How to Craft a Financial Blow Up

Last year around this time I had several posts on the U.S. budget, given the fiscal cliff battle. In Updated: ZeroHedge has a more pessimistic debt model, I looked at some assumptions from ZeroHedge against my own. I created a very simplistic static model, projecting GDP and debt growth at a fixed rate into the future, and then applied various interest rates. Long story short: unless there is significant growth or spending cuts in the economy, a rise in interest rates to 4-5% will trigger a major crisis.

Here's David Stockman on the latest budget deal.

Stockman raises an important political point in this video. The deal will last until the end of FY2015, which comes in the autumn of 2015, just as the presidential election season heats up. At that point, both parties will turn to electoral politics and put budget issues aside until after the 2016 election. The earliest the government will address fiscal issues is 2017 and the earliest the government can implement a policy is in the FY2018 budget, which takes effect in autumn 2017. The big issue that is being under reported is the gap between the public debt and the total debt. Here's the average interest rate on U.S. Treasury bonds in November 2013: 1.971%.
Here is the total marketable debt in November 2013: $11.8 trillion

To keep it simple, there is about $12 trillion in marketable securities (that trade in the market) and $5 trillion in intra agency debt, such as the Social Security trust fund. The average interest rate on Treasury debt has been fairly steady in 2013, multiplying the 1.97% rate by $12 trillion comes to $236 billion, which is very close to the $254 billion in interest payments currently estimated as of December 11.

The debt is headed towards $20 trillion in 2016. The non-marketable debt is still growing because it has an average interest rate of about 3.4% and that interest is being accrued. Those bonds are falling off and being replaced with lower interest debt. Due to rising disability payments, retiring Boomers and a weak economy, the SS trust fund is already moving into deficit. Taken together, sometime soon the non-marketable debt will begin to decline and start adding to the marketable debt totals. For the sake of simplicity, let's assume the bulk of the $3 trillion in debt to be added will be public. That will cause a 25% increase in interest payments ($3 trillion added to $12 trillion) holding interest rates steady. If interagency debt begins to turn into marketable debt, the cash costs to the U.S. government will increase even more.

U.S. Treasury debt is also heavily tilted towards short term debt. When interest rise or fall, the average interest rates on Treasury debt respond quickly. Were interest rates to move towards 3% over the next few years, cash costs on the debt could be on the order of 75%. This will cost the U.S. government $200 billion more per year. The budget cuts that came out of sequestration, some of which are restored with the latest Ryan-Murray budget deal, only totaled about $140 billion per year over 8 years.

Even ignoring the impact of the Affordable Care Act, plus the propensity of politicians to increase spending, the U.S. budget picture is already bleak. The budget deal that restores some cuts will only make the situation worst for the next president in 2017. He or she will have to decide whether they want to get a handle on spending and suffer a big loss in the 2018 mid-term elections, or whether they will roll the dice and risk a financial catastrophe, since their term may end with debt up around $25 trillion based on current trends.

No comments:

Post a Comment