Where are the funds going to come from?

The risk profile of sovereign debt has changed a lot over the last year.  The United States lost its AAA debt rating last summer and on Friday nine European countires that included France, Spain, Italy and Austria were also downgraded.  John Mauldin points out the risks of peddling goverment bonds that are perceived as risky in his most recent newsletter, "The End of Europe?".

Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe.

If they wanted risk, there are lots of opportunities to invest with the potential for more reward.

The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot.

That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.

This brings us to the United States which is living on borrowed time as well as borrowed money. See my earlier post "Living on Borrowed Money and Borrowed Time. The Federal Reserve bailed us out of what could have been a day of reckoning with its QE2 program last year.  Just as that ended, Europe fell apart and provided another reprieve.  We may have our problems but Europe's are much more visible right now.  A lot of scared money has moved to US government debt as a result.  All the while time is running out to get our fiscal house in order.

On December 31, 2011 we had federal debt outstanding of just over $15 trillion.  $10.5 trillion of this debt is held by the public and the remainder is held in intragovernmental accounts (the largest amount of which is owed to the Social Security Trust Fund).  The average interest rate on all this borrowed money was 2.826% at year end.  For the fiscal year ended September 30, 2011 the total interest cost was $454.4 billion.  This chart from the Viable Opposition blog shows the trend in the average interest rate on federal debt since 2000 (as of September 30 of each year).

If we went back to September 30, 2000, the average interest rate was 6.639%.  However, debt outstanding was a mere $5.7 trillion at that time. It cost the federal government $362 billion in interest cost to service that debt.  Therefore, even though we have added almost $10 trillion of federal debt over the last 11 years, the interest costs on that debt has increased by less than $100 million over that time! ($454 billion this year on $15 trillion in debt compared to $363 billion on $5.7 billion in debt in 2000.

This is why we are living on borrowed time.  Historically low interest rates are effectively giving the federal government what amounts to a free ride on its borrowing needs right now.  It is as if they have gale force winds at their backs.  Our policy makers have unprecedented breathing room to get something done and yet they do nothing.  The wind at our backs can just as easily start blowing in the opposite direction.

If we had the same average interest rates today as in 2000, the annual interest cost to the federal government would be almost $1 trillion-an additional $550 billion over current costs.  This is equal to what we paid for Medicare in 2011.

Let me put $1 trillion in interest costs in perspective for you.  In 2011, total individual tax collections only amounted to $1.1 trillion.  In other words, we are just a few interest rate increases away from needing all individual income tax collections just to pay for interest on the federal debt each year!  This also means that we would be in the position of paying all of our hard earned taxes today (and tomorrow) for borrowed federal government costs of yesterday.  Bear in mind that this also assumes the federal debt is static.  In reality, it is increasing at $100 billion a month.

We are very close to the point of no return in dealing with our deficits and debt.  Keep a close eye on what is happening in Europe.  We have the good fortune of being able to see someone else have to storm up the hill first.  I hope we are paying attention.  It is going to be a very hard climb from where we are today and it is likely to be right into the teeth of the gale winds of increasing interest rates.