U.S. Public Debt: Going Greek

Here is one chart that may be used in our grandchildren’s economic and political history classes.   The current debt service burden on the national debt (as % of GDP) is as low as it has been in last thirty years.  As one Latin American finance minister used to say, “debt and deficits without tears.”

The chart may surprise many given the huge run up in the U.S. federal debt over the past 10 years.  The data show that the total public debt stock has increased from $5.7 trillion on September 30, 2000 to $14.8 trillion on September 30, 2011.

The net interest cost to service the debt, however, has fallen as percent of GDP due to the sharp drop in the average interest rate paid on the debt, which fell from 6.63% in 2000 to 2.886% on September 30, 2011.  Growth also contributed to the drop and as a rule of thumb if the average interest rate is below the nominal growth rate, the ratio falls.

The danger of massive borrowing at record low interest rates is that it makes the borrower extremely vulnerable to an increase in rates.     This was the case of the housing bubble.   This is the case of Greece.   Furthermore, debt and leverage is rewarded in a declining interest rate environment and punished as rates increase.   A repeat of the 30-year secular decline in interest rates is not likely.

Rising interest rates can also reduce market confidence in a heavily indebted borrower’s ability to service its debt, which in turn reduces market access and increases the rollover risk of maturing debt.   Default, bailout, or, in the case of a country with an autonomous central bank, hyperinflationary monetization of maturing debt becomes the only options.    

What puts the “acute” in an acute sovereign debt crisis is the inability to roll over maturing debt.    No doubt Secretary Geithner understands this and, as the chart illustrates, is trying to extend the average maturity of the public debt.

Borrowing at low interest rates also raises several questions.   What will happen to the U.S. budget deficit if economy picks up and interest rates return to normal?  Will the increase in cyclical tax revenues be offset and increase in interest payments on the national debt?   What are the political implications as debt service crowds out expenditures in the rest of the budget?   Did the Fed enable the borrowing binge by its zero interest rate policy?

Borrowing at low interest rates is the like the analogy of the two frogs in a pot of boiling water.  One is dropped into a pot of boiling of water, feels the pain, and immediately jumps out. The other is put into pot of cold water and as the heat is turned up enjoys itself in the Jacuzzi while boiling to death.   High interest rates are penal, low rates are not, until they begin to increase.

Greece borrowed most of its bond denominated public debt at an average interest rate of around 5.0 percent.  That was some Jacuzzi.

P.S.   If you think the U.S. is vulnerable to an interest rate shock, take a look at Japan.   Yikes!

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