By John Weeks

The spend-thrift government bird and the public camel?
(Thanks to Google free images.)

In the previous 99%’er I explained why we should have no fear of the public debt, first because our government owns about forty percent of its own debt, and second because a substantial portion of the debt is an asset that finances retirement programs (the Social Security Fund alone holds 25 percent of the federal debt).

For many people my explanation may be the proverbial H2O cascading down the dorsal side of an aquatic fowl. Readers and the interviewer in a recent RNN video with me raised the following objections. First, the debt represents a growing burden on future generations. Second, and coming off statistics showing that interest payments are low and falling, might these balloon as a result of jittery speculators driving up government borrowing rates (think Greece, Portugal, Spain, etc)?

As anyone with a mortgage knows, the burden of a debt is the interest payment. The same holds for governments, and the chart below shows interest payments per person in the United States, 1960-2012. The thinnest line reports annual per person payments with no adjustment for inflation – actual payments. These hit their peak in the mid-1990s at about $900 a head, and fell to just over $700 in 2012. This does not correctly measure the cost of borrowing over time, because it ignores inflation. In 2012 prices, debt service in 2012 was more than $500 below than in 1996 (when our economy was booming).

Even the inflation adjusted interest cost overstates the burden of the debt. As I wrote at the start, part of the federal debt is owned by federal government agencies. The interest on this part of the total debt costs the taxpayer nothing. This part of the interest is a loop, from one government pocket to another. An easy way to think about it is that the interest the government must pay to itself could be used to pay that same interest.

When we omit the non-burdensome debt that the government itself owns, interest payments per person fall to slightly over $500. While higher than in the early 2000s, this $500 is lower than every year during 1981-2001. Indeed, the present interest payments, even adjusted for inflation, are more than $300 less than during the years of the Clinton presidency when the economy grew rapidly.

Federal Government debt service per person, 1960-2012

Source: Economic Report of the President 2012.

“So what?”, the debt skeptics say. With the debt as large as it is, and growing larger as deficits continue, any day now “financial markets” could lose faith in federal government solvency and interest rates would shoot up. When that happens the cost of the debt, small now, will be unsustainable.

Well, actually, no. We face no danger that an increase in interest rates will take us the way of Greece and the other debt-disaster countries of Europe. The probability is not just small, it is zero. To see this, we need to know a bit of basics about US federal government borrowing. First, and as many have pointed out, US bonds serve as the safest of “safe havens”. When speculators abandon the bonds of other countries, forcing those governments to raise their borrowing rates, the self-same speculators buy US bonds. To put it simply, bad economic conditions in other countries result in lower cost of borrowing in the United States.

But what if the US economy really “went south” while Europe recovered? Wouldn’t that push up our interest rates? Or, what if speculators abandoned US bonds and stuffed their money into the proverbial mattress? Disaster? No. The nature of federal bonds prevents large increases in debt service in a short time period. The US government issues fixed rate bonds. This means that if our government borrows at an interest rate of 0.75 percent, the current rate for three year Treasury bonds, the interest rate on those bonds remains the same no matter what happens to rates subsequently. At present the average “maturity” of the federal debt held in the private sector is five years (when they must be repaid). Almost all of that debt carries an interest rate higher than current rates. This means more current borrowing brings down the interest rate on the whole debt.

Put these two facts together, fixed rate bonds and an average maturity of five years, and the result is the next chart. The thicker line shows the average interest rate on the total federal debt – the interest paid divided by the value of the debt. The thinner line shows that average interest rate for the bonds sold in each year. The message comes out clearly – short term changes in the interest rate on bonds have a very small effect on total interest payments. In 1981, the interest rate on 3 month bonds, the speculator’s favorite, hit 14 percent. The average interest rate on the total debt reached its peak eight years later, at 3.2%.

Against all probability, if tomorrow the 3 month bond rate again went to 14 percent, we would not feel the impact for several years. Bond speculation caused such havoc in Europe because the average maturity of the public debts was and is quite short. To a great extent these short maturities resulted from governments taking on the debt of bankrupt companies in the private sector. In other words, the speculative runs on euro debt resulted from feckless borrowing by the private sector. But that is a story for another day.

Interest rate on new federal short term debt and the actual interest rate

on the total debt, 1960-2012

And, there is a yet another reason why interest rates will not shoot up due to speculation. This has to do with the primary function of Treasury bonds, to regulate private sector interest rates. The Federal Reserve System, the US “central bank”, changes the interest rate on short period federal bonds with the purpose of reducing or increasing credit and, therefore, investment, in the private sector. When, as for the last four years, the “Fed” seeks to encourage private lending, it lowers the interest rate on public bonds. Since banks borrow from the Fed, the lower bond rate should bring down the private lending rate.

The chart below shows this interaction of public and private interest rates. A bit of simple statistical testing shows that the corporate bond rate follows the government bond rate, not vice-versa, and the same holds for municipal bonds, which are quite important in pension funds. But what if speculators refused to purchase US bonds at the rate offered by the Fed? No problem, because the Fed could sell the bonds to the government itself.

Interest rates, daily trading averages, 1960-2011

All of this tedious discussion of bonds and debt takes us to a simple conclusion – the “debt burden” is not very burdensome and the likelihood of that changing is very small. This conclusion requires no esoteric economic analysis. It comes from the characteristics of bonds and debt:

1. interest payments per person are moving towards their lowest level in decades;

2. increases in interest rates have very little short term effect on debt payment (because US bonds are fixed rate); and

3. an agency of the US government, the Federal Reserve System, sets private sector interest rates, not the reverse.

John Weeks

John Weeks is Professor Emeritus and Senior Researcher at the Centre for Development Policy and Research, and Research on Money and Finance Group at the School of Oriental & African Studies at the University of London.