Recent events in Europe have once again focused the markets on the huge overhang of debt in the high debt European economies with Ireland now effectively joining Greece on life support from the EU and IMF. Can Portugal (Spain) be far behind? (Most Americans and Germans would have a fit if they knew how much of the IMF commitments were borne by them!) During that first European debt crisis last spring, I blogged about the level of debt in the U.S. (see “Wow! That’s a Lot of Debt!” at TheStreet.com 5/21/10). Now, with QE, QE2, and trillion dollar structural deficits as far as the eye can see, I wonder how many people recognize the potential devastating costs of the national debt as deficits continue, especially if interest rates start to rise as many pundits believe is fairly imminent.
This is a blog about the cost of the national debt. But, to set the table, let’s look at some data. The national debt currently stands at $13.7 trillion, and, under the most optimistic Congressional Budget Office (CBO) projections for 2015, it is projected at $17.4 trillion (based on 4.9% GDP growth between now and 2015). More likely, unless economic growth improves dramatically, the debt will rise to $20 trillion, perhaps $22 trillion in the next five years. The Federal Budget is nearly $3.5 trillion (23.9% of GDP) and CBO projects a Federal Budget of $4.2 trillion (22.8% of GDP) in 2015. Tax collections for 2010 are expected to be $2.1 trillion, of which $894 billion are from income taxes. CBO projects total taxes to rise to $3.7 trillion by 2015 (an 11.7% annual growth rate), and for income taxes to rise to $1.9 trillion (16.1% annual growth rate!). Clearly, such projections occurred prior to the recent elections. Today, for every dollar spent by the Federal Government, nearly $.39 is borrowed. USDebtClock.org indicates
Six Largest Federal Budget Categories
|Budget ($Mill)||% of Total Budget|
|Interest on Debt||$200,340||5.7%|
* Includes Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, Making Work Pay.
that the six budget categories shown in the table account for nearly 86% of the Federal Budget.
The six categories shown account for nearly $3 trillion of spending and are 140% of total tax collections indicating the nature and extent of the structural deficit. A few of these six categories have become “sacred cows” with any politician or would be politician attempting to “fix” any of the four “social” categories (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) subject to vicious political attack. It also appears that these four are also subject to fierce upward spending pressures as the population ages, the recession continues, and federal employee wages remain significantly above those available in the private sector (and rising!). As long as the U.S. continues to fight two wars and must defend itself against the war declared on it by the jihadists, upward pressure on the defense budget will continue. That leaves Interest on the Debt.
The website USTreasuryDirect.gov has a wealth of data concerning the national debt. As of October 31, the official debt was $13.689 trillion consisting of $8.497 trillion of marketable debt and $5.192 trillion of non-marketable. Debt held by the public (including foreigners), which consists of most of the marketable debt plus a few minor items (like savings bonds), was $9.07 trillion.
The remainder of this paper investigates what happens to the cost of the debt if interest rates rise? It isn’t a simple answer because the debt matures issue by issue on widely different dates. If a maturing issue, for example, has a coupon higher than current market conditions require, the total cost of the debt would fall. So, changes in interest rates take time to work their way through the debt maze. To analyze what happens to the cost of the debt, I made the following assumptions: a) the shifts in the yield curve would be parallel shifts; b) a maturing issue would be reissued to its original term (for example, an issue that matures on 11/15/10 that was issued on 11/15/2000 (i.e., a 10 year Note) would be reissued on 11/15/10 at current market interest rates to mature 11/15/20); c) the marketable debt ($8.497 trillion) is a close proxy for the debt held by the public ($9.07 trillion). While the “cost” of the $13.689 trillion is a number in the $325 billion range on an annual basis, the real cost of the debt is the cost of the portion held by the public because that is the net amount of interest to be paid out; the rest is just intra-governmental transfers. Some may argue that the budgets of those agencies must reflect the interest that has to be paid, but for this analysis, I have used the “net” debt concept. The existing marketable debt (Bills, TIPS, Notes, and Bonds) has a weighted average maturity of 4.9 years and a current cost of 2.41%. The base yield curve used is the yield curve for Treasuries and the yield curve for TIPS on 11/15/10 as shown in the following table:
11/15/10 Yield Curves
The table below shows the percent change (from current costs) in the cost of the marketable debt in 1, 3, 5 and 10 year periods using parallel shifts in the base yield curve of between 0 and 700 basis points (bps). As the table shows, the longer the yield curve stays where it is (or goes lower), the better it is for the cost of the existing debt. For example, under the constant yield curve scenario (0 bps change), because the issues maturing have a higher coupon than newly issued debt, the cost of the existing debt falls. So, if the 11/15/10 yield curves exist for the next year, the cost of the debt would fall by 5.2%, or approximately $10.6 billion. And, over 10 years, the annual cost reduction would be quite significant. Under the parallel shift of 100 basis points scenario, the cost of the existing marketable debt rises 7.3% (approximately $14.9 billion) after 1 year. Under this scenario, things stabilize and actually improve between the 5 and 10 year marks. However, as the table shows, as rates rise more than 100 basis points, things deteriorate. For example, at a 200 basis point rise, 5 years out the cost of the existing debt will have risen 37.4% (approximately $76.5 billion). So, if the economy begins to experience inflation, or if we simply cannot place the maturing debt without higher coupon yields, the cost of the existing debt becomes a significant issue. Using the 5 year column, the cost of the existing marketable debt for rises of 300 and 500 basis points is 66.0% ($135.0 billion) and 123.2% ($251.9 billion) respectively.
Percent (%) and Dollar Changes (Bill $) in the Cost of Existing Marketable Debt
Under Parallel Shifts in the Yield Curve
|Yield Curve Shift||1 Yr||3 Yr||5YR||10YR|
Of course, this does not tell the whole story, as the U.S. continues to run significant budget deficits, and each added dollar of debt results in increased interests costs. The CBO has projected the national debt at $17.35 trillion in 2015. That is $3.68 trillion more than now exists. Given the current deficit estimate of $1.27 trillion for fiscal year 2011 (which began October 1) after $1.56 trillion of red ink in fiscal 2010, and an economy clearly in low gear, the CBO number is clearly optimistic.
In the table below, I show the change in the cost of the marketable debt using the CBO $17.35 trillion of total debt, and adding more realistic $20 and $22 trillion columns (I note that on June 9th, the Treasury projected the 2015 deficit at $19.6 trillion). Besides the assumptions used in the table for the existing debt, the following assumptions were added to create the estimates for higher levels of debt: a) all of the new debt created is marketable; and b) the term structure of the total marketable debt would not change from what it is currently. As can be seen from the table, deterioration in the cost of the debt is rapid, even if interest rates rise only slightly. For example, even at a parallel shift in the yield curve of only 100 basis points, at $20 or $22 trillion of debt, the cost rises 63.8% ($130.5 billion) or 81.2% ($166.0 billion) from current levels. The cost of the debt, which is currently 5.7% of the Federal Budget, would rise to 11.1% under CBO projections and to 13.4% or 15.1% of the Federal Budget under the $20 trillion and $22 trillion scenarios at the more “normal” interest rate levels represented by the 300 basis point shift row in the table. While that is daunting, the rest of the table is truly terrifying, especially if the Fed’s QE programs end up putting the U.S. economy into a 1970’s type inflation.
Percent (%) and Dollar Changes (Bill $) in the Cost of 2015 Marketable Debt
Under Parallel Shifts in the Yield Curve
|Yield Curve Shift||CBO ($17.35 trillion)||$20 trillion||$22 trillion|
It is a fine line the Congress and Federal Reserve is walking. Given the structural nature of the deficits and the difficulty of slowing or reversing defense costs or the costs of the “social” categories, even small upward changes in interest rates toward “normality” will exacerbate the deficit and economic growth issues.
Robert N. Barone, Ph.D.
November 29, 2010
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