Monday, April 02, 2012

U.S. Debt Crisis, Straight Ahead!

Within the next five years, $5.9 trillion — or 71 percent — of the U.S. government's privately held marketable debt will come due.

This means the government will somehow have to roll over nearly three-quarters of its debt by 2017 — almost certainly at higher interest rates than at present.

Simply put, an enormous amount of debt — perhaps too much — will come due in a very narrow time frame.

The U.S. has become overly reliant on short-term funding; only 10 percent of the public debt matures beyond ten years. This creates constant pressure to issue new debt and get debt holders to roll over existing debt with the promise of even more interest payments down the road.

The U.S. paid $454 billion in interest on its publicly held debt in fiscal 2011, which ended September 30. For perspective, the entire U.S. budget deficit in 2007 was $161 billion. The current interest payments, alone, now exceed that figure.

The scary thing is that even if Congress manages to balance spending with revenues, it would still have roughly half-a-trillion dollars in interest payments to make this fiscal year. And the situation can get even worse.

As interest rates rise — and they surely will — the interest payments will become even more cumbersome. Based on the current structure, a one percentage-point increase in the average interest rate will add $88 billion to the Treasury’s interest payments this year alone, according to Lawrence Goodman, president of the Center for Financial Stability. Goodman is an expert in such matters; he previously served at the U.S. Treasury.

When rates return to historic norms, the interest payments will become unmanageable.

In 1970 the yield on a 10-year Treasury averaged 7.35 percent; in 1980 it was 11.43 percent; in 1990 it was 8.55 percent; in 2000 it was 6.03 percent; and in 2010 it was 3.22 percent. You can see the long term downward trend. But rates can just as easily trend upward instead.

It is reasonable to ask how the government will convince foreign governments and sovereign wealth funds to roll over their existing debt, rather than taking their money and going home.

After all, the U.S. private sector — namely banks, mutual funds, corporations and individuals — reduced its purchases of U.S. government debt to a meager 0.9 percent of GDP in 2011, from a peak of more than 6 percent in 2009. That's because they're all chasing higher yields in riskier markets.

Buyers of U.S. debt have become scarce enough that last year the Federal Reserve purchased a stunning 61 percent of the total net Treasury issuance. That is simply insane. It is also patently unsustainable.

The Fed is effectively subsidizing U.S. government spending and borrowing. This masks the reduced demand for U.S. debt by sovereign entities and the U.S. private sector.

Simply put, the U.S. government would cease to function without the absolutely massive intervention of the central bank. But there are limits to all of the Fed's money-printing schemes.

At present, the U.S. government's demand on the credit markets for its annual interest and principal payments is equivalent to 25 percent of GDP, according to Goodman, which is 10 percentage points higher than the norm.

This level of indebtedness cannot continue. Interest payments on the debt steal from more productive uses, whether its infrastructure, research & development or education.

More importantly, at some point large interest payments can force some rather unfortunate social choices and even the potential of default. Never in the history of the Republic has that happened. But there is a first time for everything.

The likely outcomes are a debt crisis, spiking interest rates, and spiraling inflation due to all of the Fed's monetization of the debt (meaning, printing money backed by nothing so that the government can maintain its deficit spending).

One needs only to look at the European sovereign-debt crisis to see how this all ends. Things can seem just fine for many years, until there is a sudden shock to the system.

In other words, everything can seem just fine until, quite suddenly, it isn't.

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