The Federal Debt Bomb

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. - Charles Dickens

While everyone has been cheering the market gains so far this year, the European debt crisis which fueled last year's volatility is still very much on the minds of the financial markets. The recent calm has been largely driven by the bailouts of European borrowers and banks. All of this has been made possible by a debt market awash in cheap money. These bargain rates have also greatly helped the world's biggest borrower, the U.S.

Over the last several years, the United States has been quietly benefiting from historically low interest rates. These ultra-low rates have masked a budgetary challenge to service this debt in the future. The issue deserves more attention as the nation will be stuck paying the bill when rates inevitably rise.

First, a couple facts: The U.S. Treasury currently has $10.8 trillion in outstanding publicly-held debt, and more than $8 trillion of it must be repaid within the next seven years. More than $5.5 trillion falls due within the next three years.

This relatively short-term debt due is no accident. Like a consumer opting for a low teaser rate, the government has structured its debt to keep the current interest payments low. This is a political temptation for every administration because it means lower budget deficits on its watch.

The government has added close to $5 trillion in debt in the last four years alone. To keep the interest payments low, it much prefers to finance all of this at a rate of 0.3% in two-year notes than at 2% in 10-year notes. Even though the federal debt has soared during those years, the net federal interest payments are lower than they were in 2007. In nominal dollars, the interest payments are even less than they were in 1997 when public debt was a mere $3.8 trillion. This year the debt is expected to reach a whopping $11.58 trillion.

These low rates have disguised the magnitude of the debt threat that is building for future taxpayers. The Congressional Budget Office (CBO), for example, forecasts that in the period 2014-2017, the average rates on three-month Treasury bills will rise to 2% from less than 0.1% today. The CBO expects average rates on 10-year Treasury notes to climb to 3.8%, from 2.03% now. The CBO adds that every 100 basis-point rise in government borrowing costs over the next decade will trigger almost $1 trillion in additional interest expense, which of course will be paid with yet more borrowing.

As of January 2012, taking into account all the various notes and bonds issued by the federal government to the public, the U.S. is paying an average interest rate of 2.24%. The government expects to spend in the neighborhood of $225 billion this year on those interest payments.

That may seem like a large sum, and it is, but consider what happens if rates quickly rise back toward their historical norms. As recently as early 2007 the government was paying 5% on its debt, which is the average of the last two decades, though rates could always go higher of course. During the 1990s, the average was well above 6%.

If the government had to pay the 5% rate that it was offering before the financial crisis on today's debt, the annual interest payments would be $535 billion, twice CBO's projection for total federal spending on Medicaid this year. If the government had to pay 6% on its debt, the annual interest payments of $642 billion would surpass total federal spending on Medicare, currently $484 billion.

There has been far too little talk of the impact on our federal budget when (not if) interest rates normalize. These numbers will only get worse with the one point something trillion dollar deficits that are currently being run up every year. The situation has become so extreme at this point that even if all the tax increases being discussed were enacted, they wouldn't even cover half of these higher interest payments - let alone reduce the deficits.

The Treasury Department says it's aware of this risk and has stated that it is making changes to its debt structure. In the past year and a half, the Treasury Department has reduced the debt maturing in three years from 55% to 52%, but the short term outstanding debt is still far too and the move to rebalance the maturities far too slow.

The Fed has been buying its own debt in the open market through its "Operation Twist". In addition to greatly increasing the money supply, it is also purchasing 30 year bonds in part to keep longer term rates down. Eventually this will have to end. When it does, rates will start to rise to historically normal levels. The question remains, how quickly will the debt bomb go off after that?

We've seen what the future looks like - Europe. Crushing debt loads greatly reduce economic growth and employment. They also force a nation to be beholden to their creditors. In our case, that is looking more and more like the communist Chinese.