In recent days, the world's bond market has been repeatedly shocked and awed by the very rapid rise in both long and short-term interest rates in several European countries. Investors are demanding higher returns because they perceive an increase in risk, particularly in debt issued by Italy, Greece and Spain among others and now even France and Germany are feeling the sting of investor anxiety.
As Mr. Bernanke and his fellow bankers at the Federal Reserve have made quite clear, they wish to maintain an ultra-low interest rate environment for the foreseeable future. I'm certain that their European counterparts wished the same thing, however, sometimes the market dictates what direction interest rates will move in rather than accepting the official rates posted by the Fed and their pals at other central banks around the world. In light of the rather rapid move upward in European sovereign bond interest rates, I thought that it would be interesting to see what would happen if the United States suddenly found itself caught in the bond market squeeze and how higher interest rates would impact the ability of Congress to reach the ever elusive and never achieved goal of fiscal balance.
For your illumination, here are 10 year bond interest charts for France:
Notice how in each case, there was a long period of relatively low and stable interest rates prior to the sharp recent rise in yields. Just long enough to lull both bond traders and governments into thinking that everything was just fine.
Let's start by looking at the most up-to-date debt figures:
Now, let's take a look at the government's books to October 31, 2011 as found on the TreasuryDirect website. Here is a screen capture showing the summary of Treasury Securities:
Notice that of the $9.75 trillion in marketable securities, the vast majority is in the form of Treasury notes (maturities between one and ten years) which make up $6.5 trillion of the total. The remainder of the marketable debt is composed of Treasury Bills (up to roughly one year maturity) totalling $1.48 trillion, followed by Treasury Bonds (maturities between twenty and thirty years) totalling $1.03 trillion and TIPS (Inflation Protected Securities) totalling $715 billion. The debt also includes a nonmarketable component, the vast majority of which consists of $4.72 trillion worth of intragovernmental holdings along with savings bonds that are not traded in a bond marketplace. Intragovernmental debt is a rather sneaky form of debt; it is incurred when government borrows from federal trust funds such as the Medicare Trust Fund and the Social Security Trust Fund to help fund everyday operations. Just think of it as robbing Peter (American taxpayers) to pay Paul (those in Washington). At the end of October 2011, the total combination of marketable and nonmarketable debt reached $14.994 trillion.
Now let's look at how much interest was paid in the last fiscal year on that debt:
Now, let's break down Washington's current marketable debt into its constituent parts and look at the range of interest rates paid on each component and its average:
Here's a chart showing the average interest rate on marketable debt, non-marketable debt and the average interest rate on the combination of the two and by how much the interest owing on the debt has changed on a year-over-year basis:
To summarize, effective at the end of fiscal 2011, the average interest rate on $15 trillion of both marketable and nonmarketable debt was 2.859 percent.
For fun, let's look back at the October (since that is the end of Washington's fiscal year) average interest rate data back to the year 2000 and graph the data:
Notice how the average interest rate on the debt has generally declined since the turn of the millenium and how the interest rate in 2011 is at a decade-long low. As well, the average interest rate for the decade is 4.539 percent, once again, the interest rate in 2011 is only 63 percent of the long-term average.
Now, let's go back to the debt. As I noted above, the most up-to-date debt figure for the debt was November 23, 2011 and the debt on that day stood at $15.036 trillion. Now, let's multiply that by the average interest rate on the debt for 2011 (2.859 percent) along with other interest rates ranging up to 7 percent to see just how rapidly things could go very, very wrong. Here is a graph showing the results:
You must remember one thing. I am holding the level of the debt constant when, in fact, it is growing by billions every day, making my calculations a best-case scenario. As well, notice that the 7 percent interest rate seems stratospherically high by today's standards but it is less than one half percent below the rate back in 2000. Let's put these interest totals into context. If we look at Washington's final tally for fiscal 2011, the budget deficit was $1.299 trillion for the year. Receipts from individual income tax reached $1.091 trillion, just above my calculated total interest owing on the debt should the average interest rate on the debt reach 7 percent. So much for those fantasies of fiscal balance.
Now, let's take the 12 year average interest rate on the entire debt of 4.539 percent and elevate the debt in trillion dollar jumps and see how the interest owing on the debt rises as Washington incurs increasing levels of debt:
With a historically accurate 12 year average interest rate of 4.539 percent, the interest owing on the debt rises by $45.39 billion for each $1 trillion increase in the level of the debt. By the time Washington's debt reaches $22 trillion, the interest owing on the debt at the above noted level will nearly reach the trillion mark and, as I noted above, would consume all of the 2011 revenue from individual taxes.
I'm not going to go through the entire exercise, but if the debt reaches $20 trillion (a most achievable goal; should Washington continue to accumulate debt at $1.3 trillion annually, the $20 trillion mark will be reached in 3 years and 10 months) and average interest rates on the debt reach a still modest 6 percent, the annual interest on the debt will be $1 trillion. This is basically what Washington spent on Medicare and Social Security in fiscal 2011.
Some time back, a reader asked me to see if I could provide a method for balancing the budget. Here is ModeratePoli's attempt to balance Washington's budget, a most interesting effort. I thought rather than repeating ModeratePoli's exercise, I'd rather take a look at the achievability of fiscal balance from the existing debt side of the equation. From the calculations that I've completed for this posting, my gut instinct is that Washington will never achieve fiscal balance, largely because the debt is already too large. We are entering a phase where structural deficits will be a permanent annual fixture; no matter how much the economy grows, spending will always be more than revenue, largely because of one factor - interest owing on the debt. Right now, Washington is in the fortunate, once-in-a-lifetime situation of having two factors working in its favour; first, a prolonged period of ultra-low interest rates and second, the fact that Treasuries are regarded by the world's bond markets as the investment of last resort. What is particularly frightening is that these two factors are completely out of their control. Should the world's bond traders decide that the United States no longer deserves the status of the world's reserve currency, things could get very ugly, very fast. Just ask Europe. They know.