In the wake of the financial crisis and recession, Moody's Investors Service has brought new transparency to its sovereign ratings analysis — so much so that 2018 lights up as the year the U.S. could be in line for a downgrade if Congressional Budget Office projections hold.
The key data point in Moody's view is the size of federal interest payments on the public debt as a percentage of tax revenue. For the U.S., debt service of 18%-20% of federal revenue is the outer limit of AAA-territory, Moody's managing director Pierre Cailleteau confirmed in an e-mail.
Under the Obama budget, interest would top 18% of revenue in 2018 and 20% in 2020, CBO projects.
But under more adverse scenarios than the CBO considered, including higher interest rates, Moody's projects that debt service could hit 22.4% of revenue by 2013.
That's pretty staggering. Can you imagine living in a world where it's safer to lend money to Microsoft (or any other AAA rated corporation) than to the US government? That's an amazing thought. More to the point, can you imagine a world where the US government is forced to default on its debt? I can't imagine anything that would destroy the prestige and power of the US faster than being humiliated by the Chinese government after approaching them to renegotiate a trillion dollars in debt.
Even setting aside the risk of a credit downgrade, the United States can expect to spend more and more of its tax revenues on interest on the debt. Over the last year, the Federal Government spent about 187 billion dollars paying interest on the approximately 7.8 trillion dollars of the national debt that is held by the public, with "public" in this context meaning anyone who isn't the US government: individuals, China, banks, etc. (The usual figure for the national debt of 12.9 trillion includes money that the government owes to programs like Social Security and Medicare. As far as I can tell, this money doesn't have interest paid on it.) The overall interest rate for the government's debt right now works out to something like 3.2%, which is absurdly low. While 187 billion dollars is certainly a large amount of money, it's not too painfully large by government standards. After all, it only represents something like 13% of the federal deficit of 1.4 trillion dollars in 2009 and 8% of the total of 2.4 trillion dollars in revenue. If the cost of interest were to remain at these levels, we would be ok.
Of course, the amount that the government spends on interest won't remain anywhere near 200 billion dollars a year, for two reasons. First, the amount of publicly held debt has been skyrocketing. In 2009 alone, it increased a staggering 22%, from 6.4 trillion dollars to 7.8 trillion dollars. With another 1.3 trillion dollar deficit expected for 2011 and 10 trillion dollars in projected deficits for the next decade, this trend will only continue. If Congress doesn't slash spending now, we could quite possibly see the publicly held debt triple in size by 2020, and that's assuming the deficits don't turn out to be larger than is now projected.
On top of this, interest rates will have to go up. Indeed, despite the explosion in publicly held debt, interest payments actually declined by 65 billion dollars last year as interest rates plummeted. As I mentioned above, the government is now paying about 3.2 percent interest on its debt. As recently as September 2007 that rate was above 5%, and within the last decade it was above 6.5%, or more than twice what it is now. So over the next decade, and perhaps even over the next two years, we can expect to see interest rates increase by two thirds or even double.
The combination of these means that interest payments could quintuple to a billion dollars or more annually over the next decade. (The CBO figure of $700 billion is quite a bit lower than this, but history shows us that CBO estimates are consistently quite a bit lower than reality.) Either scenario would leave us in a place where interest payments represented at least 20% of government revenue. The government would lose its AAA credit rating, which would cause interest payments to grow even more. (A reduction from AAA to AA would probably increase the total amount of the interest payments by about 8%) All other forms of government spending would have to be cut drastically just to keep deficits at the same level they are at now.
Ultimately, some method for reducing the debt would need to be found. My guess is that when the time comes, we can expect high inflation. As painful as that inflation will be, politicians will opt for it rather than showing the courage necessary to cut government spending in a meaningful way through pursuing entitlement reform. If Obama and the Democrats don't get serious about deficit reduction now, it's going to be a rough decade.
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