Digging a Deeper Hole

Bond traders took a case of the frights yesterday, driving up yields on 10-year Treasury notes and 30-year mortgages. Investors are scared, reports the Wall Street Journal, because the United States government is racking up such enormous quantities of debt.

The government will sell nearly $2 trillion in U.S. Treasury bonds this year to fund its stimulus programs, and investors worry there won't be enough demand for it. Slack demand would send bond prices down and push up the government's cost of raising money.

So, what does this mean to people who don't speculate in interest rate futures? For starters, it means that the interest rate on 30-year mortgages jumped from 5.03% to 5.29%, which will make real estate a bit more expensive to finance, thus depressing housing prices generally.

And what does it portend for the solvency of the U.S. government? What most people don't realize is that, as the world's largest debtor, Uncle Sam has benefited the last 20 years from steadily declining interest rates. Lower interest rates have made it easier to finance the staggering amount of debt the nation has added to its balance sheet. Conversely, higher interest rates will make the ever-escalating debt more difficult to manage.

Eighteen years ago (December 1990), the U.S. debt stood at $3.0 trillion. At the end of 2008, it had almost quadrupled, to $11.2 trillion. Yet interest payments on the national debt had less than doubled, from about $265 billion in 1990 to $451 billion in 2008. How did that happen? In a word, a global surplus of capital cut interest rates in half. The table below compares the interest rates the U.S. paid across the so-called yield curve. (Click on image for a more legible version.)

As you can see, the 10-year and 30-year interest rates at close of business Tuesday (May 26) were less than half of what they were almost two decades ago. The short-term notes are a tiny fraction.

It doesn't take a Ph.D. in economics to forecast what would happen if interest rates rose again to the levels that prevailed only 18 years ago: The debt burden would double, adding an untouchable $450 billion a year in interest payments to the U.S. budget, year after year, forever.

Of course, long-term rates ticked up only one-quarter percent Wednesday. There's a long way before they get back to 8.0%. But significantly higher rates could await us as the governments of the largest economies of the world (not just the U.S., but all major economies) continue their borrowing binges, and as aging populations around the world begin drawing down their savings, thus diminishing the supply of capital instead of adding to it.