Rising Rates Reveal Debt Reality

01/03/2011 10:14 am ET | Updated May 25, 2011

The Fed's lucky streak of deceiving bond investors with low interest rates may be drawing to a close. Nevertheless, the extended period of low borrowing costs has bred a new breed of bulls - not even bulls, more like ostriches - which bury their heads in the sand of declining debt service ratios so they don't have to face intractable levels of US government debt and the potential for an interest rate surge. If these ostriches were to actually look at the numbers, they would realize that the US is simply living on borrowed time.
The government of the United States is the holder of the world's reserve currency and, as such, has enjoyed the benefits of low interest rates despite its inflationary practices. The recycling of our trade deficit has hidden what would otherwise be much higher borrowing costs and a much lower purchasing power for the dollar. That condition has prompted pundits like Paul Krugman to claim, "...many economists, myself included, warned from the beginning that the plan [Obama's stimulus program] was grossly inadequate. Put it this way: A policy under which government employment actually fell, under which government spending on goods and services grew more slowly than during the Bush years hardly constitutes a test of Keynesian economics." Mr. Krugman (a Nobel Prize winner in economics) actually laments that government spending and debt accumulation isn't growing fast enough!
Not to be outdone, Brian Wesbury of First Trust Advisors claimed during my debate with him on CNBC's The Kudlow Report last week that our $9.3 trillion national debt is of little consequence because our GDP is a far greater number. However, that $14.7 trillion of gross domestic product only yields about $2.2 trillion in revenue for the Treasury. For him to claim that we have access to the entirety of present US GDP, he must assume we can raise all tax brackets to 100% and not experience any reduction in output or decrease in revenue. This is, of course, preposterous. As was demonstrated in the 1970s, even small increases in marginal tax rates have a substantial negative impact on output. This is the theory behind the famed Laffer Curve. Therefore, it would be more realistic to focus on the fact that our publicly traded debt is now 422% of our annual revenue! Wesbury also claimed that the government would never default on our debt because the Fed could always inflate it away--which, by the way, is still a form of default.
So Krugman would have you believe that our debt isn't growing fast enough. And Wesbury wants you to believe that we can either; dramatically raise taxes, auction off the country's assets, or print away our troubles in a sea of greenbacks.
Unfortunately, a low debt service ratio has only masked what would otherwise be an unmitigated catastrophe for the consumer and the federal government. So, I present the facts and the math that accurately describe the gravity of the situation. First, we'll look at the numbers behind this so-called "deleveraging consumer," and then we will look at the debt of the nation.
The data point most utilized by those who espouse the idea of a healthy consumer is the household debt service ratio (DSR). The DSR is an estimate put out by the Federal Reserve of the ratio of debt payments to disposable personal income. It was 11.2% in 1980; it peaked at 13.96% in the third quarter of 2007; it is now at 11.89%. There you have it... no problems here, Krugman has been exonerated. But wait! When viewing nominal levels of debt, one can clearly see how artificially low interest rates have simply masked reality. In 1980, total household debt was just $1.39 trillion; it peaked at $13.92 trillion in Q1 2008; it is now - drum roll please - still an unbelievable $13.42 trillion. How's that for deleveraging‽ If you express that debt level as a percentage of GDP, the conclusion is still the same. In 1980, it was 47.8%; it peaked at 97.9% in Q1 2009; it is now 91%. Hence, we haven't really delevered at all, it's just that our interest rates have plunged.
When looking at the nation's debt, the situation is even more baneful. At the end of 2006, total debt held by the public was $4.9 trillion. According to the Department of the Treasury, the average interest rate paid on that debt was 4.9%. Therefore, the annualized interest payment at that time was $240 billion. At the end of 2010, our publicly traded debt has increased to $9.3 trillion and the average interest rate on that debt has plummeted to just 2.3%. So, despite an over 87% increase in debt in just a 4-year time span, the annualized debt service payment actually fell to only $213 billion. Today, the average maturity on our debt is just about 5.5 years. Compare that with the UK's gilts, which average about 14 years, or even to Greece's bonds, which average about 8 years. Falling interest rates and reduced durations have merely given the illusion of solvency to the US as compared to these other ailing sovereigns.
And the future looks even dimmer. By 2015, our publicly traded debt should be at least $15 trillion. Even if interest rates simply revert to their average level - not a stretch, given surging commodity prices and endless Fed money printing - the debt service expense could easily reach over $1 trillion, or about 50% of all federal revenue collected today. However, just imagine what would happen if rates were to rise to the level of Greece, nearly 12% on a 10-year note, as opposed to our current 10-year yield of just 3.5%. This would wreak complete and utter fiscal devastation. Don't forget: as interest rates rise, GDP growth slows and thus sends the debt-to-GDP ratio even higher.
It wasn't the nominal level of debt that suddenly sent euroland into insolvency, but rather a spike in debt service payments. Right now, the US national debt is the biggest subprime ARM of all time. Much like homeowners who thought they could afford a mortgage that was 10 times their annual income; economists like Krugman and Wesbury are blinded by deceptively low current rates of interest. These ostriches won't poke their heads up to see the writing on the wall: low rates and rising inflation cannot coexist for long. As rates continue to rise, the reality of US insolvency will be revealed.

Michael Pento is the Senior Economist for Euro Pacific Capital