Do Deficits Matter?
Here at Wanderer, we pay attention to interest rates and their trajectory. So, it’s not a secret to us that rates are rising, and money is becoming more scarce. So far, we’ve focused on how rising rates will affect the economy or the stock market, but we didn’t look at what it could do to Uncle Sam. Today, we’ll tackle that subject.
When it comes to spending money, government takes the task seriously and divides the duties up among separate branches. While Congress determines the budget, the Treasury determines how to pay for all of the latest spending proposals by selling debt of varying maturities. This division of labor makes it even easier for government to spend more than it makes.
Think about it, it is easy for Congress to propose spending when they aren’t the ones who have to directly pay for it, and it's not so bad for the Treasury to continually borrow to get by when it isn’t them that determines how much is being spent. The end result is that the US government spends more than the revenue they take in. The result is a constantly growing balance that continually gets rolled over into new debt.
In our personal lives, this is akin to using a credit card to pay for current expenses, and when the charges become due, use another card to pay off that card, while continuing to add more spending to the card.
With government spending out of control, the total debt has become unpayable for all practical purposes. If taxpayers were to combine spending power and everyone chipped in their fair share to pay it all off, it would require $245,191 from each of us! Yeah, that ain’t gonna happen.
We’ve now reached a point where we borrow to pay our immediate expenses, and also borrow to pay back previous expenses. In other words, when US debt is due, much of it gets paid back with newly issued debt. This is where a problem is created.
As the debt-berg grows, it becomes sensitive to changes in the interest rate. The average duration of US debt is about 5 years. The 5-year interest rate was almost at 0% in 2020 when Congress voted for massive deficit spending to stimulate the economy. The spending added $7 trillion to the existing debt pile, but with almost no interest.
Soon, that debt will become due, along with all of the other accumulated debt. The problem is, the US government doesn’t take in enough revenue to pay this year’s expenses, much less pay down previous years’ deficits.
So, what do they do? They roll old debt into new debt. When a bond becomes due, they issue a new bond and use the proceeds to pay off the old bond. Under this system, the total debt continues to grow, as well as the annual interest payments that are due on the outstanding balance.
Herein lies the potential problem. When Congress rolled old debt into new debt in the past, it was typically retiring debt that had a higher interest rate with new debt that was cheaper because rates had been falling. That is, until last year when rates began to creep higher. A little bit at first, and then a lot faster as we've rolled through 2022.
Now there is over $30 trillion of outstanding debt—all of which will eventually be refinanced—and interest rates have shot up from around .2% in 2020 to over 4% as of this writing. See the problem? Figures are only available up to August of this year, but already by then, the interest expense on the debt had risen to over a trillion dollars per year! That's just the interest.
With the way rates are rising, interest expense is quickly working its way up the expense ladder to become one of the leading expenses for the government. It won’t take much higher rates to swamp the government’s ability to pay without issuing massive amounts of new debt yet again.
This is a negative feedback loop where the government continues to issue new supplies of debt, which causes rates to rise even more, exacerbating the problem. But it gets even more interesting. In a growing economy, tax receipts continually grow, making it possible for the government to continue to add new debt onto old debt.
But now the economy is slowing and federal tax revenue is likely to erode. 2022 capital gains taxes, for example, have all but disappeared as almost every asset is declining in price rather than rising. Loss of that revenue alone will result in the issuance of hundreds of billions of new debt. New debt that will be more expensive because of rising interest rates.
Although we've focused on the US debt in this post, other nations are dealing with the same problem. Global debt, which includes private debt has now exceeded $300 trillion. Unfortunately, much of that debt is in for a rude awakening as it rolls over into a more expensive interest rate. This is a topic that will become front and center over the next few years. It is a problem that will need to be dealt with as rates continue on their current trajectory.
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