Interest Insomnia

If there is anything that should keep you awake at night it is the ravenous need of the federal government to finance its deficit spending.

Another $1 trillion of debt must be issued this year to fund the current year's spending needs in excess of revenues.  In addition, almost $6 trillion of the federal government's debt held by the public must be refinanced in the next five years.  As of April 2, there is almost $11 trillion of debt owed to the public (that includes individuals, institutions (mutual funds, insurance companies etc) and foreign governments (China, Japan etc).  Another $4.7 trillion is composed of intragovernmental obligations to Social Security and other government entities.

This means that over the next five years the federal government will have to find a way to sell in excess of $10 trillion of debt obligations to the public. 

The current average interest rate on all federal debt right now is just 2.2%.  

Let's put that in perspective.

In fiscal 2011, the U.S. had net interest expense of $230 billion on its federal debt outstanding of almost $15 trillion.  In 1997, when federal debt was less than $5 trillion, net interest costs were $232 billion.  Therefore, despite the fact that fedeal debt has increased over 3-fold in the last 15 years, the federal government paid less in interest costs in 2011than it did in 1997 due to these extraordinarily low borrowing costs.

An increase in average interest rates to the level of 1997 (around 5.8%) would add almost $500 billion in additional interest costs to the federal budget!   To be fair, some of this would inure to the benefit of the Social Security Trust Fund and other intragovernmental funds.  However, the net cost is almost $90 billion for each 1% increase in net interest costs.

Let's put that number in perspective.

In 2011, the federal government collected just slightly over $1 trillion in indvidual income taxes.  Therefore, a $500 billion increase in the federal budget to fund increased interest costs on the federal debt would require a 50% across the board increase in income taxes.  Alternatively, if these costs had to covered by reducing spending, it would require the elimination of all Medicare spending ($555 billion in 2012) or all Discretionary Spending ($528 billion in 2012).

Why haven't we seen interest rates already start to increase?   First, Europe's problems have been receiving all of the attention so we have not had to deal with the heavy glare of the world's capital markets while the Euro debt crisis melodrama plays out.  Second, the Federal Reserve is buying up almost all of the debt by printing money.  In 2011, the Fed purchased 61% of all federal debt.  This is simply not sustainable.  Even worse, this level of debt purchased is masking the reduced demand for our debt and is also delaying the inevitable day of reckoning.  We have been getting a free ride but the day is coming where we are going to be charged the full fare (and more).

Caroline Baum, a columnist for Bloomberg News, summarizes the issue very nicely in "Four Numbers Add Up to a American Debt Disaster".

She sees a major problem with the short duration of the Treasury debt.  In fact, only 10 percent of federal debt matures beyond a decade from now.

The U.S. is more dependent on short- term funding than many of Europe’s highly indebted countries, including Greece, Spain and Portugal, according to Lawrence Goodman, president of the Center for Financial Stability, a non- partisan New York think tank focusing on financial markets.

The U.S. may have had a lot more debt in relation to the size of its economy following World War II, but the structure was much more favorable, with 41 percent maturing in less than five years, 31 percent in five-to-10 years and 21 percent in 10 years or more, according to CFS data. Today, only 10 percent of the public debt matures outside of a decade.

We hear some liberal economists argue that the current ability to borrow so much at 2 percent interest rates means that we should be doing even more stimulus spending.  However, the funny thing about the access to credit is that it can literally dry up in the blink of an eye.  There is nothing more dangerous than borrowing short term while using the money for long term commitments.  This is exactly how we are financing the federal government right now.  Baum says it succinctly.

So the next time you hear someone say the Treasury can borrow all it wants at 2 percent, tell him, that’s true -- until it can’t.

We would also be wise to consider some thoughts on debt by our first President.

"There is no practice more dangerous than that of borrowing money; for when money can be had in this way,' repayment is seldom thought of in time, the interest becomes a moth, exertions to raise it by dent of industry ceases, it comes easy and is spent freely, and many things [are] indulged in that would never be thought of if [they were] to be purchased by the sweat of the brow.... in the mean time the debt is accumulating like a snow ball in rolling."

-George Washington in a letter to his nephew, Samuel Washington, Mount Vernon, 12 July, 1797

"To contract new debts is not the way to pay old ones."

-George Washington in a letter to James Welch, Apr. 7, 1799

Thanks, George.  However, thinking about the interest costs that are building on our national debt should cause all of us a lot of insomnia.