Interest Burden Is More Important Than Total Debt

Who has a bigger debt?

Total Debt Outstanding Interest Rate Monthly Payments
Barry $100k 2% $370
Ronny $40k 11% $381

Both Barry and Ronny have the same incomes and both expect to pay off their debt in 30 years at the monthly payment rate. Who would you rather be?  In this scenario, Barry has a lower real debt burden because he has lower monthly payments.  Every single month for 30 years  Barry is better off.  This is how lower interest rates literally make borrowers wealthier. Ronny could borrow twice as much money and still have a lower real debt if his interest rate dropped from 11% to 2%.  This is also why people spend more money on houses when interest rates drop.  Borrowers become wealthier because they can borrow more, so they buy bigger houses.  The only scenario where Ronny’s debt burden is smaller than Barry’s is if they pay off their debts early.  That would reduce the benefit of low interest rates, but few people pay off their debts early.

For example, the US federal government rarely pays off any of its principle debt at all.   It usually just pays the interest and borrows more principle.  Again, the interest rate is a crucial part of the real debt burden.  Here is a similar example for public debt:

Debt
Outstanding
Interest Rate
(10-year treasury)
Annual Interest Payments
(% of GDP)
Obama (Feb 2013 – Beginning of second term)   100% of GDP   2% 1.3%
Reagan (Feb 1985 – Beginning of second term)   40% of GDP  11% 3%

This example only includes interest payments rather than amortizing the principle in the payments too, but the same principle applies as in the first table. In the most important way, the real debt burden was lower at the beginning of Obama’s second term in 2013 than it was at the beginning of Reagan’s second term in 1985.   The real burden of a debt is the amount of income that must be sacrificed to pay for debt service which is the blue line in the graph below.

fed debt

Most people look at the green line as the measure of debt burden, but the blue line is just as important if not more so.  Dean Baker says that the blue line (interest payment) is a better measure of our government debt burden than the green line (total amount of debt).  Note that when he was writing, the interest rate was expected to rise but it hasn’t so far.  And what would happen if interest rates did rise?  Baker has a good answer for that too:

Suppose we issue $4 trillion in 30-year bonds in 2012 at 2.75 percent interest (roughly the going yield). Suppose the economy recovers, as CBO predicts, and the interest rate is up around 6.0 percent in 4-5 years. The federal government would be able to buy back the $4 trillion in bonds it had issued for roughly $2 trillion, immediately eliminating $2 trillion of its debt. This will make those who fixate on the debt hysterically happy, but will not affect the government’s finances in the least. It will still face the same interest obligation.

I am not as sanguine as Baker about rising interest rates, because the government would eventually have to refinance its debt at higher interest rates.  But Baker is certainly correct that interest rates have no impact on outstanding debt that has already been sold to the public.  Only new debt (and rolled-over debt when it must pay back old bonds and sell new ones) will face a higher interest burden.  That would still be a problem in the future if interest rates rise because the government almost always runs a deficit and it rolls over a lot of old debt.   In fact the CBO has been projecting that the deficit will rise in the future (almost) solely due to the CBO’s projections that interest rates will rise.   But the CBO is only guessing about future interest rates and so far it has been overly pessimistic for several years.  Nobody can really predict future interest rates.

Anyhow, higher interest rates could be a good thing, depending on what causes them.  Interest rates would rise due to a rapidly growing economy which would raise government revenues and help the government pay off the debt.  The bad thing that could raise interest rates is a fear that the US government is going to default or otherwise renege on its debts (like in Greece), but I’m not worried about that because the markets are clearly signalling a strong faith in US government debt.  That is why government interest rates have been at historic lows.  And that is why interest payments are so low despite high total debts.

govt interest ratesI won’t start worrying about US government debt until interest payments start rising (as a percent of GDP) and/or until interest rates rise which could cause more trouble in the long run when the government refinances its debt at higher interest rates.  Fortunately, the doomsayers have been wrong about both since the Great Recession of 2008.  So far so good.

 

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Posted in Macro, Public Finance

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