Building on my post from last week about the cost of our debt, I have made this chart showing the changes that will occur when the Congressional Budget Office’s interest-rate assumptions are modified to reflect historical interest rates and private-sector forecasts.
Using data from the CBO’s “January 2011 Budget and Economic Outlook” and “Analysis of the Effects of Three Interest Rate Scenarios on the Federal Budget Deficit,” the above chart compares CBO baseline interest costs between 2011 and 2021 with interest costs under each of three interest-rate scenarios: 1) a scenario similar to that experienced in the 1980s; 2) a scenario similar to that experienced in the 1990s; and 3) a scenario consistent with the ten highest projections found in Blue Chip Economic Indicators. Under each of these scenarios, the cost of servicing our debt exceeds the costs projected in the CBO baseline.
This suggests that CBO baseline projections, which already show an explosion in the cost of servicing our debt, may in fact be an underestimate.
For instance, if interest rates were modified to reflect the average rates in the 1980s — a time in U.S. history when interest rates were driven up by inflation and economic uncertainty — in 2021 our interest payments would nearly triple from CBO’s projection of $749 billion to $2.0 trillion. Accumulated interest payments over this period would double from their current projected level of $5.7 trillion to $11.0 trillion. Needless to say, the impact of these increased interest costs on the deficit would be huge.
But why would interest rates increase beyond what the CBO has projected? It’s simple. A growing debt sends signals to our investors that the risk we represent is growing, too. It has consequences. What happens when you max out all your credit cards and you don’t have enough money coming in to pay your bills? One thing you do is you get another credit card and you roll over the balance. But how long before you represent such a liability that no one will give you another credit card? How long before your interest rate goes from 12 percent to 30 percent in order to get that card?
That is precisely the game the U.S. is playing right now. We are constantly rolling over short-term debt. When our lenders wise up, they are likely to increase interest rates to reflect the risk that we’ve become.
This fuels another concern: inflation. To get deficits under control, the federal government could cut spending or increase taxes (or both). Neither of these policies are popular, hence the temptation to resort to printing money (or “monetizing the debt”) to pay its bills.
However, there is no free lunch. The resulting inflation reduces the value of each one of your dollars and also introduces high levels of uncertainty. Obviously, the Federal Reserve is unwilling to take such a dramatic step today. However, investors know that other central banks have done this in the past and it could happen again, so, in exchange for extending more loans to the federal government (which has become a riskier client), lenders could soon be asking for a higher interest rate — an inflation premium.
The only way to address the increasing costs of our debt is to address the driving forces behind it — legislated explosions in Social Security, Medicare, and Medicaid spending.
I am all for entitlement reform, but the populist abuse of accounting has spread so widely on the right these days, and is being used for such alarmist doom mongering purposes, that it is necessary to correct its excesses.
I will start with the typical claim of $60 trillion in unfunded liabilities for entitlements. The assumptions behind these calculated present value figures are practically never stated. You have to run down the fine print in appendices to GAO or OMB monographs to find them, and once you do, they show all the scaremongering headline figures to be ridiculously misleading.
The discount rates used to arrive at those present values are typically 5 to 6%. In a typical GAO study I just read the long run discount rate used for 5.7% for example. The same study assumed GDP and inflation rates that amounted to a 5% nominal economic growth forecast.
Now, it is necessary to pay attention to the most widely abused fact in present value accounting - as the rate of discount applied to any growing stream of cash flows approaches the rate of growth of those cash flows, the present value resulting rises to infinity. Strictly, whenever the growth rate exceeds the discount rate all the present values are "infinity" because the series of flows formally diverges - terms infinitely far in the future matter as much as present ones, and there are an infinite number of future terms.
When the rate of discount is barely under the rate of growth, the present value is finite by can be made arbitrarily large by nudging the two rates closer together. A 5% growth stream discounted at 5.7% is the same as the current rate discounted at 0.7%, and it is worth 1/.007 = 142.8 times the current amount. The present value of the income stream that is the US economy, $14.3 trillion this year, if estimated to grow 5% a year and discounted at 5.7%, is thus 142.3* $14.3 trillion or $2.04 quadrillion dollars. A $60 trillion "unfunded liability" is a trivial 3% of that present value. Then again, the value of current household assets, ignoring all debts used to carry them, is only 3.5% of that figure, because that figure is basically as close to infinity as anyone cares to make it. Nudge the discount rate down to 5.1%, as I've seen in another such study, and the present value of the series is 1/.001 = 1000 times is current rate or 14.3 quadrillion, 7 times higher. For only a 0.6% change in the discount rate applied.
Basically, all present values calculated from rates of discount so low they are close to the rates of broad economic growth are completely meaningless. Because on those assumptions we are talking about a present value of the US economy that is "infinity".
The right way to report such figures is as a portion of the total economy, either in future years or in present value terms. Thus the $60 trillion figure that uses assumptions that imply a $2 quadrillion present value for the US economy, but suppresses the latter figure by simply never mentioning it, should instead be reported as "the present value of unfunded entitlement liabilities is 3% of the total economy". But this doesn't sound dramatic enough, so it is not reported that way.
Similarly, I've seen medicare projections that assume health care costs will rise 7% a year forever then assume investments will return 3.5% a year because that is the rate on 10 year treasuries this instant. Um, those two assumptions together imply that every investment in providing health care services of any kind will be worth infinity. The two assumptions are strictly incompatible in the long run. Momentarily, medical costs can rise faster than one interest rate - but the rate of return on invested capital as a whole cannot stay below that supposedly available in the health care sector forever. All capital will go into health care. The average rate of return on capital will rise or the rate of health care inflation will fall through diminishing returns or both.
Actually neither need happen, the assumptions are just accounting nonsense.
Similarly with studies of debt costs like this. The reality is, at present the country can borrow at average rates around 2% and pretending this is ruinous when the economy will surely grow 5-6% a year nominal is pretending. Yes eventually rates will rise and with it debt service. So will overall income.
The question always with debt financing is whether what you invest it in covers the cost of the debt - and never whether that cost of debt is greater than zero (it always is). Debt as such is neither good nor bad. The critical question is always dodged, what are we getting for it?
If the answer is wasteful boondoggles and give aways for present consumption to buy congress critters re-election, then it is a bad deal at 2%. If the answer is real capital invested by American business at 10% return on assets and upward then it is a good deal even at 6%.
Why can't we find economically literate conservatives to discuss these things fairly, instead of all this one entry accounting, populist, "debt will kill us all" doom?
Reply to this commentLinkReport AbuseHow is this for an economically literate conservative vs. and obvious lefty classroom jockey as opposed to the real world experience.
First of all, your $14.3 trillion GDP has a serious flaw in it. $6.7 trillion of that is simply government spending, not private sector, and that portion is growing annually. It accounts for 46% of the total GDP this year, and will be much higher in dollar and percentage next year, and each year thereafter at current trends.
Secondly, that leaves $7.6 trillion in private sector GDP or 54%, and that portion is growing at a much slower rate than government spending.
Government spending includes all levels of government, not just Federal, as all are counted in our GDP. The reason our GDP has grown as it has is not due to private sector growth, but government growth. To fund this government growth they always want to tax more, which in turn removes yet more private sector economy, rinse repeat.
What assets are we getting for this growing government? Grabbing of my junk or 4,500 scanners? We are not getting anything of value back, it is all going towards interest on the debt or repayment of Social Security now that it no longer takes in more than it pays out, or the huge waste pile of programs that begin and never end.
Debt will kill us, because our government is robbing Peter to pay Paul, and it doesn't matter what your logic is when you think the private sector economy is a GDP of 5-6% growth, when in reality it is currently 54% of that figure and falling, and you are not even adding in the government growth as a factor lol.
Genius... the entire country as a whole has $72 trillion in total assets, our debt situation when put on a super computer discloses that by 2037 there is no possible solution in any reality to forgo total economic collapse, so much for the discount rate.
Reply to this commentLinkReport AbuseOh, I also did not mention that PResident Obama has buried so much debt into the Treasury that is unknown it is sickening. Rather than let Fannie and Freddie fail, all that debt which is still unknown the total will add to the government debt since it was bailed out and now each of us is on the hook for it, and GM if they fail to hit $53 a share, we eat the loss at which point we sell. These little surprise debts are not even added into our debt figures yet as they are bubbles waiting to happen, GM might reach $200 yay, or it might fall below its IPO (already has), or it might go belly up and we eat the whole loss.
You also fail to address the issue that for every $1 our government spends .40 cents of it is borrowed. How does that make any sense or fit into your discount rate? Seems to me eventually the lenders say "No mas". Japan was the #2 holder of our debt, wonder what they plan to do with it now?
I'm a fan of Ben Franklin, "Never a borrower or a lender be." Balanced budgets, live well below your means, then I can ignore people like you, but I can't help being born in a country so in love with debt that it will ruin all of our lives much sooner than you would ever understand.
Reply to this commentLinkReport AbuseSo will the Dems try to "hide the incline?"
Reply to this commentLinkReport AbuseComplete nonsense. First, government expenditure lastest report all levels is $5.36 trillion, total GDP which definitely includes that since it is actually paid for is $14.86 trillion same reporting period, making government 36% of GDP not 46%. Second, no GDP growth is not just the growth of government. Non-government GDP is 33% higher now than in 2000, 2.43 times what it was in 1990, 4.7 times what it was in 1980. Real economic growth is the reality and always has been. It is why we are not a society of 3 million backwater farmers.
What most of that government expenditure is, of course, is transfer payments and middle class entitlements being paid to retirees, and education services being provided to children. You can argue inefficiently and I'd agree, but pretending it is buying nothing is again pretending. Money taxed from producers and given to retirees and spent by them on consumption is definitely part of the real economy, just as rents paid to landlords and spent by them on consumption are, or profits of companies paid out to owners as dividends and spent by them on consumption, all are.
For the rest, you simply have no idea what the term "discount rate" even means, hence the endless red herrings. It is simply the way future cash flows are translated to present value terms, given the real time preferences of individuals and the real possibilities for value production through the use of capital. A dollar earned 10 years from now is not worth as much as a dollar earned today because the dollar earned today includes 10 years of its profitable use.
The income of the entire country is $14.86 trillion this year and will be 5-6% higher than that, nominal, next year, and again higher the year after that, and so on. The rate may vary from year to year but it will average out to that rate of increase. In fact the past rate of increase has averaged more like 7% but we are being conservative about the future projection. The real budget constraint faced by the country as a whole and all its citizens is the present value of that entire income stream - not the value of current capital assets, nor the present year's income alone.
Discounted at 10% - a businesslike rate that major corporations routinely achieve on their capital investments in productive processes - a stream of cash flows starting at $14.86 trillion and rising 5-6% a year is worth 20-25 times the initial flow, or $300-370 trillion dollars. That is the approximate real budget constraint we face - not "federal" budget, not "government" budget, not "right now", I mean the present value of everything we can afford to consume.
Note that the current value of investable capital assets in the US is significantly less than that sum. This is to be expected, because most of that income will not fall to owners of capital as their income share; most will be earned as wages and spent on consumption, without ever appearing as capital (or only briefly, in short term forms, etc).
Being able to do the math that tells us we are a profoundly rich society and in no way even close to being broke or facing any kind of collapse, economic or financial, does not mean defending high government spending or running budget decifits. It does mean being "accounting literate" enough to recognize ignorant doom mongering as utter nonsense. Americans are not paupers and they aren't going to be, in this generation or in the next. Yes we should get our fiscal house in order and trim the growth of entitlements, which frankly aren't efficient to begin with, but they aren't going to "bankrupt" us, any more than a man who decides his left pocket owes his right pocket a million dollars is broke.
Reply to this commentLinkReport Abuse"The income of the entire country is $14.86 trillion this year and will be 5-6% higher than that, nominal, next year, and again higher the year after that, and so on. The rate may vary from year to year but it will average out to that rate of increase. In fact the past rate of increase has averaged more like 7% but we are being conservative about the future projection" - More nonsence from JasonC
U.S. real GDP growth has averaged 3.3 percent since 1947
Reply to this commentLinkReport AbuseExternal Link