Increasing U.S. Debt, Interest Payments, and Why It Matters Now!

by Victor Sperandeo and The Curmudgeon

Background:

Does anyone remember that during Bill Clinton's second term, several years of budget surpluses actually reduced the national debt? In fiscal year 2000, the budget surplus was $236.2B with the national debt at $5.674T. The talk then was how the U.S. could possibly cope with the national debt being reduced to zero. That was then and this is now!

The U.S. Treasury estimates that the current national debt (as of Oct 31, 2013) is $17.156T. That's more than triple the fiscal year 2000 number!

The total budget deficit/surplus along with other statistics from 1970-2009 are shown in this table.

The national debt started to increase during the George W. Bush presidency and then sharply accelerated when the federal budget deficit skyrocketed during and after the great recession. It has continued to expand during the so called "economic recovery" of the Obama administration. For more information, we direct readers to Frequently Asked Questions about the Public Debt

Exponentially increasing U.S. debt has now become a major political issue, as evidenced by Congressional squabbling over the current budget and raising the debt ceiling. Let's dig deeper into this huge ongoing problem.

Differences of Opinion on the U.S. Debt:

Some politicians and journalists (e.g. Paul Krugman) argue that "the federal debt does not matter" and consequently, the U.S. can run large budget deficits indefinitely. Fiscal conservatives strongly disagree, pointing to huge debt service obligations for future generations (especially if interest rates increase as we analyze later in this article).

Sharply increasing U.S. federal debt started The Tea Party after the great recession supposedly ended in June 2009. According to Wikipedia:

"The Tea Party movement is an American political movement that is primarily known for advocating a reduction in the U.S. national debt and federal budget deficit by reducing U.S. government spending and taxes. The movement has been called partly conservative, partly libertarian, and partly populist. It has sponsored protests and supported political candidates since 2009."

How Could the U.S. Debt Get So Large Without Severe Consequences?

The massive increase in U.S. debt was facilitated by the Fed's printing press. Under various QE programs, the Fed has been purchasing U.S. debt with money created "out of thin air." That has kept long term interest rates relatively low and real yields close to zero or negative. Without such a printing press, the U.S. debt could never be able to be so massive. That's because buyers of U.S. federal debt (i.e. Treasury securities) would demand a much higher interest rate, which would have a very negative effect on the U.S. and world economy.

The Fed's balance sheet has increased dramatically since June 2009 and is now over $3.8T as can be clearly seen from this chart:

Total Assets of the Federal Reserve

The Real U.S. Debt is Much Larger than Reported:

What does massive mean? The stated U.S. debt is $17.156T. Note that many government liabilities -like social security, Medicare, student loans, etc. are not in the annual U.S. budget, but are included in the national debt as "debt held by government accounts." A working paper by University of California-San Diego Economics Professor James Hamilton ($5 to download) estimates that the US had more than $70 trillion in off balance sheet liabilities at the end of 2012. That puts the real amount of total U.S. debt at $86.9T!

Note: For a detailed breakdown of how Hamilton arrived at that number, please refer to this article.

Opinion: We think politicians are fooling the people and themselves by trying to hide the real debt numbers. A pessimist or "conspiracy theorist " might deduce that the federal government is trying to destroy the system in order to change it.

Just the Facts Please:

· From September 31 1978 to October 31 2013 (or any other reasonable period of time) total U.S. debt has grown at a compounded annual rate of 9.23% from $771B to $17.1T.

· The annual U.S. budget deficit at the end of the 2013 fiscal year (Sept 30, 2013) was $680B. However, that is based on cash accounting. If one used GAAP or what every U.S. company must use for accounting, the deficit would be 6.6T for the last fiscal year!

· Accounting gimmicks abound. For example, when the federal government funds Fannie Mae, its spending is off- budget and not counted in the budget as an expense. But when Fannie Mae remits a payment to the U.S. Treasury it's counted as revenue. How can that be?

· The official U.S. debt is reported to be $17.1 Trillion (T), but the Federal Reserve Board (the Fed) holds almost $4 T of that debt (see above chart). Recently, FOMC member Charles Plosser said the Fed has discussed holding the QE Treasury securities purchases to maturity, rather than selling them to reduce its balance sheet. If so, then the U.S. debt is actually $21 T. That's because the U.S. Treasury has no funds to pay the Fed when the debt it holds matures. Therefore, the debt the Fed purchased under QE must be counted as part of the total national debt. -->The CURMUDGEON has been pounding the table for some time, claiming QE is the greatest Ponzi scheme of all time!

· In addition to the actual U.S. debt and off balance sheet/ unfunded liabilities, there are other types of public U.S. debt that are important. For example, state debt of approximately $3 T, public pension unfunded liabilities -estimated at $3 T, FDIC liabilities, and more. Note that social security obligations are included in total U.S. debt.

· Public pension liabilities are a big part of what is financially crippling state and local governments. A recent CNBC.com analysis of more than 120 of the nation's largest state and local pension plans finds they face a wide range of burdens as their aging workforces near retirement. ..."It's not even clear just how big a financial hole many states and cities have dug for themselves." A former Chairman of the Council of Economic Advisers told CNBC that "a lot of state and local governments have too much debt, too generous public pensions. We need a national conversation on how to fix this."

· On September 30, 2013, the U.S. Postal Service defaulted on a $5.6 billion payment for retiree health benefits that was due. The Postal Service expects to end fiscal year 2013 with a loss of about $6 billion.

Analysis of Normalized U.S. Interest Rates on Debt:

The critical problem of the debt is not in its ratio's to GDP, but in the nominal numbers and in the "average” or "normalized" interest rate, which compounds over time. The effect of that interest rate compounding is to make the debt grow ever larger, even if the budget deficit is substantially reduced or even eliminated.

Today, the average interest rate paid on U.S. government debt {3 month T bills at 0.04% + 30 year T Bonds 3.69%÷ 2} is 1.87 %. But that rate is artificially low, due to Fed and Foreign Central Bank massive purchases of U.S. government securities.

According to Ibbotson Associates 52 year averages, the T Bill rate was 5.1% and T Bonds were 7.02% (not including capital appreciation). That puts the average interest rate at 6.06 % over the same time period. It's not unreasonable for U.S. interest rates to revert to that mean sometime in the near future. That might occur once the Fed ends its QE programs, money velocity accelerates or there is more private credit demand.

The U.S. budget deficit for the 2013 fiscal year totaled $680.3 billion, down from $1.09 trillion in 2012 and the first time in five years, the U.S. government has run a budget deficit below $1 trillion. That seems like good news- and it is on a relative basis.

But at the 52 year average U.S. interest rate of 6.06%, the national debt would continue to grow at an alarming rate. That's because interest payments are an uncontrollable federal budget expense that adds to the budget deficit and national debt. Over 30 years, the interest paid (at normalized/average interest rates) would be $3,972.4T or 23.2% of the total debt of today! That's 5.8 times the deficit for the past fiscal year- under several full economic cycles, with normalized interest rates.

Now let's make the "pie in the sky" assumption that the U.S. has balanced budgets forever, but the government pays normalized interest rates for the next 10 years. The total debt would then be $30,797 T and interest payments would be $1.8 T. That would be ~ 30% of federal government spending, according to CBO estimates for the next 10 years.

In other words, normalized interests rates would produce an uncontrollable U.S. debt service budget item that would sharply increase U.S. budget deficits and the national debt. This was a huge worry in the early 1980s, when U.S. interest rates were much higher with the national debt and budget deficits much lower.

Now let's assume we don't reach 6.0 % normalized interest rates. Then the U.S. economy would look a lot like Japan's - big budget deficits, increasingly larger national debt, and virtually no economic growth for decades.

With the reported national debt compounding at a rate of 9% (as it has historically) it would be over $40 Trillion in 10 years. Clearly, that's unsustainable and cause for concern.

Closing Comment:

This real problem of the total U.S. debt (and increasing interest payments on it) is almost never discussed by politicians, economists, or the main stream media. Why not? We think that there are very bright people in government that understand this problem. Perhaps, they just don't talk about it so as not to scare the public. Or they don't want to expose the reality that the U.S. doesn't have a financial plan to cope with its spiraling debt.

It's one thing for the federal government to run huge budget deficits to recover from a steep recession. But the U.S. is supposedly 4 1/2 years into an "economic recovery," yet the debt is still soaring-even with artificially low interest rates. What happens in coming years is why the debt matters now! Is anyone in Washington paying attention?

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies.  As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.