12/30/2010 04:37 pm ET Updated May 25, 2011

The Ticking Bomb No One Hears: Exploding Interest on the Debt

You've heard it already -- the government spends too much; we run up huge deficits; and finance it on the backs of future generations. We owe China the mother-load. We're in deep and we don't seem to be able to stimulate our way out of it. Yada. Yada. Yada.

Despite these scary facts, most of us don't believe that the U.S. could "really" wind up on the skids, like Greece or Ireland. That would be like...really, really bad. Catastrophic. As opposed to just, say, lousy.

But ladies and gentlemen, the truth is that the cliff could be right in front of us.

Every month most of us gasp at the interest charge on our credit cards (still in the double digits --thieves!). Ever wonder how much the U.S. government pays for its debt?

In 1995, when we first began writing The Annual Report of the USA, the interest on the debt comprised nearly 15% of the federal budget. Today it comprises a measly 5%. That's still a big number nominally -- more than the federal government spends on education -- but relative to the past, it's pretty darn small. Why?

Back in 1995, the prime rate was over 9%. Today, it's 3.25% -- a 30-year low. The blended rate the federal government pays for its debt is just over 2%. That's a lot better rate than you get on your credit card, right?

That low cost of debt means that we've been able to borrow a cool $3 trillion over the last two years with a net benefit to our federal budget. Wait, what? That's right, our net interest costs dropped from $253 billion in 2008 to $197 billion in 2010 -- even though we borrowed a whole lot more.

So you really can date Jennifer Aniston and Angelina Jolie at the same time? Not so fast. Interest rates don't decrease forever. Our current interest rates are almost 2% below our 40-year historical average. And if that rate increases --just to historical averages -- we are in deep trouble.

In the Congressional Budget Office's most recent projections, "the cumulative deficit from 2011 through 2020 will exceeds $6.2 trillion. Borrowing to finance that deficit -- in combination with an expected rise in interest rates -- would lead to a fourfold increase in net interest payments over the next 10 years, from $197 billion in 2010 to $778 billion in 2020. As a percentage of GDP, net interest outlays would more than double during that period, rising from 1.4 percent to 3.4 percent."

$778 billion, huh? That's more than our entire military budget today. And that's just with a moderate increase in interest rates.

What if the interest rate went even higher? What if inflation got away from us? What if China didn't want to buy our debt anymore? What if there were a global capital squeeze, as many economists are predicting. In short, what if the global markets forced up interest rates - Fed be damned. Then what?

In one scenario, all our federal revenue would be required just to fund the interest on the debt alone-- with nothing left to spend on the military, or build roads, or send out Social Security checks. Say dramatically: Catastrophic.

Could we look to increasing tax revenue to fill the gap? Not likely. Tax revenues have been stagnant over the last half-decade and those who could pay the most -- the top 10% -- could likely seek tax havens abroad.

The Congressional Budget office warns that a rise in interest rates -- not government spending or tax cuts -- will drive the deficits of the future. And that's dangerous because we will have unleashed a monster we can neither control nor predict: Bernanke is not Oz and the Fed does not rule the interest rates of the world.

So what then? Here's the scenario: Higher interest rates caused by an exogenous factor (like global capital demand) means that the U.S. would have to pay more for its debt, which means we'd have to raise more debt by increasing the interest rates to entice new investment. Or we could do some more Quantitative Easing -- printing new money -- and inflate our way out of the problem. You see where this goes.

Either way, the existence of our debt pushes domestic interest rates even higher. That means citizens have harder times finding mortgages; credit cards are more expensive; and there is less capital to start new ventures and fund businesses. All of this is bad for the economy, bad for employment and likely results in a weaker dollar and lower asset values -- to say nothing of the risk of actually defaulting on our debt.

This scenario seems unavoidable unless we rapidly begin to cut government spending and increase tax revenue. Could we actually do it? We may not have a choice.

As we begin this New Year, we citizens need to demand -- like there's no tomorrow -- immediate action from the incoming Congress. And as investors, we must begin storing up our nuts. It could be a very long winter.

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