Thursday, October 3, 2013

A Penny And A Few Thoughts

I walk every morning.

I often see a penny lying on the sidewalk on my walks.  I have never fully understood why I see so many more pennies than nickels, dimes or quarters.

Is it because there are many more pennies in circulation?  Are people just more careless with their pennies?  Is it because many people won't bother to pick up a penny like they would with something larger?

This is a penny I picked up on a walk last week.

If I see a penny, I always pick it up.  I hope it is good luck.  More importantly, I know the power of that penny.  I am not going to ignore it.

One of the big reasons I don't ever ignore a penny is this story I read a long time ago about Brutus and Caesar.

Brutus and Caesar

Caesar was a great politician but like all politicians he had his share of enemies.  In order to insure that his children were taken care of if he met an early demise, he instructed Brutus to set up a trust for his children with $1,000 Roman dollars.  

Of course, Brutus was not the most trustworthy guy.  He skimmed off a penny and set up a trust for his own heirs invested in safe government bonds yielding 3%.  Caesar's children got $999.99.  Brutus left  instructions that no one was to touch the money he put in trust for 2,000 years. 

How would that work out?  One cent compounded for 2,000 years at 3% would grow to $473,000,000,000,000,000,000,000 ( that is 473 billion billion).  The current GDP of the United States is about $16 trillion.  In other words, one single penny compounded for 2,000 years would be able to buy everything in the U.S. economy for the next 30 billion years.

If one penny could grow to that sum over the last 2,000 years why isn't there more wealth?  The biggest reason is that people rarely can keep their hands off the money.  Compounding only works if interest compounds on interest.  Most people can't do that.  They spend the income as soon as they earn it.

Another big reason is that the original investment capital is lost and the compounding stops with it.  Brutus thought he was being smart by investing in the safest investment around-government bonds.  Unfortunately, those bonds were Roman Empire bonds.  The empire fell apart and the government bonds became worthless.  Not only was the compound effect lost but so was the original penny.

Now you know why I pick that penny up.

However, that penny and that story also explain why I am so concerned about our country and our debt.

History shows that it is impossible to keep up with compounding interest on debt beyond a generation of two.  The burden is simply too much.  The only way out is default of inflation.  That is the way the system purges the debt and clears the deck for the future.  Of course, those holding that debt are wiped out.

In a couple of weeks we will reach the current debt ceiling limit of $16.7 billion.  About $12 billion of that debt is held by the public.  The remainder is owed to various other government entities like Social Security.  These are called intragovernmental holdings and amounts to approximately $4.7 billion.

When you are dealing with compound interest you reach a point as a borrower that you simply cannot keep up with the compounding interest payments.  It is like a small snowball rolling down a hill.  It just keeps getting bigger and picking up speed.  Pretty soon it becomes a gigantic boulder that has the potential to crush everything in its path.

We are at the bottom of that hill and that snowball is getting bigger and bigger.

Were it not for the Federal Reserve's QE policy the snowball would be accelerating at a frightening pace.  It has been "printing money" to buy most of our current borrowing needs over the last couple of years which is keeping interest rates low.

Consider the fact that, thanks to the Fed, the average interest rate on our national debt right now is at an historic low of only 2.4%.

How does this compare to historical averages?  The average interest rate over the last 20 years is 5.7%.

Peter J. Tanous wrote about this recently on

So here's where it gets scary: U.S. debt held by the public today is about $12 trillion. The budget deficit projections are going down, true, but the United States is still incurring an annual budget deficit by spending more than we take in in taxes and revenue.
The CBO estimates that by 2020 total debt held by the public will be $16.6 trillion as a result of the rising accumulated debt.
Do the math: If we were to pay an average interest rate on our debt of 5.7 percent, rather than the 2.4 percent we pay today, in 2020 our debt service cost will be about $930 billion.
Now compare that to the amount the Internal Revenue Service collects from us in personal income taxes.
In 2012, that amount was $1.1 trillion, meaning that if interest rates went back to a more normal level of, say, 5.7 percent, 85 percent of all personal income taxes collected would go to servicing the debt. No wonder the Fed is worried.

Of course, who knows where interest rates might go once the QE money printing stops?   

This chart give you a general sense in the average net interest borrowing costs of the federal government since the early 1980's.


What is especially troubling is how much of the debt outstanding is in short maturities.  This chart is from last year but it gives you the general idea.  Fully half of the debt matures ( and most be refinanced) within 36 months.

This is a dangerous situation to be in if interest rates rise as borrowing costs could rise in a very short time that would greatly increase the budget deficit.  Not only would the federal budget have to pay interest on new borrowings to finance the deficit but debt already on the books must be refinanced.

For example, in 2012, $3.7 trillion in treasury securities were issued.  $1.1 trillion was to finance the current year's deficit and an additional $2.6 trillion was needed to refinance older debt.

A 300 basis point increase in interest rates (3%) would mean this would increase borrowing costs (and federal spending) by an additional $111 billion annually.

That snowball can get big in a hurry.

Those pennies quickly add up on the borrower.

That is why there are usually only two ways out when debt starts to reach the levels we are at today.

Inflation or Default.

Therefore, watch your pennies.  And pick up as many as you can.  You may need them.

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