The specter of bankruptcy hangs over our heads.
Relevant Features of the National Debt
Many Americans today blithely expect future Americans to pay off our national debt. Sorry, future Americans will be even less likely to limit their consumption to repay our debts than we are to limit consumption to repay our own debts.
The federal debt owned by the domestic and foreign public is $20.8 trillion. (I disregard an additional $6 trillion of U.S. debt owned by federal agencies.) $20.8 trillion is about equal to the nation’s GDP, that being the year’s economic activity of America’s 328 million people.
Relevant Features of the Federal Reserve Bank
Our bills and coins are a tiny fraction of the nation’s money. Most of our money consists of electronic numbers in bank accounts. The Fed creates bank money out of nothing by pressing keys on a computer. It’s easy as pie, and the Fed does a lot of it. It then buys Treasury and mortgage-backed securities owned by the public, paying for them with the new money.
Relevant Features of Money
Say you buy a hamburger costing $5. Later on, after the amount of your money has doubled because the swashbuckling Fed created so much of it, the hamburger would cost $10. That’s inflation. The larger number of dollars have only half the buying power of the dollars held before.
Under Federal Reserve management, the value of the dollar has indeed declined. An item costing one dollar in 1913, when the Fed was created, would cost $26 today. The rate of that inflation was 3.1% a year.
Relevant Factors Determining Rates of Interest
The riskier a loan, the higher the rate of interest. Assume that when a bond is first bought, it’s considered riskless. Until maturity, the bond may be bought and sold among investors. If people begin to suspect along the way that the bond is riskier than originally thought, the price would fall.
In the short term, the more money in circulation, the lower the interest rates. After the Fed has created a ton of money, dollars are in surplus, causing the interest rates to be low.
But creditors want the money to have the same buying power when it’s returned that it had when it was lent. If they expect the buying power to deteriorate because so many dollars have been created, creditors want to be compensated for the expected loss of buying power. The interest rates would therefore rise.
Why the Economy is Under Stress
Debt is implacable; it cannot be willed away. The interest cost each year crowds out other uses of the money. Higher debt also puts the economy under stress and makes price changes more volatile.
From the year 1800, when the national debt was $83 million, the debt grew to $5.6 trillion by the year 2000, a growth of 5.7% a year in 200 years. (In this example, the debt also includes bonds that are owned by federal agencies.) From the year 2000, the debt increased to $27 trillion in 2020, a growth of 8.2% a year in 20 years. Note that the pace of growth has increased.
Why America is Nearer to Bankruptcy than Most People Know
Say you lend money to the government by buying a U.S. bond. You consider this a risk-free loan, and you want the money back in ten years. In normal times, you would probably receive about 3% interest a year.
These are not normal times. Well, times are never normal, but they’ve been especially unsettling lately. The Credit Crisis occurred in 2008, following by the Great Recession. The unemployment rate soared, and the Federal Reserve rushed to the rescue by creating three trillion, yes, trillion, dollars, out of nothing. Interest rates fell.
The Credit Crunch was followed in 2020 by the Covid-19 pandemic and lockdowns. Again, unemployment soared, and the Fed again created enough money to drive interest rates further down. The interest rate for the bellwether Treasury bonds due in ten years is now below 1%. With the volume of money enormously increased, the interest rate has declined.
But if the Fed creates too much money for too long, inflation results, putting interest rates up instead. Inflation raises the price of everything, including interest rates. The reduced buying power of the dollar also cuts the value of savings, making everyone poorer.
Current interest rates are still at rock bottom. The Fed assures us that substantial, long-term inflation will not occur. I believe this will be proven wrong. Here’s why:
As mentioned above, the federal debt owned by the domestic and foreign public is $20.8 trillion. The interest paid on this debt amounts to $393.5 billion. That $393.5 billion interest, divided by the $20.8 trillion debt, gives an interest rate of 1.89%. This is the low percentage interest the government currently pays on its debt to the domestic and foreign public.
The total federal expenses for the year amount of $4.4 trillion. The $393.5 billion interest, divided by the $4.4 trillion expenses, reveals that the portion of federal expenses devoted to the payment of interest is 8.9%.
Note that the portion of federal expenses devoted to paying interest on the debt is high (8.9%), even though the rate of interest on the debt itself is low (1.89%).
“What if the rate rises?” you ask.
Good question. The Federal Reserve Bank expects interest rates to rise a little. But substantial increases? Naah, that can’t happen.
But substantial increases of interest rates do indeed happen. Once again, take the ten-year Treasuries. Currently, their interest rate is extraordinarily low at 0.93%. Earlier in 2020, the rate fell to 0.52%. Never, in United States history, have the interest rates on ten-year Treasuries been anywhere near that low. In 1890, when there was no inflation, the interest rate on ten-year bonds was 3.4%. During the Great Depression, the rates stayed above 2.5% and fell to a little below 2% in 1941. In 1960, the interest rate on ten-year Treasuries was about 4%. It first hit 8% around 1970, soared to 15.5% around 1980, and hit 8% for the last time in 1994. Now, it’s a measly 0.93%.
Currently, there are about $13 billion of the world’s bonds whose rates are not only low, they’re negative. Instead of creditors receiving interest from debtors for the right to borrow the creditor’s money, the creditors pay interest to the debtors for accepting and using the money. James Grant, of Grant’s Interest Rate Observer, informs us that this has never happened before in 4,000 years of recorded interest-rate history.
To avert financial disaster, much depends on the Federal Reserve Bank keeping interest rates extraordinarily low. Can it do this?
I think not. The creation of ever more money eventually causes inflation, which makes the prices of everything, including interest rates, rise. With the magnitude of the national debt bringing increased economic volatility, interest rates are unlikely to remain at the current low levels.
If the interest rate on 10-year Treasuries rises, this does not mean that the interest payments on the entire national debt would go up at the same pace. Treasury debt has a wide range of maturities, ranging from one day to thirty years. As the securities come due, they’re rolled over to new debt, with the up-to-date interest rate. Interest payments on the one-day debt will rise the next day, of course. Securities that originally came due in one year would gain higher interest payments only after the year has passed and the debt is rolled over. People that recently bought new thirty-year bonds would have to wait thirty years for the interest payments to rise. The point is, when the interest rate on ten-year bonds go up, the increase of interest payments on the entire debt lag behind.
Okay, if the rate on ten-year Treasuries returns to 4%, that’s about four times the current 0.93%. The interest rate paid on all U.S. debt owned by the public would, with a lag, increase by about four times from the current 1.89%, making it 7.5%. The increase in interest rates would occur all the faster if investors begin to suspect that Treasury securities are not risk free.
To be conservative, let’s assume that the federal debt owned by the public increases from the current $20.8 trillion to $24 trillion. Assuming that the interest rate on the federal debt is then 7.5%, as projected two paragraphs above, the total interest payments for the year would be $1.8 trillion (7.5% of $24 trillion).
To be conservative, let’s further assume that total federal expenses have increased by that time from the current $4.4 trillion to $5 trillion. The $1.8 trillion interest payment on the debt for the year would then constitute 36% of the year’s $5 trillion expenses ($1.8 trillion divided by $5 trillion). In other words, more than a third of federal expenses would be required just to cover the interest on the debt! If the Treasury has to borrow just to pay the interest costs, it would probably be bankrupt.
Raise tax rates? It’s likely that the government would already have raised tax rates as high as it can. Anyway, the higher the rates, the weaker the economy, causing less government revenues, not more.
Alternatively, let’s say the interest rate of ten-year Treasuries rises, not just to 4%, but to 8%, which it first hit in 1970 and last hit in 1994 (remaining above 8% during most of the intervening 24 years). Under the same assumptions as above, the annual cost of interest on the U.S. debt would amount to $3.6 trillion and would gobble up 72% of the $5 trillion assumed federal expenses for the year, an untenable situation. America by that time would certainly have gone bankrupt.
(Here’s how the 72% was calculated: The 1.89% current rate of interest on the national debt, times 8 = 15.1% projected interest rate. 15.1% of the assumed $24 trillion federal expenses = $3.6 trillion projected interest cost for the year. $3.6 trillion divided by the $5 trillion assumed federal expenses means that 72% of the year’s federal expenses would be devoted to the interest only.)
The European Central Bank and the Bank of Japan have also expanded their money supplies exponentially. Any significant increase of interest rates is likely to be worldwide.
The poor old Fed would have no room to rumble. Debt is an implacable foe. The higher it goes, the greater the economic volatility.
In bankruptcy, the Treasury would stop paying its debts, rendering worthless the huge amounts of Treasury securities held throughout the economy. (People bought a lot of Treasuries because they were riskless, right?) This would reduce America’s wealth by the equivalent of a year’s worth of economic activity, bringing on a Second Great Depression, hurting the poor most.
Alternatively, if the Fed causes rampant inflation to reduce the national debt to near nothing, the values of everything valued in dollars – bank accounts, insurance policies, bonds, Social Security, Medicare payments – would also be reduced to near nothing. Widespread misery and death would prevail, again hurting the poor most.
In place of MAGA (Make America Great Again), LARS (Let America Remain a Spendthrift) would be more realistic.
The notion that America can accumulate debt indefinitely works only as long as the historically low interest rates remain low. The rubber band stretches ever tighter until finally, inflation flairs, interest rates fly, and we’re over the cliff.
Is there a way out of this conundrum? Yes, but that is presented elsewhere.
