Rising Interest Rates Reveal Debt Reality

By: Michael_Pento

The Fed's lucky streak of luring bond investors with low interest rates may be drawing to a close. Nevertheless, the extended period of low borrowing costs has bred a new breed of investor. To the bulls and bears, we can now add the ostriches - those who bury their heads in the sand of declining debt service ratios while refusing to face up to intractable levels of total US government debt. If these ostriches were to actually look at the numbers, they would realize that it is their investments which are made of sand.

As the issuer of the world's reserve currency, the US government has enjoyed the benefits of low interest rates despite its inflationary practices. When we run a trade deficit with a country like China, they have a strong incentive to 'recycle' the deficit back into our dollars and Treasuries. This practice has hidden what would otherwise be much higher borrowing costs and much lower purchasing power for the dollar. This artificial price signal allows people like Paul Krugman to claim that the Obama Administration's stimulus programs should be much larger. Because our yawning fiscal deficits have not driven bond yields significantly higher, he sees no reason to curtail spending. Krugman wants to spend like its World War III, and then has the nerve to call those worried about the budget mindless zombies!

Krugman is just one partisan Democrat shouting at mirrors, but the misunderstanding has struck the right-wing as well. Last week, in a debate with me on CNBC's The Kudlow Report, Brian Wesbury, Chief Economist of First Trust Advisors and writer for The American Spectator, claimed that our $9.3 trillion national debt is of little consequence because our GDP is a far greater. However, he failed to note that our $14.7 trillion of GDP only yields about $2.2 trillion in revenue for the Treasury. To fully access that entire GDP, the government would have to raise all tax brackets to 100% without producing any reduction in output or decrease in revenue. This is, of course, preposterous. As was demonstrated in the 1970s, even small increases in marginal tax rates have a substantial negative impact on output. A healthier appraisal would center on the fact that our publicly traded debt is now 422% of our annual tax revenue.

Wesbury did mention that if the government could not raise revenue to pay off the bonds, it could simply monetize the debt with few significant consequences. Apparently, paying back one's creditors in worthless paper is not technically "default" to an economist.

So neither Krugman nor Wesbury, both intelligent, highly educated economists, see our current course leading to imminent crisis. Unfortunately, both have been led astray by the low debt service ratio which has masked our economy's underlying insolvency. To see through the haze, you have to look at the numbers behind this so-called "deleveraging consumer" and then look at the debt of the nation.

The data point most utilized by those who espouse the idea of a healthy consumer is the household debt service ratio (DSR), a metric that relates debt payments to disposable personal income. This figure peaked at 13.96% in the third quarter of 2007; it has since dropped by 15%, to 11.89%. It is hard to see this as a significant amount of deleveraging, especially when looking at longer term trends. But it gets worse! Most of that modest decline is simply a function of lower interest rates, which have made debt easier to bear. Total household debt has gone down much less. This figure peaked at $13.92 trillion in Q1 2008, and has since declined only 3.5% to $13.42 trillion. How's that for deleveraging?!

It's also worth noting that back in the first quarter of 2008, most homeowners were sitting on a pile of home equity to offset that debt. Today, most of the equity has vanished, yet the debt still remains.

When looking at the national debt, the situation is even more depressing. At the end of 2006, total debt held by the public was $4.9 trillion. According to the Treasury Department, the average interest rate paid on that debt was 4.9%. Therefore, the annualized interest payment at that time was $240 billion. At the end of 2010, our publicly traded debt has increased to $9.3 trillion, but the average interest rate on that debt has plummeted to just 2.3%. So, despite an 87% increase in debt in just a 4-year time span, the annualized debt service payment actually fell 11% to $213 billion. Krugman and Wesbury look at this and see progress.

Meanwhile, the average maturity on our debt has declined to 5.5 years. Compare that with the UK's gilts, which average about 14 years, or even to Greece's bonds, which average about 8 years. Falling interest rates and reduced durations have merely given the illusion of solvency to the US as compared to these other ailing sovereigns.

By 2015, our publicly traded debt is projected to be at least $15 trillion. Even if interest rates simply revert to their average level - not a stretch, given surging commodity prices and endless Fed money printing - the debt service expense could easily reach over $1 trillion, or about 50% of all federal revenue collected today. Just imagine what would happen if rates were to rise to the level of Greece, nearly 12% on a 10-year note, as opposed to our current 10-year yield of just 3.5%. I bet Athens, Georgia wouldn't look much better than its namesake. Don't forget: as interest rates rise, GDP growth slows, sending the debt-to-GDP ratio even higher.

Earlier this year, it wasn't the nominal level of debt that suddenly sent euroland into insolvency, but rather a spike in debt service payments. Right now, the US national debt is the biggest subprime ARM of all time. Much like homeowners who thought they could afford a mortgage that was 10 times their annual incomes, Messrs. Krugman and Wesbury are blinded by deceptively low current rates of interest. These ostriches won't poke their heads up to see the writing on the wall: low rates and quantitative easing cannot coexist for long. As rates continue to rise, the reality of US insolvency will be revealed.

For in-depth analysis of this and other investment topics, subscribe to The Global Investor, Peter Schiff's free newsletter. Click here for more information.

By Michael Pento
Euro Pacific Capital
http://www.europac.net/

Michael Pento is Senior Economist and Vice President of Managed Products for Euro Pacific Capital. He is a well-established specialist in the Austrian School of economic theory and a regular guest on CNBC and other national media outlets.

Copyright © 2010 Euro Pacific Capital, Inc.

Disclosure: Euro Pacific Capital, Inc. is a member of FINRA and SIPC. This document has been prepared for the intended recipient only as an example of strategy consistent with our recommendations; it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns if measured in U.S. Dollars. Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.

Data from various sources was used in the preparation of this document; the information is believed but in no way warranted to be reliable, accurate and appropriate. Euro Pacific Capital, Inc. employees buy and sell shares of the companies that are recommend for their own accounts and for the accounts of other clients.

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.