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Thursday, February 24, 2011

Number Crunching - Low Interest Rates And Federal Interest Expense

Hello Everyone,

This is step 2 in my quest to figure out just how much the federal debt is going to affect the economy, and whether we are beyond the point of no return with regards to hyperinflation. First, let me explain the question I am asking and trying to answer. If, as my daughter's Columbia University Macro Economics professor asserts, the Fed can "mop up" all the excess liquidity it has been pumping into the economy by simply raising the discount rate, (effectively raising interest rates), what will that do to the Federal Governments financial predicament?

That the Federal Government (FG) is running a big fat deficit is common knowledge. In order to run this deficit - which means it is spending more money than in receives in taxes from you and me, the FG has to borrow the money. It does this by selling bonds to the general public of the entire world. In order to convince people to buy the bonds, the FG must offer an attractive interest rate. As anybody who has ever had a credit card, car loan, or mortgage knows, the interest rate you pay to borrow the money can make a big difference in a) your monthly payments and b) how much you actually end up paying for whatever it is you are buying. For example, if you have an equity loan of $100,000 at 2% interest (simple, per annum) you will pay $2,000 per year in interest (assuming you pay back no principle). This would work out to about $167 per month. If the interest rate in the second year rose to 4%, you would pay  $4,000 per year in interest or about $333 per month, at 6% $6,000/year or $500 per month. The point being that a nice manageable $167 at 2% starts to look uglier and uglier as interest rates rise.

I put together the following chart to see what our FG's credit card statements look like these days, and how they compare to prior years:

What I found is that annual federal interest payments to debt holders have declined by roughly half since 1993 - which can be attributed to the steady drop in interest rates over the same period. In fact, annual interest on the debt in 2009 was roughly the same as it was in 1999, despite our total debt having more than doubled. Since then, we have tacked on lots more so that we now have 3 times the amount of debt than we did in 1999.

So, back to the Fed mopping up all of that excess liquidity via increasing the interest rate. What is going to happen when the interest rate rises substantially, which it must for mopping purposes, to the amount the FG has to pay every month/year in interest to all of those bond holders? What will happen to all of those programs when annual interest payments triple so that we are paying 30, 40, 50% of all of our tax revenues just to meet the interest payments on our debt?  And don't forget that Social Security is now running a deficit and the Federal Government is paying some of that out of pocket (because that famous trust fund is full of federal debt- cute, dontcha think?)

So, although the Federal Reserve is supposed to be independent of the politicians, if they go a mopping, they  just might drive the FG into bankruptcy. So the question is, how likely is it that the Fed is willing to bring down the FG to save the economy from the inevitable inflationary effects of loose money? What will they do? Enquiring minds want to know...


PS. I am looking into the composition of our debt and trying to come up with some sort of model to play with to see how short-term/long-term debt w various interest rate assumptions affects things. If I come up with something reasonable, I'll post it.... but don't hold your breath.

PPS. I just read a Stanford study on the state of the California public employee pension funds which points out that those pensions are underfunded and underreported to the tune of $200 Billion. That's right, folks, $200 Billion dollarinos in the hole. We are currently fighting over how to plug a $20 Billion deficit which is really kind of funny when you think about it, and makes me wonder whether the governor is planning on selling our kidneys to rich Arabs and Chinese - I hear you can get as much as $40K for a kidney?

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