By: George Noga
This post kicks off a three-part series about the crisis of spending, debt and deficits.
The next part deals with the interval between now and the inevitable arrival of the Minsky Moment, i.e. the unknown and unknowable time when an unsustainable economic phenomenon suddenly collapses.
The third post will address Gotterdammerung, or what happens after the Minsky Moment. After two years of research I believe I can see the endgame in reasonable focus including one result I believe certain to occur, i.e. the US defaulting on its sovereign debt.
The United States of America will default on its sovereign debt.
Let’s begin with the spectre of deflation, the peril that prompted the now infamous (and misunderstood) Bernanke comment about throwing money out of helicopters. The point he was emphasizing was that deflation is so dangerous it is to be avoided at any cost. Second, it is much better to pull out every conceivable stop (money from helicopters) to prevent deflation because it is far easier to prevent than it is to reverse once it begins.
Deflation can become a death spiral, hence its ability to instill fear in economists and particularly in central bankers. The point being that future deflation is much less likely than inflation. Therefore, the remainder of this post assumes inflation, albeit either peril is devastating.
Current Debt, Interest Rates, Maturity and Interest Cost
The USA currently has $11 trillion of public debt. Although our total debt is $16 trillion, we must pay real interest only on the publicly held portion; the remainder is paid notionally – such as that on the social security funds Congress has spent and for which it has issued IOUs.
The maturity of the debt is particularly troublesome as Obama has borrowed short term solely for window dressing to make the deficit appear smaller than it really is. This is recklessly dangerous. Imagine you have a mortgage and you could borrow ultra short term for about .3%, or borrow 10 years for 2%, 20 years for 3% or 30 years for 3.3%. Moreover, 45% of your existing mortgage was coming due within 3 years and 73% within 7 years. Would you lock in historically low long-term rates or would you continue to borrow ultra short knowing nearly for certain that rates would be much higher in the future when it came time for you to refinance?
“For every 1% rise in rates, the deficit will balloon $1 trillion.”
Because of the confluence of historically low rates, borrowing ultra short on the yield curve and serial episodes of aggressive central bank quantitative easing, the current composite rate on US sovereign debt and the amount of interest payments are artificially low. The composite rate on US sovereign debt is 2.3% compared to an average of 5% for the past two decades and 6+% during the 1990s.
Actual interest payments, currently around $250 billion, are lower than in 2007 and even lower than 1997 in nominal terms. When rates inevitably rise, the consequences are stark. According to CBO, during the coming decade for every 100 basis point (one percent) increase in the US borrowing rate, the deficit will balloon by $1 trillion. And then it gets really ugly as interest on top of interest puts us on a fast path to perdition.
Even Modest Inflation Produces Fiscal Nitroglycerin
I could create numerous scenarios; however, I will present only two. The first depicts what are consensus numbers about deficits and debt. By 2020 the public debt will be at least $22 trillion. If inflation is moderate (3%-4%) and rates return only to their long term historical average, the annual interest will be $1.32 trillion – equal to 33% of revenue and more than social security, equal to Medicare and Medicaid combined and 40% more than defense.
One dollar of every three paid in taxes will go to service the debt. And it will get worse every year after 2020. However, the consensus numbers significantly understate the risks.
“Under more realistic conditions, interest on the debt in 2020 would consume $2 trillion, equal to half of all tax revenue.”
Even though the previous scenario would result in Armageddon, it is too optimistic. Let’s explore a second, more realistic scenario. The public debt is only marginally higher, say $25 trillion versus $22 trillion in the first scenario. However, inflation now is in the 7%-9% range and the average interest rate on the debt is 8%. The math is straightforward resulting in exactly $2 trillion per year of interest on the debt.
This would devour half of all revenue and clearly would not be survivable for America. An 8% rate is not far-fetched given the circumstances; what rate would you charge to loan money to a drunken sailor whose income already was half spent on interest toward his previous debts and was all but certain to default? I didn’t bother to show you a really ugly scenario such as the late 1970s and early 1980s when inflation was 14%, the interest rate was 21% and 30-year Treasury bonds paid 13.75%.
“There is absolutely no escape from the Obama debt bomb.”
The real problem is that even if a future administration in Washington tries to do the right thing (highly unlikely), it will be damned by the present artificially favorable maturity and interest rate situation. Even if many hundreds of billions of dollars in spending are slashed from the budget (again, unlikely), it will be offset by a like amount of spending on higher debt service. I don’t see any escape from the Obama debt bomb. Next up: The Endgame!
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